Print Reference This Reddit This

The Determination Of Islamic Banking Profitability Finance Essay

The development of Islamic banking and finance in the world showed that consciousness of Muslim to avoid Riba’ that implemented by Conventional Banking System. Islamic Bank is seen as a good substitution for conventional bank especially for muslim to avoid them from the element of Riba’, Gharar and Maysir. The implementation of Islamic bank showed that the large moving of people especially for Muslim countries to Islamic bank. This showed by the increase amount of Islamic bank establishment over the year.

The implementation of Islamic banking system began since 1975 with the establishment of Dubai Islamic bank in United Arab Emirates and the Islamic Development (IDB) Bank in Jeddah, Saudi Arabia. After that there have the increasing amount of Islamic Banking in the world. In Malaysia, the establishment of Islamic Banking System began with the establishment Bank Islam Malaysia Berhad in 1983. Followed by the implementation of Interest Free Banking Scheme (SPTF) or known as Islamic Banking Scheme (SPI) and the establishment of Bank Muamalat Malaysia Berhad in October 1999. The existence of dual system of Islamic banking promotes Malayysia as the first nation to have full-fledged Islamic system operating in tandem with conventional banking. Therefore, the requirement to examine the performance of Islamic bank is important especially to investigate the expansion of the performance of Islamic banks activities, which affected bank’s profitability (Azura & Ghafar, 2005, pg 1).

This paper will examine the internal and external factors that affect Islamic banking profitability. Internal factor is considered as the factors that are influenced by bank’s management decision which is can be obtain from balance sheet and income statement. External determinant is defined as the factors that are beyond the control of a bank’s management which is the macroeconomic factor.


The studies of determinant of bank profitability have been developed a long time ago. Most studies focus to Conventional bank’s profitability but a little research focused about the Islamic banking profitability. The studies of determinant of Conventional bank by Vong & Chan (n.d.), Fadzlan & Royfaizal (2008), Masood et al (2009), while the studies of determinant of Islamic banking profitability developed by Haron (1996 & 2004), Bashir (2003), Alkassim (2005), Shahida et al (2005), Azura & Ghafar (2005), Melaty (2008), Rasiah (2010).

To determine the factors that influence Islamic bank profitability, first we need to define the profit. Rasiah (2010) that studied about the theoretical review of the profitability of Commercial banks defined profit as the different between total revenue and total cost. So, the factors that influences the profit of Islamic bank is the factors that influence the total revenue and the total cost of Islamic bank.

To measure the performance of Islamic banking, one measurement that have been used to many researchers is profitability. There various method that been used to measure the profitability. Haron (1996 & 2004), Rasiah (2010) used TITA (Total income as a percentage of total assets), BITA (Bank’s portion of income as percentage of total assets), BTTA (Net profit and ATCR in his studies. Vong & Chan, Fadzlan & Royfaizal (2008) used ROA as a proxy of profitability. Alkassim (2005), Shahida & et al. (2005), Melaty (2008), extended the research of profitability on ROA, ROE and NIM. While Azura & Ghafar (2005) used ROA, ROE and ROD and Bashir (2003) used ROA, ROE and BTP/TA. Most of the studies used the regression technique to determine the factor that effected the bank profitability. Most of the studies divided determination of bank profitability to two categories which is internal and external determinant.

Internal Determinant

Internal determinant as the factors that are influenced by bank’s management decision. Management effect will definitely affect the operating result of the bank. Internal determinant can be founded from the balance sheet and income statement in financial statement of the bank (Vong & Chan). Vong & Chan examined the impact of bank characteristics as well as macroeconomic and financial structure variable on the performance of the Macao banking industry during 1993 to 2007. They found that capital ratio, asset composition, asset quality and market share have a significant impact on bank profitability. Rasiah (2010) identified internal factor which tend to have direct impact on bank revenue and cost are the bank’s assets and liability portfolio management and overhead expenses management while liquidity ratio and capital ratios tend to have an indirect effect on bank profitability.

Capital ratio is a valuable tool to measure the capital adequacy and should capture the general safety and soundness to of a bank. Most of the researchers used total equity as a percentages of total asset to measure the capital adequacy of the bank.

Liquidity ratio

Shahida (2005) examined the underlying determinant of net income margin (NIM) across two full fledged Islamic banks and twenty Islamic banking scheme(IBS) in Malaysia use market power, degree of risk aversion, average operating cost, default risk, market risk, interaction of default and market risk, financing and loss provision and statutory reserve requirement as a proxy of internal determinant. In this study Shahida (2005) found that financing and loss provision affects NIM positively. This suggested that the higher provision made by bank, the more secured the margin from external shock. However, high operating cost, default risk as well as market risk tend to reduce margin. This finding also found that the different characteristics of full-fledged bank namely Bank Islam and Bank Muamalat and Islamic banking scheme offered by conventional bank play an important role in determining their NIM.

