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Journal cover: Humanomics

Humanomics

ISSN: 0828-8666

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Subject Area: Economics

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Comparative study of the performance of Islamic and conventional banks: The case of Malaysia


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DOI (Permanent URL): 10.1108/08288661311299312

Article citation: Shaista Wasiuzzaman, Umadevi Nair Gunasegavan, (2013) "Comparative study of the performance of Islamic and conventional banks: The case of Malaysia", Humanomics, Vol. 29 Iss: 1, pp.43 - 60


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The case of Malaysia

The Authors

Shaista Wasiuzzaman, Faculty of Management, Multimedia University, Cyberjaya, Malaysia

Umadevi Nair Gunasegavan, MBA Centre, Multimedia University, Cyberjaya, Malaysia

Abstract

Purpose – The aim of this paper is to analyze the differences in bank characteristics of Islamic and conventional banks in Malaysia, especially when it comes to their profitability, capital adequacy, liquidity, operational efficiency and asset quality are also considered. Corporate governance issues and economic conditions are also included in the analysis.

Design/methodology/approach – A total of 14 banks (nine conventional and five Islamic) were considered over the period of 2005-2009. Three stages of analysis were performed. First, descriptive statistics were computed to understand the differences in characteristics of the two types of banks. Next, to determine whether these differences were significant, independent t-tests were carried out on each variable. Finally, regression analysis was carried out to analyze the effect of the variables on bank profitability.

Findings – It is found that the return on average assets, bank size and board size values of conventional banks was higher compared to Islamic banks. The other variables – operational efficiency, asset quality, liquidity, capital adequacy and board independence – were higher for Islamic banks. Significant differences between the two bank types were found for all the variables, except for profitability and board independence. All variables except for liquidity, board characteristics and type of bank, were found to be highly significant in affecting profitability.

Originality/value – This paper looks at the differences between Islamic and conventional banking systems in Malaysia. Contrasting results were found for the independent t-tests and regression analysis, which makes it an interesting study that should be pursued further.

Article Type:

Research paper

Keyword(s):

Performance; Islamic bank; Corporate governance; Economic conditions; Banks; Malaysia.

Journal:

Humanomics

Volume:

29

Number:

1

Year:

2013

pp:

43-60

Copyright ©

Emerald Group Publishing Limited

ISSN:

0828-8666

Introduction

The banking industry in Malaysia has come a long way over the last few decades. This industry is highly regulated by the Government and the Central Bank of Malaysia (or the Bank Negara Malaysia). Segments such as commercial, retail, investments and Islamic banking have made great inroads in the industry. A report in The Star newspaper (a local newspaper) puts the domestic banking industry's annualized growth to be 9.8 percent, with a 9.5 percent growth in fixed deposits and 9.1 percent growth in savings deposits. However, the performance of all the banks in the country may not necessarily be on the positive side especially since the recent financial crisis of 2007. Banks have managed to pull through but not without some being injured in terms of stock prices or profits.

The Malaysian banking industry today has been carved into two main sections which is conventional banking and Islamic banking. In an attempt to profit from the growing hype of Islamic banking, most banks have created a separate entity or subsidiary under their wing to focus primarily on this growing market. Islamic banking institutions reported increases in total income year on year (from RM9.71 billion in 2009 to RM11.80 billion in 2010) and net income (from RM6.1 billion in 2009 to RM6.84 billion in 2010) with a 22.6 percent market share of total deposits in Malaysia in 2010, compared to 20.7 percent in 2009 (Parker, 2011). The Bank Negara Malaysia is giving ample focus to the Islamic banking industry in an attempt to establish Malaysia as a global Islamic centre.

In order to maintain the profitability and proper operations of these separate entities and subsidiaries, Bank Negara Malaysia provided various guidelines and measures that need to be adhered to. Although there are various industrial and external factors identified by previous literatures that affect the performance of banks, there is a school of thought that identifies corporate governance as an important factor which influences the performance of banks in Malaysia. Governance issues are important in banks compared to industrial firms due to the importance of regulations, convolution of agency problems and the low rate of capitalization existing in the banking sector (Ciancanelli and Gonzalez, 2000). Islamic banks have a different governance structure compared to conventional banks with the Sharia Supervisory Board being central to their corporate governance framework (Suleiman, 2009).

