Islamic Banking Deposits and Profitability Relationship
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The purpose of this research study is to analyze the impact of Islamic Banking Deposits (Investment, Savings and Current accounts) on the profitability measure ROE of the Islamic banking industry in Paksitan. For this purpose, time series data of eleven quarters covering the period 2007 to 2009 is taken for the required variables from State Bank of Pakistan's quarterly editions of the 'Islamic banking bulletin'. The results showed that all the deposit variables had a significant positive relation with the profitability of Islamic banks. The aim is to contribute to the literature on deposit-profitability relationship of Islamic banks.
Islamic banking is a banking activity based on Islamic principles, which do not allow the paying and receiving of interest (riba') and promotes profit sharing in the conduct of banking business. (Ghazali, 2008). According to the latest quarterly edition of State Bank of Pakistan's Islamic Banking Bulletin?, the total Shariah-compliant assets worldwide have grown to about US$ 700 billion “ with annual growth exceeding 10.0 percent during the past decade and are projected to grow to US$ 1.6 trillion by 2012. State Bank of Pakistan's strategic plan for Islamic banking industry launched in 2008, aims to increase the size of the Islamic banking industry to 12.0 percent (of total banking assets) by 2012.
Islamic financial institutions do not only play a vital role in resource mobilization, resource allocation and employment but are also actively involved in the course of implementing government monetary policy. Apart from offering nearly all traditional banking facilities, Islamic banks also assist domestic and international trades. Seeing the potential of the Islamic market, western conventional-based financial institutions such as Citibank, JP Morgan, Deutsche Bank, ABN Amro and American Express have introduced interest-free products to customers. Similarly, multinational corporations such as General Motors, IBM and Dewoo Corporation have already begun to use interest-free services.(Haron and Azmi, 2003).
Studies that assess the influence of various factors that determine Islamic banks profitability are still at initial stage. Few attempts have up till now been made to empirically analyze the Islamic banks' performance. In the Islamic banking literature, the work of Haron (1996a) was the first attempt to examine factors that contributed towards Islamic banks' profitability. Most of the research used multiple regression analysis technique in measuring the relationship among the determining factors and profitability ratios.
Extending the previous work in Islamic banks' performance, this paper examines the strength of relationship between deposit variables and profitability of Islamic banks using univariate regression methodology. By studying the association between Islamic banks'Ÿ performance and the deposit variables, this paper contributes to the on-going discussion on the deposits and profitability relationship of Islamic banks.
The paper is divided into seven sections. The literature review on determinants of Islamic bank performance is highlighted in Section 2. Section 3 examines the methodology used in analyzing the relationship between the deposits variables used in this study and the performance of Islamic banks. Section 4 presents the discussion and implication. The references are listed in section 5. The tables are listed in section 6 and figures in section 7.
The whole foundation of Islamic Finance is that the two sides of the equation (i.e. the fund-providers and the fund-users) work in agreement as partners, without depositors being assured of any return from those who use their money. In practice, Islamic banks draw approximately three-quarters of the capital from their depositors, and do not guarantee any precise level of return to these fund-providers. (Shubber and Alzafri,2008).
Ghafoor (1995) states that all Islamic banks have three kinds of deposit accounts: current, savings and investment. Current or demand deposit accounts are almost the same as in all conventional banks. Deposit is assured. Savings deposit accounts function in different ways. In some banks, the depositors permit the banks to make use of their money but they attain a guarantee of being paid the complete amount back from the bank. Banks adopt a number of methods of inducing their customers to deposit with them, but profit is not promised. In others, savings accounts are treated as investment accounts but with less strict conditions as to withdrawals and minimum balance. Capital is not assured but the banks take care to invest capital from such accounts in fairly risk-free short-term projects. Therefore, lower profit rates are expected and that too only on a section of the average minimum balance on the ground that a high level of reserve funds need to be kept at all times to meet up withdrawal demands. Contrastingly, Investment deposits are accepted for a predetermined or indefinite period of time and the investors consent in advance to share the profit (or loss) in an agreed proportion with the bank. Capital is not assured. (Ghafoor, 1995).
Some IFIs (Islamic Financial Institutions) classify deposits in terms of wadiah or amanah. Current accounts of IFIs are regarded as qard hasan or qard (alternatively, as wadiah/amanah). (Farooq, 2008). Qard al-Hasana is defined as deposits whose full repayment on demand is guaranteed by bank. (Ahmad, 1994). The deposits in the current account are regarded as if they are loans from the customers to the bank and therefore, bear no yield to the account holders.? (Al-Jarhi and Iqbal. 2001). Deposit accounts are neither a liability nor equity capital. They are a hybrid? source of capital, and must be acknowledged as such. Depositors are partners with the bank, but enjoy no ownership rights. (Shubber and Alzafri,2008).
Sudin Haron (1996) mentions that the law allows the banks to accept two types of deposits, i.e., qard al-hasanah deposits and term investment deposits. The qard al-hasanah deposits includes current as well as savings accounts which vary in their operational rules. (Ahmad, 1994). If it is allowed that the borrower can pay extra money voluntarily, then treating deposits as qard-hasan allows the banks as the borrowers to pay extra money to the depositors (lenders). Unlike savings account services at conventional banks, where depositors are automatically rewarded upon appointment of their funds, returns to savings account holders are reliant on the Shariah (Islamic laws) principles which are practiced by Islamic banks when offering this service. When wadiah (trusteeship) or qard hassan (benevolent loan) are used, the returns are entirely at the discretion of the banks. (Sudin Haron, 1996).
Nienhaus, (2004) argues that if the customers of Islamic banks desire a return on their funds, they should pay into investment accounts (also called 'participation accounts' or 'PLS', profit and loss sharing accounts). Whereas, credit balances on these accounts are not considered deposits in the conventional sense. The returns on Islamic banks' investment accounts are not fixed in advance; the customers participate by a certain proportion in the financial outcome of the utilization of their investment funds by the bank. These results could also result in a loss. In case of loss, the clients will have to bear a portion of the loss which would reduce the nominal value of the credit balances of their respective investment accounts. In such a situation, the clients cannot claim a full reimbursement of the money paid in. The full reimbursement, however, is constituent for a deposit in the strict sense. (Nienhaus, 2004).
Rosly and Zaini, (2008) say that the public in general put their money in banks for either fulfilling transactional needs or for investment needs. To suffice the transactional objective, Islamic banks offer services such as wadiah yad dhamanah deposit, which facilitates safekeeping of their deposit money with guarantee services. In this product, depositors no longer deposit funds to receive a fixed income. Instead, they place their deposits for protection.`Wadiah yad dhamanah' means safekeeping with guarantee. Wadiah yad dhamanah depositors permit the Islamic bank to invest their money in return for deposit safety that they got for free. Since the caretaker service is given without a fee, the Islamic bank holds no legal compulsion to pay depositors a predetermined return and may do so only on voluntary basis. In this way, the bank holds choice on profit distribution policy in the form of gift (hibah). The same is not correct for Islamic fixed deposits, frequently known as mudarabah investment deposits. In this partnership composition, no guarantee is given to capital protection and fixed income, as it runs under equity principle. It is a precarious product as the underlying contract is based on profit“loss sharing system. Profits are shared only in case of performing investments, while capital may depreciate or even shrink if the investment ends in losses. (Rosly and Zaini, 2008).
Haron and Azmi, (2004) discuss that similar to conventional banks, Islamic banks also rely on depositors' money as a key source of fund. Bank Muamalat Malaysia Berhad for example, had total deposits amounting to 94 percent of total liabilities and shareholders' equity at the end of December 2003. While in the case of Jordan Islamic Bank, Islamic Bank of Bangladesh, Bank Muamalat of Indonesia, and Bank Shariah Mandiri of Indonesia, the corresponding amounts were 94%, 86%, 76%, and 79%, respectively. These figures reveal the vast high total of the depositors' money as a supply of finance for Islamic banks. Hence, it becomes indispensable for the management of Islamic banks to identify the factors that are most likely to convince customers' decision making in depositing their capital with Islamic banks. (Haron and Azmi, 2004).
With the exception of a study done by Metawa and Almossawi (1998) where religion was seen as a reason influencing customers' choice to support Islamic banks in Bahrain, other studies have proven counter wise. The evidence from studies done in Sudan and Turkey, for example, revealed that religion was not the main motive for customers choosing Islamic banks (Erol and El-Bdour, 1989). Likewise, studies conducted in Malaysia and Singapore revealed both religion and profit as the explanation for people maintaining their association with Islamic banks (Haron et al., 1994; Gerrad and Cunningham, 1997). Since depositors are attracted by profits, it is vital for Islamic banks management to be aware of the fact that return rates on deposits persuade their customers' decision to deposit. (Haron and Azmi, 2004).
Relating to commercial banks' deposit composition, Hester and Zoellner (1966) and Heggested (1977) found that time and savings deposits had a significant inverse correlation with profitability. Smirlock's (1985) findings demonstrated a significant positive relationship amid demand deposits and profits. In contrast, Fraser and Rose (1971) found that loan rate; time deposit rate and loan-to-deposit ratio had no outcome on profitability. Haron (1996a) found evidence to suggest that current, savings and investment accounts of Islamic banks are positively related to profitability. Fraser et al (1974) considered operating costs, deposit and loan structures as factors within the control of management and found that the factor which had the biggest control on bank performance was bank cost followed by bank's deposit and loan composition.
Heggested (1977) proved that banks heavily devoted to time and savings deposits earned considerably lower returns than banks which have higher reliance on demand deposits. Smirlock (1985) confirmed that demand deposits were a cheaper source of funds and had a positive impact on bank profits.
In the literature, the majority of studies found that savings and time deposits have a negative relationship with profitability, while a positive relationship has been found for current account deposits. Haron (2004) found that nearly all deposit structure variables had no significant relationship with the profitability ratios. Deposits in current account, was the only variable which had a significant relationship with Bank's portion of income as a percentage of total assets and Net profit before tax as a percentage of total assets. Each 1% increase in the current account holdings increased the bank's income by 0.034% and profit before tax by 0.036%. This end result was in line with the findings reported by Smirlock (1985). Since a current account service is considered a cost-free facility, it is anticipated that the more funds deposited into this account, the more Islamic banks would stand to profit. Interestingly, no significant relationship was found between current account deposits and Total income as a percentage of total assets, which implied that an increase in current accounts does not generate more proceeds to the bank as a whole but only functions as a cost saving measure. That is, no returns are paid to these depositors. In the case of savings and investment accounts, even though their relationships with all profitability ratios were at an insignificant level, the signs of their regression coefficients warranted further clarification. No contradiction with the findings of conventional banking literature with regard to savings accounts was apparent. A negative relationship was found between Savings account deposits and the profitability measures. This result suggests that any increase in savings accounts will reduce profits and it corresponds to the findings in the current banking literature (see for example Hester and Zoellner, 1966; and Heggested, 1977).
The results on Investment account deposits in Haron's (2004) study are not similar to those findings reported in earlier researches. Hester and Zoellner (1966) and Heggested (1977), for example, found that fixed deposit facilities had an inverse relationship with profitability. Since some of the characteristics of investment deposits at Islamic banks are similar to the fixed deposit facilities of conventional banks, it is expected that more funds deposited into these accounts would result in less profit to the bank. In contrast, Smirlock (1985) believed that an increasing amount in fixed deposits would have a positive relationship with a bank's profitability. Haron's (2004) study found that Investment account deposits had a positive relationship with all profitability measures and thus, confirmed Smirlock's hypothesis.
Haron and Azmi (2004) attempted to investigate the strength of influence between both internal and external variables and profitability of Islamic banks in selected countries using timeseries techniques of cointegration and error-correction mechanism. They found a significant long-run relationship between profitability measures of Islamic banks and determining variables such as liquidity, deposit items, assets structure, inflation and money supply. They also found that 'Investment account deposits' was the only variable which had a significant relationship with all three profitability ratios. For Current account deposits, a positive relationship was found with 'Bank's portion of income as a percentage of total assets'. The result indicated that a 1% increase in current account holdings increased the bank's portion of income by 0.064%. Given that current account facility is a cost-free service, the more funds deposited into this account, the higher profits will be made available to Islamic banks. Interestingly, current account deposits had no significant relationship with 'Total income as a percentage of total assets' implying that an increase in current accounts does not generate more income to the bank, but only functions as a cost saving measure. On other words, Islamic banks do not pay any rewards to their depositors. These results were in line with the findings of Haron (1996a, 2004). Savings deposits variable was found to have a significant positive relationship with 'Total income as a percentage of total assets'. For every 1% rise in savings account, total income increased by 0.26%. This was in line with normal banking practices whereby Islamic bank could use the funds deposited in this account for productive purposes and thus, generating additional revenue for the bank.
Increases in deposits size has a positive impact on Earnings per share (EPS), as a portion of depositors' profits is minused as a fee for the benefit of the bank and its shareholders. (Shubber and Alzafri, 2008). Returns on Islamic deposits are though flexible in nature since returns are based on performance rather than contracted upfront as evident in all interest bearing deposits. Although the mudarabah rates (investment deposit rates) are quoted using the rates given in the previous months, they are not fixed beforehand and serve as an indicative rate of return on Mudarabah deposits (ROMD). The Mudarabah (investment deposits) contract works along profit“loss sharing principles while fixed deposits of conventional banks are based on the contract of debt. As an equity product, a Mudarabah deposit offers no principal protection and legal claims against any form of returns. To make up for the risk exposure of the product, Mudarabah depositors are expected to be given higher returns relative to that of commercial banks' fixed depositors who avoided risk. (Rosly and Zaini, 2008).
Haron and Shanmugam (1995) in their study try to link the profit rates to Islamic bank's deposits. Using Pearson's Correlation and First Order Autoregressive model, they found strong negative relationship between the two variables. Likewise, their finding showed a positive linear relationship between conventional and Islamic bank deposits.
Haron and Ahmed (2000) argue that people who placed their deposits at saving and investment account facilities were guided by the profit motive. The utility maximization theory amongst the Muslim customers was further confirmed by the negative relationship between the rate of interest in conventional banks and the sum deposited in interest-free deposit facilities. Muslims should be guided by Islamic doctrines when making their economic decisions. Therefore, role of educating people regarding Islamic banking system should be played globally. It is indeed a challenging task. (Haron and Ahmed, 2000).
Shubber and Alzafri, (2008) say that EPS (Earnings per share) improves as the level of deposits increases, as depositors were viewed as sharers in the profit and loss, rather than being entitled to a fixed interest rate. This supports that increasing deposits have a positive impact on EPS (Earnings per share). Increasing deposits, therefore, do not direct any increment in the cost of equity. In fact, equity holders benefited from larger deposits, as owners of the latter pay out management fees, which is deducted from the depositors' share of the profits. Also, the market value of Islamic banks is independent of WACC. (Shubber and Alzafri,2008).
Haron and Azmi (2004a) demonstrated that with the exception of fixed and investment deposits, any increase in rates of interest, deposits at conventional system will increase and deposits at Islamic system will decrease, and vice-versa. As for the fixed and investment deposits, ambiguous results were found. One possible explanation for this is that rates of profit for deposits at Islamic system are known at the end of the deposit period and not at the beginning as opposed to the conventional system. Any upward changes in interest rate of conventional system will have an adverse impact to the deposit levels in the Islamic system. Therefore, rates of profit of Islamic system must at any time be similar to those of the conventional system. Finally, religious dimension can be considered as an important element to attract more people to deposit their funds in the Islamic system. This could also be the reason why more and more conventional banks are starting to offer Islamic banking facilities to their customers not only in Malaysia but also to other parts of the world. (Haron and Azmi, 2004a).
Hasan and Bashir (2003) argue that the rising contest and continuous innovation to provide financial services, all contribute to a increasing interest in a detailed evaluation of Islamic banks. Depositors are interested in evaluating the performance of their banks since they are not given fixed returns and the nominal values of their deposits are not assured. In trying to make best use of the value of shareholders' investment, Islamic banks are exposed to risks. Hence, analyzing the Islamic banks' performance is important from economic and public policy perspectives. (Hasan and Bashir, 2003).
This study uses univariate regression analysis to examine the relationship between deposits and profitability of Islamic banking industry in Pakistan. Univariate regression is a method of regression analysis that uses one explanatory variable to predict values of a single dependent variable. SPSS software is applied to obtain the univariate regression. In this study, three independent variables titled Fixed deposits, Savings Deposits and Current account deposits have been used. The dependent variable of profitability is measured by ROE which is the ratio of a bank's net after-tax income divided by its total equity capital. The return on equity (ROE) is considered to be one of the profitability performance ratios (Tarawneh, 2006). It indicates how effectively the management of the bank is able to turn shareholders' funds (i.e. equity) into net profit. ROE (Return on Equity) has been tested separately for the three independent deposit variables to avoid the issue of multicollinearity since all the deposit variables are highly correlated to each other.
This paper attempts to test three hypotheses. According to Becker (1995), hypothesis testing is the process of judging which of two contradictory statements is correct.
Hypothesis 1: Investment Deposits increase the profitability of Islamic banks.
Hypothesis 2: Saving Deposits increase the profitability of Islamic banks.
Hypothesis 3: Current Account Deposits increase the profitability of Islamic banks.
The data for this study is time series data taken from the quarterly editions of the Islamic banking bulletin? published by the State Bank of Pakistan. These bulletins publish the consolidated financial statement variables representing the entire Islamic banking industry of Pakistan including all the full fledge Islamic banks (Al Baraka Islamic bank, Bank Islami Pakistan limited, Dawood Islamic bank Limited, Dubai Islamic bank limited, Emirates Global Islamic bank Ltd and Meezan Bank Ltd.) as well as the Islamic branches of conventional banks (Askari Bank Limited, Bank Al Falah Ltd., Bank Al Habib, Faysal Bank, Habib Metropolitan bank, MCB Bank Ltd, National bank of Pakistan, Soneri Bank Ltd, Standard Chartered Bank, The Bank of Khyber, Royal bank of Scotland, United Bank Ltd). The sample period for this study is limited from 2007 to 2009 as most of the Islamic banks started operations from 2007 in Pakistan. Hence, the consolidated data of the eleven consecutive quarters has been used in this study.
The general equations of the three models are:
Profitability = b0 + b1(ID)---------(1)
Profitability = b0 + b1(SD)---------(2)
Profitability = b0 + b1(CD)---------(3)
b0 = intercept (constant)
Profitability = ROE (Return on Equity)
ID = Investment Deposits
SD = Savings Deposits
CD = Current Account Deposits
The results of the regression analysis for model.1, 2 and 3 are shown in Tables 1, 2 and 3 respectively. All the three models were significant at the 5% level of significance. The value of the adjusted coefficient of determination (adjusted R2) for ROE in model.1 is 0.4 which demonstrates that 40% of the variability in total is explained by its linear association with Fixed deposits variable. As for model 2 and 3, the corresponding values of adjusted R2 are 0.399 and 0.377 respectively. A relatively small value of adjusted R2 does not necessarily mean that the model is in appropriate to measure the relationship between independent and dependent variables. (Haron, 2004).
The value of adjusted R2 is usually influenced by a number of predictive variables relative to the sample size and it becomes smaller as we have fewer observations per predictor variable (Hair et al., 1995). To provide a rationale for the variance in R2 and adjusted R2 values, the Dublin-Walter test was conducted. The Dublin-Walter statistics values for all the three values were less than two which proves that the variance was due to negative autocorrelation in the sample observations. Also, the adequacy of a model for predicting is validated by the F-test. (Haron, 2004). As presented in Table 1, 2 and 3, all F-ratio values are statistically significant at 5% significance level for all profitability models. Hence, these results confirmed that the models applied were useful for measuring the relationship between deposits variable items and the profitability variable.
The results supported all the three hypotheses that Investment, Savings and Current account deposits increase the profitability of Islamic banks. This result is in line with Haron (1996a, 2004) who founded evidence to suggest that all three sources of funds (current, savings and investment accounts) for Islamic banks are positively related to profitability.
Hypothesis 1 of this study suggested that investment deposits increase the profitability of Islamic banks. The results show that the value of the adjusted coefficient of determination (adjusted R2) for ROE in model.1 is 0.4 which demonstrates that 40% of the variability in total is explained by its linear association with investment deposits variable. Hence, results support Hypothesis 1.
Similarly, hypothesis 2 stated that savings deposits increase the profitability of Islamic banks. The results show that the value of the adjusted R2 for ROE in model.2 is 0.399 at 5% significance which shows that 39.9% of the variability in total is explained by its linear association with savings deposit variable. Hence, results also support Hypothesis 2.
Finally, hypothesis 3 proposed that savings deposits increase the profitability of Islamic banks. The results show that the value of the adjusted R2 for ROE in model.3 is 0.377 which shows that 37.7% of the variability in total is explained by its linear association with savings deposit variable at 5% level of significance. Hence, results support Hypothesis 3 also. All these results were significant at a 5% level of significance.
Referring to previous literature, the results are mixed. In the literature, most studies found that savings and investment deposits have an inverse relationship with profitability, while a positive relationship has been found for current account deposits. In this study, the current account deposit variable had significant positive relationship with profitability. This result is in line with the findings reported by Smirlock (1985), Haron (1996a, 2004) and Haron & Azmi (2004). Since a current account service is considered a cost-free facility, it is expected that the more funds deposited into this account (current), the more Islamic banks will stand to profit.
In the case of savings deposits, a positive relationship was found between these deposits and profitability. This result suggests that any increase in savings accounts will increase profits and this is in line with Haron (1996a) and Haron & Azmi (2004) as Islamic banks can use these savings funds deposited in this account for productive purposes and therefore, generating additional revenue for the Islamic banks.
The results on investment deposits in this study are not similar to most of the findings reported in commercial banking literature. For example, Hester and Zoellner (1966) and Heggested (1977) found that fixed deposit facilities had an inverse relationship with profitability. In contrast, Smirlock (1985), Haron (1996a, 2004), Haron and Azmi (2004) believed that an increasing amount in fixed deposits would have a positive relationship with a bank's profitability. This study found that investment deposits had a positive relationship with all profitability measures and thus, confirmed Smirlock's, Haron's and Azmi's hypothesis.
In light of the above findings, Islamic banking provides a better and ethical alternative that is not only Riba-free according to the rules of Shariah but also profitable to depositors and investors since all the deposit accounts are positively correlated to profitability. Since, Islamic banking provides three different interest-free deposit facilities to its depositors and investors to facilitate them according to their financial needs, people should invest in these deposit accounts in order to patronize the Islamic banking industry and to receive good returns in the form of 'hiba' from these Islamic banks.
In addition, Ghazali (2008) suggests that Islamic banking is indeed relevant to the current economic crisis. The global financial meltdown stemming from the US actually poses an opportunity for the Islamic banking system to demonstrate its distinctiveness. The financial meltdown revealed the desperate need for a system like Islamic finance, based on the principle of profit-sharing where both parties are subjected to probable losses and returns. It is a fair and just system. This is contrasting to the conventional system, where Islamic banks do not acquire or trade debt; rather they manage substantial assets which are tied to real economic activities.. This is really an opportunity for the Islamic financial community to reveal to the global market that the Islamic financial system is actually a robust and feasible alternative to the conventional interest-based system.
Hence, people should support the Islamic banking industry worldwide since deposits are positively related to the profitability of Islamic banks. Hence, increased deposits would result in higher profitability of Islamic banks which in return would provide higher returns to its depositors. This would finally lead to implement a justified and ethical economic system which encourages a fair distribution of wealth and resources throughout the society.
This study can be extended to include more time series and cross-sectional data of Islamic banks of other countries. The study may also be extended to cover other determinants of Islamic banking profitability.
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