Azura (2005) found that the ratio of total loan over total assets and ratio of non interest income over total assets are significant. Similar result are found by Bashir (2003) which is there have a positive relationship between ratio of loan over total assets and profit. Azura (2005) also included the zakat paid as a proxy of taxation. Zakat is important for the Islamic banking and one of taxation instruments to help the poor in Islam. In her study, Azura (2005) found that zakat have positively significant influencing ROA.

The effect of financing and loan loss provision is the most important factors that influence profit of Islamic bank. Since the operation of Islamic bank allows the losses to be shared among shareholders, it could be suggested that the bank can have a lower risk-weighted capital ratio due to lower financing loss reserve. This is because the losses from equity-financing are partly absorbed, whilst debt-financing are fully absorbed by the bank, the depositors, bringing lower income to depositors. Shahida (2005) found that financing and loss provision affects NIM positively. This suggested that the higher provision made by bank, the more secured the margin from external shock.



Capital Ratio

Capital ratio is used as a tool for assessing capital adequacy and capture the general safety and soundness of banks

Deposit structure

Overhead Expenses

The efficiency in expenses management is a important internal factor that can be construct in income statement. It reflects employment, total amount of wages and salaries as well as the cost of running branch office facilities. The higher the expense of a bank, the lesser the bank’s profitability will be. The empirical studies of overhead expenses showed the mix result. Harun (2004) found a positive relationship between overhead expenses and profitability in Islamic banking. Similar result also found by Alkasim (2005) in Islamic banking in GCC countries. Alkasim (2005) also found that total expenses in conventional banking are high compared than Islamic banking in GCC counties. The result on Islamic banking are different with conventional banking in Malaysia which is Rasiah (2010) found that the negatively significant relationship between overhead expenditure with BTTA of conventional banking.

External Determinant

External determinant defined as factors that are beyond the control of a bank’s management. Two major component of the external determinant which is macroeconomic factors and financial structure factors. The macroeconomic factors include economic growth, real interest rate and inflation, whereas the financial structural factors comprise the size of banking sector.


The gross domestic product (GDP) s the most commonly used macroeconomic indicators for measuring an economy’s total economic activity. The GDP is expected to influence factors that related to demand and supply for loans and deposits. As GDP growth slows down particularly during recessions, credit quality deteriorates and default increase, thus reducing bank returns.

Money supply

The market expansion could produce for earning increased profit. Most of the researchers used the annual growth in money supply as a proxy for growth market. Change in money supply may lead to changes in the nominal GDP and the price level. Although the money supply is basically determined by the central bank’s policy, it may also affected by the behavior of households and banks.

Bank size

Bank size is generally used to capture potential economies or diseconomies of scale in the banking sector. Economies of scale defined as reduction in the cost per unit of the product being manufactured and sold. If an industry is subject to economies of scale, larger institutions will be more efficient and can provide services at a lower cost. As a result, larger banks will earn higher rates of profit if enty is impeded (Sudin, 1996, pg 54).

Most of the researcher used total assets as a proxy for size. Vong & Chan found that the negative significant effect between bank size and ROA suggested that larger banks achieve a lower ROA than smaller ones. This shows that the interbank market is competitive and efficient since banks with the large retail deposits-taking network do not necessarily enjoy a cost advantage against other banks. Contras with Sudin (1996 & 2004), he found that size of the bank have a significant positive relationship with profitability.


Inflation is the most important factor that influences the bank profitability. The effect of inflation is depend on anticipated and unanticipated. In the case of anticipated inflation, when the inflation occurred, bank can timely adjust interest rate, the revenue will increase faster than cost. This cause the profit will be increase. But in the case of unanticipated inflation, bank may be slow in adjusting their interest rates resulting that bank cost will increase faster than revenue. Consequently, the profit will be decrease.

In study the effect of inflation to profitability, most of the researchers used CPI as a proxy of inflation. Fadzlan & Royfaizal (2008) found that rate of inflation is negatively related to Philippines bank’s profitability level suggested that during the period 1990-2005, the level of inflation was anticipated by banks. Contradict to the result of the study by Haron (1996 & 2004), he found that inflation have a significant positive impact on the profits of the Islamic bank similar with conventional bank. Similar result found by Vong & Chan which is inflation rate shows highly positive impact on banks’ return on assets. This implied that bank management may anticipate the rate of inflation and react accordingly. This suggest that banks in Macao tend to be more profitable in inflationary environment.


The objective of the study is divided by two parts.

Overall objective

This study is aimed to examine the determination that influence the profitability of Islamic bank in Malaysia during 2000 to 2009.

Specific Objective

To determine the internal and external factor that may influence the profitability of Islamic banks.

To examine the impact of internal and external determinants on Islamic bank profitability in 2000 to 2009.

To investigate whether internal and external variables that influence the profitability of conventional bank have similar impact on Islamic banks.


This paper intend to provide answer to these question :-

What are the factors/variables that influences the profitability of Islamic bank in Malaysia?

What is the impact of bank characteristic determinant on Islamic banking in Malaysia?

How do macroeconomic variable affect the profitability of Islamic banks in Malaysia?