This is one of the areas of concern for the Bank Negara Malaysia. This concern is justified as can be seen with the recent case of a local bank. The case involved the awarding of branch renovation contracts by the CEO to vendors. It seemed that there were gaps in this process which led to a full scale probe on the CEO and caused an impact on the stock prices and ratings of the bank. Although the impact was not considered severe in nature, it is able to underline the criticality of proper corporate governance and its impact on bank performance.

Hence, it is believed that these two items; corporate governance and bank performance; share a direct relationship whereby the level of corporate governance determines the strength or performance of the bank. This is due to the understanding that by enforcing a high level of corporate governance better management, in terms of operations and finance, is achieved and this in turn allows the bank to make the right decisions and choices that will enable the overall performance of the bank to improve.

Therefore, with the border between conventional and Islamic entities becoming clearer, this paper attempts to investigate if there is any difference in the corporate governance structures of these two types of banks and whether corporate governance, among other factors, is important in the determination of a bank's profitability.

Literature review

Prior studies on bank performance and efficiency have tackled various issues such as firm-specific attributes, economic environment and the corporate governance structures of banks.

Board size is usually found to have a positive relationship with performance, even when using different measurements for performance such as ROA, ROE and Tobin's Q. Some of the studies which confirmed this are such as by Kyereboah-Coleman and Biekpe (2006-2007), Adams and Maheran (2005), Belkhir (2009), Andres and Vallelado (2008) and Tanna et al. (2011). However, Sierra et al. (2006) and Agoraki et al. (2010) argued that smaller boards would result in higher efficiency and hence higher profitability.

Sierra et al. (2006) also found significant evidence that the more independent the board, the better the bank would perform. This was supported by Belkhir (2009), Tanna et al. (2011), Mishra and Nielsen (1999), Busta (2007) and Pathan et al. (2007). While Kyereboah-Coleman and Biekpe (2006-2007) could support this result when using interest income as the measurement of efficiency, they however found that a negative relationship when using return on assets (ROA). Woodruff (2007) too supported a negative relationship but showed leadership type to be more important in contributing towards performance rather than governance. However, Adams and Maheran (2005), Wang et al. (2008) and Agoraki et al. (2010) found that board independence did not have any significant effect on bank profitability. An interesting result was discovered by Andres and Vallelado (2008) where a U-shaped relationship seemed to exist between the number of outsiders on the board and performance, indicating that there is an optimum number of executive and non-executive directors which would result in the best performance.

Economic conditions were also found to affect bank performance. For instance, Abreu and Mendes (2003), Guru et al. (2002), Naceur (2003), Tanna et al. (2002), Athanasoglou et al. (2005), Heffernan and Fu (2008), Flamini et al. (2009), Sufian and Habibbullah (2009) and Wasiuzzaman and Tarmizi (2010) found a positive relationship between inflation rate and profitability of banks for the various countries/regions they studied.

According to Alkassim (2005), liquidity plays an essential role in determining the profitability of banks. By taking the net loans to total asset as a liquidity proxy, this ratio provides a measure of income source. He confirmed this for both conventional and Islamic banks, which tend to have similar liquidity ratios. Loans are the largest component of interest bearing assets of a bank and are expected to have a positive effect on bank's profitability (Vong and Hoi, 2009). Bashir (2000), Athanasoglou et al. (2005), Sufian and Habibbullah (2009) and Wasiuzzaman and Tarmizi (2010) supported this positive relationship. But Srairi (2009) emphasized that in order to hedge against liquidity risk, banks often hold liquid assets to meet adverse shocks and so the less liquid the bank, the higher will be the profitability. Chaudhry et al. (1995) and Tanna et al. (2005) too found this in their studies, even when using different measurements for liquidity. A Study by Molyneux and Thornton (1992) is among those who found a weak inverse relationship between liquidity and bank performance.

Operational efficiency is normally proxied by the ratio of cost to total income (Srairi, 2008) and this ratio is able to reflect the ability of the bank's management in controlling operating expenses (Alkassim, 2005). As the operational ratio becomes smaller the bank becomes less risky and this will lead to positive growth in profitability. Tanna et al. (2005) and Heffernan and Fu (2008) are some studies using this measurement to find a negative relationship between operational efficiency and profitability. However, when using the ratio of operating expenses to total asset as the proxy, Bashir (2000), Naceur (2003), Barth et al. (2003), Athanasoglou et al. (2005) and Vong and Hoi (2009) found that a higher value results in increased profitability. The operational ratio can also be measured by how profitable a bank is in terms of its loan (Alkassim, 2005). Ahmad and Hassan (2007) used net interest margin as one of their proxies and concluded that the commercial banks perform significantly better then Islamic banks due to larger operational ratios. The positive relationship between net interest margin and performance was also supported by Wasiuzzaman and Tarmizi (2010).

Capital requirements constitute a buffer against any unexpected losses and can affect risk taking by bank owners and so it is the centerpiece if the government intervention (Lamoreaux, 1994). Kim and Rasiah (2010) used the capital adequacy ratio to argue that the Central Bank alleviates the deterioration of financial performance in banks by using capital adequacy requirement to classify the health level of financial institutions and the Central Bank of Malaysia as the regulator determines the minimum capital ratio of 8 percent for banks in Malaysia. Schaek and Čihak (2007) showed that banks in a competitive market tend to hold higher capital ratios. Using the equity total assets ratio, Bashir (2000), Naceur (2003), Tanna et al. (2005), Flamini et al. (2009), Vong and Hoi (2009) and Sufian and Habibbullah (2009) confirmed the positive relationship between capital efficiency and profitability. However, Athanasoglou et al. (2005), Pratomo and Ismail (2006) and Wasiuzzaman and Tarmizi (2010) found a significantly negative relationship using the same ratio. Pratomo and Ismail (2006) argued this negative relationship through the agency cost hypothesis.

The ratio that measures the quality of the bank's assets usually utilizes the loans and the leases and is also able to be used in assessing the credit risk that is associated with a particular asset. Cebenoyan and Strahanm (2004) argued that banks which are efficient (indicated by a low cost to income ratio) enhance their skills to manage credit risk and therefore would be able to lend more of their assets to borrowers who could be considered risky and would also have the competence to use credit derivatives in order to trade credit risks. Srairi (2009) used loan less loss reserve to total assets to proxy this variable and found that the increased exposure to credit risk is normally associated with decreased profitability. Hence, the higher the ratio, the higher would be the profitability. Tanna et al. (2005), Athanasoglou et al. (2005), Vong and Hoi (2009) and Wasiuzzaman and Tarmizi (2010) are some studies which used the loan loss reserves to total/gross loans ratio and found a negative relationship between this ratio and profitability. Heffernan and Fu (2008) argued that the relationship can be either negative or positive.

Finally, Camilleri (2005) found that larger banks perform better and this was supported by Yung (2009), Flamini et al. (2009) and Srairi (2009). According to Yung (2009), larger banks will perform better because they may have more diversified investment opportunities, better management and employ better technology. However, Heffernan and Fu (2008) and Wasiuzzaman and Tarmizi (2010) discovered that bank size was not significant and dropping the variable seemed to improve their diagnostic on bank profitability. Also some studies such as by Bashir (2000), Tanna et al. (2005), Pasiouras and Kosmidou (2007) and Sufian and Habibbullah (2009) found the existence of diseconomies of scale, hence a negative relationship between size and profitability.

Data and methodology

This study uses the financial statements and the statement of corporate governance of both conventional banks and Islamic banks in Malaysia, as the sources of sample data, for the sample period from 2005 to 2009. There are a total of nine conventional banks and 12 Islamic banks present among the local-owned banks in Malaysia. The sample consists of nine conventional banks which are Maybank Berhad, CIMB Bank Berhad, Public Bank Berhad, RHB Bank Berhad, Hong Leong Bank Berhad, AmBank Berhad, Alliance Bank Berhad, EON Bank Berhad and Affin Bank Berhad and five Islamic banks which are CIMB Islamic Bank Berhad, RHB Islamic Bank Berhad, Bank Islam Malaysia Berhad, Bank Muamalat Malaysia Berhad and Bank Kerjasama Rakyat Malaysia Berhad. The figures from the balance sheet, income statements and the ratios were collected from the Bankscope database and the corporate governance details were obtained from the annual reports of the banks under consideration. For macroeconomic data, the EIU CountryData database was used.

There are two limitations identified during the sample data collection. First, the research sample incorporates only the local-owned banks in Malaysia and the foreign-owned banks are not included due to the different ownership structure. Second, since the sample period for this research is taken from the year 2005 to 2009 and most of the information for the other Islamic banks were only available from year 2007 onwards, these banks were not included in the sample. Also, due to some extreme values, some data had to be removed, resulting in a total of 67 firm-year observations for the banks mentioned above.

Measurement of variables

Return on average asset (ROAA) measures how well a company uses its assets to generate additional profits and can be calculated by dividing net income after tax with the average asset value for a given period.

Board size

Board size is measured by the total number of directors. According to Agoraki et al. (2010), large boards are usually associated with more intense coordination, communication and process problems. Larger boards are also known to decrease bank performance and give rise to agency problems. In addition, the study by Belkhir (2009) found that smaller boards are more effective but the increasing number of directors in banking firms does not undermine performance. Pathan et al. (2007) too obtained a negative relation between board size and both ROE and ROA.

On the other hand, Adams and Maheran (2005) found that the inclusion of more directors is positively associated with the performance (Andres and Vallelado, 2008).

Board independence

The proportion of independent non-executive directors is one of the important characteristics of the board effectiveness and prior studies have suggested that banks may enhance their performance by including more independent directors. Board independence is found by dividing the total number of independent directors with the total number of directors.

Prior studies show that independent directors protect shareholders' interest in specific instances such as reducing the possibility of a hostile takeover or providing higher return to the target firms (Cotter et al., 1997). According to Pathan et al. (2007), independent directors would be better monitors than other directors because independent directors have a market reputation to maintain. They cited Skully (2002) who recommended that in order to have better governance, it is necessary to have a majority of independent directors. Zengji and Yeqin (2009) too discovered that the shareholders' economic interests are best protected when the board remains independent. However, Woodruff (2007) argued that the performance of banks may be driven more by the leadership type rather than governance or higher levels of director independence, which results in lower corporate performances. Wang et al. (2008) indicated that, there is no strong relationship between board independence and performance.

Liquidity – liquid assets over customer's short-term funding

According to Alkassim (2005), liquidity measures the solvency of banks and indicates how fast a bank can meet debt obligations. It also plays an essential role towards the profitability of banks. Generally, the higher the value of the ratio, the larger the margin of safety the bank possesses to cover the debts. By including the liquid assets over customer's short-term funding as a liquidity proxy, this ratio accounts for deposits ran off. This ratio works as an indication to highlight the extent to which deposit takers can meet the short-term withdrawal without facing liquidity problems. This ratio should be higher for more liquid banks because it shows, as a percentage, how short-term funding can be met if there is sudden customer withdraw (Alkassim, 2005). Here, the log of liquid assets over customer's short-term funding is used to measure liquidity of the banks.

Bashir and Hassan (2003) showed that commercial banks are more liquid compared to Islamic banks. This was also confirmed by Akhtar et al. (2011) who discovered that the liquid assets to customer deposits and short-term funds ratio was higher for conventional/national banks compared to Islamic banks. Only their net loan deposit and borrowing ratio (another measure of liquidity) was lower for Islamic banks, which according to them indicated higher liquidity efficiency of Islamic banks.

Bashir and Hassan (2003) argued that the liquidity ratio tends to be higher for high-performing banks. Also, Srairi (2008) argued that the less liquidity the bank has and the higher will be the profitability. This is because the liquid assets are usually associated with the lower rates of return. By investing more in liquid assets, the bank is able to meet its obligations faster but it is not able to invest in long-term assets with the funds so that higher returns can be generated. From the arguments from the studies above, the predicted relationship between the liquid assets over customer's short-term funding ratio and bank profitability can be positive or negative.

Operational efficiency – net interest margin

Alkassim (2005) mentioned that there are many operations in the banking environment and operations which involve market risk and the most important components of market risk, which significantly impact assets and liabilities of financial institutions, are interest and exchange rate risks. The operations ratios give an indication of banking effectiveness and soundness. The higher the operational ratio, the better the bank performs.

Due to the lack of data on the other ratios in Bankscope, the study will take the net interest margin as the proxy for operational efficiency. According to Alkassim (2005), for conventional banks, net interest margin measures how profitable a bank is in terms of loans and the ratio indicates the lending income as a percentage. The ratio for Islamic banks is derived from profits from interest free lending contracts. Bankscope classifies the ratio as the cash-flow of its interest free lending in order to make the data more consistent with other types of banks.

Naceur (2003) and Simpson (2002) included net interest margin as an indicator of bank's efficiency. The net interest margin ratios could represent bank efficiency, i.e. how successful is the investment made by banks compared to the debt situation (Hesse, 2007). Based on studies on banking systems of developed countries, Doliente (2003) found that net interest margins have significant positive relationships with a bank's efficiency. This ratio is therefore predicted to have a positive relationship with bank performance.

Capital adequacy – equity over net loans

Capital adequacy ratio is a ratio which indicates a bank's capital strength and it shows how equity of a bank influences the profit made by the bank. This ratio measures the capability for a bank to absorb losses in the future. As a general rule, the higher the ratio, the more sound the bank. A bank with a high capital-to-asset ratio is protected against operating losses more than a bank with a lower ratio.

The Central Bank uses capital ratios to quantify a bank's ability to handle risk exposure and according to Kim and Rasiah (2010), the Central Bank requires banks to maintain an eight percent capital-asset ratio in order to protect depositor's interest. Although both type of banks maintain a capital adequacy of 8 percent, Islamic banks tend to maintain higher capital-assets ratio compared to conventional banks. Banks with high capital ratios would be considered relatively safer in the event of loss or liquidation, would normally have lower needs for external funding and therefore will lead to higher profitability.

The ratio of total equity to net loans is used as a capital proxy and it quantifies the equity cushion available to withstand losses on the loan book (Alkassim, 2005). In this study, the log of this ratio is used. Akhtar et al. (2011) discovered that the ratio of equity to net loans is significant and positively related to profitability of the banks. It was also found that the ratio of equity to net loan is significantly stronger for Islamic banks compared to conventional banks. Ahmad and Hassan (2007) too discovered that Islamic banks seem to be better capitalised than commercial banks of similar size. The predicted relationship between the equity over the net loans is however not clear since the study of Adrian and Hyun (2006) discovered that the ratio was negatively related to the banks profit.

Asset quality – loan loss reserve to gross loans

Asset quality is an estimation of the quality of bank assets and is normally based on the loans and leases. The asset quality ratios involve taking into account the likelihood of borrowers paying back loans (Alkassim, 2005). The ratio is used in evaluating the credit risk associated with an asset. Generally the lower the ratio, the better the asset quality of the bank.

The study takes the log of the loan loss reserve to gross loans as the asset quality indicator and this ratio will measure the amount of total loan portfolio that has been provided for but not charged off (Alkassim, 2005). Camilleri (2005), Heffernan and Fu (2008) and Alkassim (2005) are some papers that have used this ratio in their research.

According to Alkassim (2005), conventional banks have a better loan portfolio since they have lower ratio of loan loss reserve to gross loans. The expected sign of this ratio is indefinite due to higher provisioning signals which lead to higher possible loan losses in the future (Heffernan and Fu, 2008).

Bank size

Bank size indicates bank risk and it is used as a controlling variable in this study. Bank size is measured as the logarithm of the bank's total asset.

According to Yung (2009), larger banks will perform better because they may have more diversified investment opportunities, better management and employ better technology. Flamini et al. (2009) discovered that bigger the size of the banks, the lesser the requirement for profits since lower interest rate will be charged to the borrowers and the bank size is positively correlated with the profits made by banks. Srairi (2009) found that the bigger the size of the bank the higher the profitability since large size may result in economy of scale that will reduce the cost of gathering and processing information or in economies of scope that result in greater loan product diversification and accessibility to capital markets which are no available to small banks. However, Heffernan and Fu (2008) discover that bank size was not significant and dropping the variable seemed to improve their diagnostic on bank profitability.

Some studies such as those done by Pasiouras and Kosmidou (2007) and Goaid (2006) found diseconomies for larger banks, whereby when banks become extremely large, the effect of size could be negative due to bureaucratic and other reasons. Although larger banks are normally associated with lower cost and higher profits compared to smaller banks, there is evidence that smaller banks do earn high revenues too. According to Olugbenga and Olankunle (1998), bank size has proven to be statistically significant in affecting bank's performance but in two of the three cases studied, the average efficiency of smaller banks exceeded the average efficiency of the bigger banks.

Bank type

In order to distinguish between Islamic and conventional bank, a dummy variable is used. Conventional banks are assigned the value of one (1) while Islamic banks are assigned the value of zero (0).

Inflation

Prior studies have shown the impact of economic conditions on the profitability of banks. One of the macroeconomic factors considered is inflation rate. Abreu and Mendes (2003), Guru et al. (2002), Naceur (2003), Tanna et al. (2005), Athanasoglou et al. (2009), Flamini et al. (2009) and Sufian and Habibbullah (2009) discovered a positive relationship between inflation rate and profitability. According to Vong and Hoi (2009), higher inflation rates mean higher costs and higher income. The effect of inflation on profitability will be higher of course, if income is higher than costs and lower if vice versa.

Inflation is measured as the per annum percentage change in the consumer price index (CPI).

Results and analysis

Table I summarizes the descriptive statistics for the conventional and Islamic banks and it is divided into three parts; in Panel A, using data from both Islamic and conventional banking and Panels B and C present the data from each bank type separately.

In Table I, it can be noticed that the difference between the maximum and the minimum values of the ROAA are quite high for the entire sample and for the Islamic banks, which indicates that some of the banks are having a very low performance compared to the others. However, the difference is not very large. The mean ROAA is about two times higher for conventional banks compared to Islamic banks. The skewness for ROAA is found to be high and on the negative side for the entire sample and this is mainly due to the values for Islamic banks. The kurtosis for this ratio is very high for both types of banks, although higher for Islamic banks. A high kurtosis means that fewer observations are close to the average of the normal distribution curve for this ratio and more are extremes either far above or below the average. It is also found that the kurtosis is very high for net interest margin (NIM) for conventional firms compared to Islamic banks while Islamic banks have higher kurtosis values for their equity over net loans (LENL) ratio. Again, this means the existence of values far above or below the average for both these ratios. Looking at the mean figures for the ratios, it can be observed that the Islamic banks have higher operating performance due to higher net interest margins (NIM) ratio and are more liquid due to higher liquid assets over customer's short-term funding (LLASTF) ratio. The Islamic banks are also found to be sounder due to higher equity over net loans (LENL). However, conventional banks are found to have better asset quality as can be seen through their lower loan loss reserves to gross loans (LLRL) ratio. In terms of board characteristics, Islamic banks are found to have smaller board sizes with a higher proportion of independent directors.

From the descriptive statistics, it is obvious that there are differences between the conventional and Islamic banks but they are not sufficient enough to derive that the differences are statistically significant for both the banks. Independent t-tests are conducted for the variables which are normally distributed next to examine whether the differences between these two banks are significant. For the variables which are not normally distributed, the Kruskal-Wallis test for difference between means based on ranking is carried out. Table II presents the results of the test for all the variables.

From the means shown in the descriptive statistics, conventional banks were shown to have higher profitability (ROAA), which could be due to higher net financing, but the results of the independent t-tests show that the difference is not significant. However, In terms of operational efficiency (NIM), Islamic banks were found to be more efficient in the lending activities and expenses and the difference was found to be highly significant with a p-value of 0.000. However, conventional banks were found to have better asset quality in the form of their loan loss reserve to gross loans (LLLRL) ratio since their ratio is lower compared to those of Islamic banks and the difference in the means was found to be highly significant at the 1 percent level with a p-value of 0.003. On the other hand, Islamic banks have a higher liquidity or margin of safety to cover the debts compared to the conventional banks (LLASTF) and the difference is highly significant at the 1 percent level with a p-value of 0.010. This result supports the findings of Bashir and Hassan (2003) and Akhtar et al. (2011) where the Islamic banks have higher liquidity compared to conventional banks since Islamic banks are highly dependent on their investment deposits in their financing activities which leads to higher level of liquidity ratios compared to the conventional banks. The Islamic banks also have higher capability to absorb losses in the future as measured by the capital adequacy ratio (LENL). Thus, the Islamic banks are more protected against the operating losses compared to the conventional banks. This result supports the findings of Akhtar et al. (2011) which also found that the Islamic banks have higher LENL compared to conventional banks since Islamic banks are better capitalized in terms of their risk weighted assets and this higher ratio would act as a cushion for the bank against any shocks. The difference is found to be highly significant at the 5 percent level with a p-value of 0.023. There is a significant difference between the size of the banks too (p-value=0.000), with conventional banks being bigger compared to Islamic banks.

In terms of the board characteristics, conventional banks have significantly larger board sizes (p-value=0.001), which could act as a boon or bane for the banks. The boards of these banks are less independent although the difference with Islamic banks is not highly significant with a p-value of 0.665.

Before running the regressions, the correlations were checked. A rule of thumb for multicollinearity to be a serious problem in regression analysis is if the pair-wise correlation coefficient between two regressors is in excess of 0.8 (Gujarati and Porter, 2009). There was no evidence of such high correlations, the highest being between type of bank and size of bank (0.707). The correlations between the variables are as shown in Table III.

Before the regression was run, the ratios were winsorized at the 5 and 95 percent levels to ensure the normality assumption for regression was met for this small sample. The result of the ordinary least squares (OLS) regression with ROAA as the dependent variable is as shown in Table IV.

The results of the regression above shows that all the variables are significant at 5 percent level except for LLASTF (0.156), type (0.285) and the board characteristics, i.e. board size (0.349) and board independence (0.285). Inflation (INF) is marginally significant at the 5 percent level with a p-value of 0.055.

It should be also noted that due to the concern of small sample size, another analysis was done with data generated through the bootstrapping method. Replications of 50 and 100 were done. The results of the regressions with the bootstrapped data were not very much different from the results above.

Discussion of the regression results

The liquid assets over customer's short-term funding ratio (LLASTF) is one of the proxies for liquidity. The coefficient of LLASTF was found to be negative but insignificant represents a positive relationship of liquid assets over customer's short-term funding and the profits of conventional and Islamic banks in Malaysia. This indicates that the profits made by the Islamic and conventional banks in Malaysia are positively correlated with the extent to which deposit takers can meet the short-term withdrawal of funds without facing liquidity problems. The argument by Srairi (2009) is that the less liquid the bank, the higher the profitability. This is also found in this result since the amount of liquid assets is taken as the numerator for the variable used to measure liquidity. However, the result is insignificant. Looking at the results of the independent tests, Islamic banks were found to have significantly higher LASTF ratios compared to conventional banks. Hence, based on the argument above, higher liquidity will mean lower profitability. But the insignificance of the ratio means that having liquidity may not necessarily mean lower profitability for Islamic banks.

Net interest margin (NIM) ratio is the proxy for operational efficiency. NIM is found to be positively related to profitability and the relationship is found to be highly significant (0.000). Loan negotiation and wise investment decision could decrease the credit risk of the banks, which will increase the net interest margin (Wasiuzzaman and Tarmizi, 2010). This will result in higher lending revenue, which will contribute to the profitability of these banks. The results support the argument of Doliente (2003). The independent test results for NIM showed that the Islamic banks have higher NIM than the conventional banks. Since NIM is highly significant in affecting profitability and higher NIM means higher profitability, then based on this ratio, Islamic banks would be more profitable.

Akhtar et al. (2011) discovered that the ratio of equity over net loans (LENL) is significant and positively related with the bank's profitability but Adrian and Hyun (2006) discovered that the ratio was negatively related to the banks profit. In this study, LENL is found to be positively related to profitability and the relationship is found to be highly significant (0.000). A higher ratio indicates the ability to cover loan losses and to handle risk exposure, hence a sounder bank. According to the independent t-test results, Islamic banks were found to have significantly higher ENL ratios compared to conventional banks, indicating a sounder position, hence less risk involved. Based on the relationship with profitability, this would mean that Islamic banks would be more profitable with respect to the ENL ratio.

In terms of the asset quality, it is found that the loan loss reserves to gross loans (LLLRL) ratio is significantly (0.000) negatively related to profitability. The results support the findings of Asthanasoglou et al. (2005) and Vong and Hoi (2009). Alkassim (2005) found conventional banks to have lower LLRL ratios (hence, better asset quality) than Islamic banks and this was also found to the case in the independent test results. Given the negative relationship with profitability, this would mean that conventional banks are more profitable than Islamic banks if based on the asset quality.

Size of bank (BANK_SIZE) is also found to be highly significant (0.009) in affecting the profitability of the banks. The relationship was found to be positive, which supports the results of Yung (2009), Flamini et al. (2009) and Srairi (2009). In the independent t-test results, conventional banks were found to be significantly bigger than Islamic banks. Hence, from the results of both the independent t-test and the regression, it can be concluded that conventional banks would be more profitable if bank size is the determining variable.

Board characteristics (LBOARD_SIZE and BINDEP) were found to be insignificant in affecting profitability. Zulkafli and Samad (2007) found an insignificant relationship between board size and ROAA for listed banks from the Asian emerging markets, including Malaysia. Wang et al. (2008) cast doubt on the significance of the effect of board independence on corporate performance and highlighted Lawrence and Stapledon's (1999) claim of no effect of independent directors on firm performance. Both these variables were found to have a positive impact on profitability. Conventional banks were found to have less independent but significantly larger boards from the t-tests and hence based on the relationship found in the regression analysis, these banks should be more profitable. But the insignificant relationship does not necessitate that.

The effect of economic conditions, particularly inflation (INF), was found to be marginally significant at the 5 percent level (0.55). A positive relationship was found, implying that the higher inflation rates would mean higher profitability. Since higher inflation would result in higher costs and higher income, this result means that inflation enables banks to earn more compared to the increase in costs, resulting in higher profitability. As mentioned earlier, most studies looking at inflation did find this relationship.

An interesting though insignificant result found in the regression analysis is for the dummy variable, TYPE. TYPE was given the value 0 for Islamic banks and 1 for conventional banks. The regression results show a negative relationship between the type of bank and profitability. In this case, this means that conventional banks are less profitable than Islamic banks. The result is interesting because it is in contrast to what was found in the descriptive statistics, which showed that the average ROAA of conventional banks are higher. However, even in the independent t-test results, there was no significant difference between the ROAA of these two types of banks. The regression result would indicate that given the factors considered and if performance is based on these factors, then Islamic banks would perform better. However, if taking only the ROAA as a figure and comparing between the two, then conventional banks would be better. This probably implies that there could be other factors influencing performance not considered here since the constant term (C) is found to be highly significant or that the ROAA figures are probably not revealing the actual performance of the banks, such as the presence of earnings management. Again, the insignificance of this variable may not mean anything but further studies on this may be warranted.

Conclusion

The aim of this paper was to analyze the differences between Islamic and conventional banks in Malaysia, especially when it comes to their profitability, proxied by ROAA. A total of 14 banks (nine conventional and five Islamic) were considered over the period of 2005-2009. Three stages of analysis were performed. First, the descriptive statistics showed that the return on average assets (ROAA), bank size and board size values of conventional banks was higher compared to Islamic banks. The other variables – net interest margin (NIM) ratio, loan loss reserves to gross loans (LLRL) ratio, liquid assets over customer's short-term funding (LASTF) ratio, equity over net loans (ENL) ratio and board independence – were higher for Islamic banks. To determine whether these differences were significant, independent t-tests were carried out on each variable. All the variables, except for ROAA and board independence, were found to be significant, i.e. there were significant differences in these values for Islamic and conventional banks. Finally, regression analysis was carried out to analyze the effect of the variables on bank profitability. All variables except for LASTF, board characteristics and type of bank, were found to be highly significant in affecting profitability. A contrasting result was found for type of bank. While the descriptive statistics showed that conventional banks were more profitable (higher ROAA), the regression analysis indicated the opposite. This could be due to some factors not taken into consideration in this study or there could simply be some discrepancies. Probably the type variable being insignificant may not warrant attention to this issue but it is worth analyzing the profitability, or other aspects of performance, of these two types of banks in more depth.

ImageTable ISummary of descriptive statistics
Table ISummary of descriptive statistics

ImageTable IIDifferences in variables between Islamic and conventional banks
Table IIDifferences in variables between Islamic and conventional banks

ImageTable IIICorrelation matrix
Table IIICorrelation matrix

ImageTable IVRegression output
Table IVRegression output

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Further Reading

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About the authors

Shaista Wasiuzzaman is currently a Lecturer at Multimedia University, Cyberjaya, Malaysia. She teaches finance subjects at the university. She is also a PhD candidate at Multimedia University, Malaysia. Shaista Wasiuzzaman is the corresponding author and can be contacted at: shaista@mmu.edu.my

Umadevi Nair Gunasegavan is an MBA graduate from Multimedia University, Cyberjaya, Malaysia.