The proposed research borrowed the ordinary least square (OLS) and dummy variable approach used by Sudin Haron (2004). It is assumed that all the behavioral differences between individual banks are captured by the intercept. This study will use time series data from 2000 to 2009 and will using Eviews 6 as a tool of analysis. A general equation of the model is represented by equation 1 below:

yit = β0+δ2D2 + δ3D3+……+ δjDj+ β1Xit,1+ β2Xit,2+……+ βkXit,k+ εit (1)


yit = independent variable

β0 = intercept term for Bank 1

D2t,D3t,…., Dj-1t = dummy variable

Xit,1, Xit,2,…., Xit,k = independent variables (1,2,….,k)

k = total number of independent variables

J = total number of banks

t = total number of bank

This model implies that marginal effect effect of βk is the same across all banks which means that a unit change in variable Xk as the same effect on profit for allbanks. Noneteless, if the dummy variables are included, it means that a different intercept applies to each bank is as follows:

Bank 1: yit = β0+ β1Xit,1+ β2Xit,2 +…….+βkXit,k+ εit

Bank 2: yit = (β0+ δ2) + β1Xit,1+ β2Xit,2 +…….+βkXit,k+ εit



Bank J: yit = (β0+ δ2) + β1Xit,1+ β2Xit,2 +…….+βkXit,k+ εit

The above models indicate that for a given value of each regressor. X1,X2, …X3; the average level of profit is different for each bank. The inclusion of dummies is verified using F-t based on the following hypothesis:

H0 = average level of profit is the same for each bank (γ2 =γ3 =…=γ3=0)

H1 = average level of profit is not the same for each bank (γ2 =γ3 =…=γ3≠0)

In the case where H0 is being rejected, dummies should be inincluded in the equation for it represents the most appropriate model. In the case, the following model (ordinary least square) is applied:

yit = β0+ β1Xit,1+ β2Xit,2 +…….+βkXit,k+ εit

On contrary, if H1 is accepted, dummies should be included in the model.

The list of independent variable

Internal variables

LIQ : Total financing as a percentage of total deposits

CRTA : Total capital assets and reserves as a percentage of total assets

DECA : Total deposits in current accounts as a percentage of total assets

DESA : Total deposits in saving accounts as a percentage of total assets

DEIA : Total deposits in investment accounts as a percentage of total assets

FIPS : Total funds in profit-sharing principles as a percentage of total assets

FIMK : Total funds in mark-up principles as a percentage of total assets

FIIV : Total funds in investment activities as a percentage of total assets

IFIN : Incomes from financing activities as a percentage of total financing

IBNK : Bank’s share of income as a percentage of total savings and investment deposits

TEXP : Total expenditure as a percentage of total assets

SEXP : Staff expense as a percentage of total assets

PEXP : Provision for loan losses as a percentage of total assets

OEXP : Other expenses as a percentage of total assets

External variables

MKTPL = Full fledged Islamic bank dummy i.e. 1 Islamic bank and 0 Otherwise.

MKTSH = Market share (total deposits of the Islamic bank as a percentage of a

country’s total deposits)

INT = The discount rate for each year

MON = Growth in the money supply (M2) for each year

CPI = Percentage increase in the consumer price index for each year.

LogSIZE = Total assets in common currency (US dollar) –in logarithm

The list of dependent variable:

TITA : Total income as a percentage of total assets

BITA : Bank’s portion of income as a percentage of total assets

BTTA: Net profit before tax as a percentage of total assets

BTCR: Net profit before tax as a percentage of capital and reserves

ATCR : Net profit after tax as a percentage of capital and reserves

The ratio of TITA is used to captures the effects of internal and external determinants on a bank’s profitability. BITA is used to capture the effect of determinants on profitability. It is hypothesized that all determinants will have similar impact on TITA and BITA. For BTTA, the ratio measures the effect of total expenditure on bank’s profitability. The effects of profitability determinants on returns to shareholders are measured by two ratios, namely BTCR and ATCR.


The data will use cross section time series data of financial ratio and macroeconomic indicator which is the data consist the period over 2000 to 2009. The source of data for internal variable is based on published financial statement of various Islamic Bank in Malaysia. Meanwhile the data for external variable is obtained from data published by Central Bank of Malaysia, Department of Statistic of Malaysia and IMF.


This study provide the information of performance of Islamic bank and it give the benefits to managerial, bank regulators and depositors. The managerial can used this information to maximize the value of the bank. The managerial can use this information to take policy about the effort for increasing the profitability. Bank regulator are concerned about the safety and soundness of the banking system and preserving public confidence. Depositors may also be interested in how well their banks are doing since they are not entitled to fixed returns and the nominal values of their deposits are not guaranteed. New researchers can use this information to examine a deeper about the profitability in Islamic banking and help them to expand the research of Islamic banking with the new idea, technique and scope of the study in the future.

Need help with your literature review?

Our qualified researchers are here to help. Click on the button below to find out more:

Literature Review Service

Related Content

In addition to the example literature review above we also have a range of free study materials to help you with your own dissertation: