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Working Paper Series 004

PROFITABLITY DETERMINANTS OF ISLAMIC BANKS:


A COINTEGRATION APPROACH*

By Professor Sudin Haron Dr Wan Nursofiza Wan Azmi December 2004

Creating Dynamic Leaders *The paper was presented at the Islamic Banking Conference, Union Arab Bank, Beirut, Lebnon, 5-7 December 2004.

Profitability Determinants of Islamic Banks: A Cointegration Approach


TABLE OF CONTENTS
Abstract Introduction Literature Review Methodology Data Description Empirical Findings Conclusion 2 2 3 6 7 10 15

Abstract
Studies that measure the influence of various factors that determine the profitability of Islamic banks are still at the initial stage. This is the first attempt 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. This study 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. However, dynamic short-run analysis indicated a slow adjustment which implies that profitability of Islamic banks does not respond speedily to changes in the explanatory variables in the short-run.

Introduction
In the last four decades, many studies have been conducted to investigate the profitability determinants of conventional banks. Since the pioneering work of Hester and Zoellner (1966), which measured the relationship between items in the balance sheet and earnings of banks in the US, studies of bank profitability have expanded to the international level (see for example Short, 1979; Bourke, 1989; Molyneux and Thornton, 1992; and Steinherr and Huveneers, 1994). In the Islamic banking literature, the empirical work of Haron (1996a) was the first attempt to investigate factors that contributed towards the profitability of Islamic banks. However, most of

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the research used multiple regression analysis in measuring the relationship between the determining factors and profitability ratios. In contrast to other studies, Chirwa (2003) applied time-series techniques of cointegration and error-correction methods to test the structure-conduct-performance hypothesis and determine whether a long-run relationship exists between the profits of commercial banks and concentration in the banking industry. Cointegration analysis, introduced in the mid1980s, has been regarded by many econometricians as the most important development in empirical modelling (Charemza and Deadman, 1992). Cointegration enables the estimation of a relationship among non-stationary variables where cointegration in the variables simply reveals the existence of a long-run equilibrium relationship among them. Error correction model (ECM), which is derived from cointegration, shows how this equilibrium relationship is achieved, i.e. indicates the short-term dynamics in the movement towards this long-run equilibrium. Extending the work of Haron (1996a, 1996b, 2004), this paper investigates the strength of influence between both external and internal variables and the profitability of Islamic banks using the cointegration and error-correction methodology. To the best of our knowledge, this is the first study which employs such an advance time series econometric techniques to determine the profitability of Islamic banks. The paper is structured into 7 sections. Section 2 contains a brief review of the literature. Section 3 discusses the methodology employed. Section 4 provides the description of the data. Section 5 presents the empirical results. Finally, Section 6 summarises the main findings and gives the conclusion of the study.

Literature Review
Researchers have examined and identified various factors that have significant influence on banks profitability. In addition to dividing the profitability determinants into two categories, i.e. internal and external, these studies have been able to postulate some profitability theories related to banking. Among the theories in the bank profitability literature are the structure-conduct-performance theory (Bain, 1951), efficient-structure theory (Demsetz, 1973; Peltzman, 1977), expense-preference theory (Becker, 1957; Williamson, 1963) and risk-aversion theory (Galbraith, 1967; Cave, 1970). However, findings on the existence of profitability theories in banking vary among the researchers. Majority of the previous profitability studies have been of conventional banks (see among others Hester and Zoellner, 1966; Emery, 1971; Mulllineaux, 1978; Kwast and Rose, 1982; Smirlock, 1985; Molyneux and Thornton, 1992; Steinherr and Huveneers, 1994). Only a handful of researches have been conducted to determine the profitability of Islamic banks (see for example Haron, 1996a, 1996b, 2004 and M. Bashir, 2003). Conventional bank profitability studies involving internal determinants were pioneered by Hester and Zoellner (1966), followed by Haslem (1968, 1969), Fraser and Rose (1971), Mullineaux (1978), Smirlock (1985) and Stienherr and Huveneers (1994) among others. For an extensive literature on the effects of internal determinants on bank profitability, see articles by Haron (1996a, 2004). Internal variables can be broadly classified into two categories: financial statement variables and non-financial statement variables. The financial statement variables are related to the management of the balance sheet and income statement. The balance sheet management is directly related to assets and liabilities man-

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agement. Hester and Zoellner (1966) studied the relationship between balance sheet items and banks earnings and found significant relationships. Asset items showed positive association whilst liability items had an adverse effect on profits. Similarly, Mullineaux (1978) established that balance sheet structure had a significant impact on profitability. However, depending on the nature of the items on the balance sheet, the relationship can either be negative or positive. Pertaining to deposit structure, Heggested (1977) reported that time and savings deposits had a significant inverse relationship with profitability. Smirlocks (1985) findings indicated a significant positive relationship between demand deposits and profits. In contrast, Fraser and Rose (1971) found that loan rate; time deposit rate and loan-to-deposit ratio had no effect on profitability. Bourke (1989) and Molynuex and Thorton (1992) found that capital and staff expenses were positively related to banks profitability. Similar relationship was ascertained for overhead expenditure by Steinherr and Huveneers (1994). Income statement management, on the other hand, is directly related to income and expense management. Areas such as managing interest sensitivity and margin, allocation of expenses, and priority in expenditure are considered to have an impact on a banks total income and expenses (Haslem, 1968; and Fraser and Rose, 1971). Non-financial statement variables encompass variables that have an indirect relationship with items in the financial statements and include the number of branches, status of branches, location and size of branches and banks. The number, status and location of branches are regarded as controllable variables when decisions related to them are within the discretion of management. Likewise, size is considered as an internal determinant on the postulation that it is the responsibility of bank management to expand the organisation through the acquisition of additional assets and liabilities (Steinherr and Huveneers, 1994). Investigating the effect of location and size on profitability, Emery (1971) and Vernon (1971) reported a significant relationship for location, whilst Mullineaux (1978) found similar relationship for size. On the contrary, studies by Vernon (1971), Kwast and Rose (1982), Heggested (1977) and Smirlock (1985) found that size had no effect on profitability. With regards to number of branches, Hester and Zoellner (1966) did not find any effect this variable had on a banks profit level. Several external factors have been identified in the conventional banking literature as having an impact on profitability. External factors considered include regulation, competition, concentration, market share, ownership, money supply, inflation and bank size. An extensive discussion of this can be found in Haron (1996b and 2004). Regulation is considered as one of important determinants of profits for conventional banks since the banking industry is highly regulated. Regulation in the industry is normally imposed on bank management and the industry itself. Direct regulations on bank management cover lending policy, deposit policy, interest rates and liquidity requirements. In the banking system, regulations include the condition of entry, establishment of new ventures, mergers and acquisitions. Studies by Pelzman (1968), Vernon (1971), Emery (1971), McCall and Peterson (1977), Mullineaux (1978) and Smirlock (1985) concluded that regulation had a significant impact on banks profitability. Fraser and Rose (1972) found conflicting results when examining whether the opening of new institutions had any significant effect on the profitability of competing institutions.

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The first researcher who measured the effects of competition on bank profitability was Emery (1971). He used market entry as a proxy for competition and found that competition had no significant impact on profits. Heggested and Mingo (1976) used market structure instead and found that market power of an individual bank increases with the degree of monopoly. Amongst the researchers who have examined the effect of concentration on profitability are Emery (1971), Vernon (1971), Fraser and Rose (1982) and Smirlock (1985). The findings of Emery; and Fraser and Rose indicated that concentration had a significant positive relationship with profits. Vernon, on the other hand, found an inverse relationship between them. The effect of concentration was insignificant in Smirlocks study. Market share is also considered a determinant of profitability under the assumption that the greater the market share, the greater is a banks control over the prices and services it offers to its customers. This assumption was verified by Heggested and Mingo (1976). However, Heggested (1977) and Mullineaux (1978) found that market share is inversely related to profitability. In a related study, Short (1979) believed that government ownership would have an impact on profitability on the grounds that government banks are non-profit oriented banks. This confirms the hypothesis that the higher amount of a banks capital owned by the government, the lower is the profit generated by these banks. Molyneux and Thornton (1992) also found a significant positive relationship between ownership and profitability. In the case of growth in the market, Bourke (1989) believed that market expansion could produce a capability for earning increased profits. In his study and a similar study by Molyneux and Thornton (1992), they found that market expansion, represented by growth in

money supply, had a significant relationship with profits. Revell (1980) contended that inflation could also be a factor contributing to the variations in a banks profitability. He proposed that inflation affected banks through a number of different routes such as interest rates and asset prices, exchange rates and operating costs. Finally, Emery (1971) and Vernon (1971) were among the earliest researchers to link bank size with profitability. The size of a bank is associated with the concept of economies of scale. Economic theory postulates that if an industry is subject to economies of scale, large institutions will be more efficient and thus are able to produce services at a lower cost, ceteris paribus. Since large banks are assumed to enjoy economies of scale, they are able to produce their outputs or services more cheaply and efficiently than can small banks. As a result, large banks will earn higher rates of profit if entry is restricted. Smirlock (1985) believed that large banks are likely to have greater product and loan diversification. This increased in diversification implies less risk and hence a lower required rate of return. Within the Islamic banking literature, Haron (1996a, 1997b, 2004) identified internal and external factors that contributed towards the profitability of Islamic banks. Haron (1996a) found evidence to suggest that all three sources of funds (current, savings and investment accounts) for Islamic banks are positively related to profitability. His study validates the current practices of Islamic banks which use mark-up principles in their financing activities where an inverse relation between profit-sharing principles and profitability measure ratios were found. Other internal variables which were found to have a significant positive relationship with profit include liquidity, capital and reserves and total expenses.

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In another study, Haron (1996b) examined the impact of external factors which may have an influence on the profitability of Islamic banks. The author identified competition, regulation, market share, interest rate, money supply, inflation and bank size as the external determinants. An interesting finding reported by Haron was that Islamic banks which operate in a competitive market earned more than those operating in a monopolistic market. Furthermore, his findings suggest that the theory which posits that the bigger the share of bank in the market, the more profitable it would be does not apply to Islamic banks. Similar results were established for money supply. However, Haron found that interest rate, inflation and size have significant positive impact on the profits of Islamic banks. These results confirm to the empirical findings in the conventional banking literature. Unlike the works of Haron (1996a, 1996b) which used international data, M. Bashir (2003) examined the determinants of profitability in Islamic banks operating in the Middle East. Analogous to the studies by Haron, M. Bashir divided these determinants into internal and external factors. Several conclusions were reached. Firstly, he found a positive relationship between capital ratio, loan ratio, foreign ownership and favourable macroeconomic environment with profitability. Secondly, taxes and reserve ratio were found to have an inverse and statistically effect on Islamic banks performance. He also found evidence to support the importance of consumer and shortterm funding, non-interest earning assets and overheads in promoting banks revenues. In his recent article, Haron (2004) examined jointly the effect of both internal and external factors that contributed towards the profitability of Islamic banks. His study found that internal factors such as liquidity, total expenditures, funds invested in Islamic securities, and the percentage of the profit-sharing ratio between the bank and the borrower of funds are highly correlated with the level of total income received by the Islamic banks. Similar effects were found for external factors such as interest rates, market share and size of the bank. One of the significant contributions of Harons work is that Islamic banks in a competitive market were found to be better managed than their counterparts. Therefore, Haron believed that protectionism policy adopted by some Muslim governments is inappropriate and could distort future development of Islamic banking.

Methodology
This paper uses cointegration and error correction model which are all conducted within a vector autoregression (VAR) framework, to examine the factors that determine the profitability of Islamic banks. These techniques represent recent advances in time series econometric. The concept of cointegration was introduced by Granger (1983, 1986) and further developed by Engle and Granger (1987). Cointegration enables the estimation of a relationship among non-stationary variables where cointegration in the variables simply reveals the existence of a long run equilibrium relationship among them. However, when using the VAR model to analyse economic relationships, all variables are required to be stationary. Hence, it is necessary to first test for the stationarity of each variable by conducting unit root tests. To do this, the paper employed the Augmented DickeyFuller (ADF) test. A multivariate test for cointegration developed by Johansen (1988) and

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Johansen and Juselius (1990) is used in this study. The Johansen-Juselius (JJ) procedure of cointegration test is based on the maximum likelihood estimation of the VAR model. The test is carried out through a VAR system such as follows:
Pt = 1 Pt-1 + 2 Pt-2 + ... + k Pt-k (1) + + t , t = 1, . . . , T

correction model (ECM), which is derived from cointegration, shows how this equilibrium relationship is achieved. According to Engle and Granger (1987) cointegration implies, and is implied by, the existence of an error correction term. This means that changes in the dependent variable are a function of the level of disequilibrium in the cointegrating relationship (captured by the error correction term) as well as changes in other explanatory variables. Once the variables are found to be cointegrated, a vector correction model (VECM) will be used to investigate the dynamic interactions among them in the system. The Granger representation states that for two cointegrated variables, an ECM can be found in the following form:
Yt = 0 + 1Xt + 2t-1 + t (3)

where Pt is a (n 1) vector of I(1) variables; i are (n n) matrices of parameters; is a (n 1) vector of constant; t is a vector of normal distributed error with zero mean and constant variance; and k is the maximum number of lag length processing the white noise. Differencing equation (3), the system can be rewritten as:
Pt = 1Pt-1 + + t + ... +

k Pt-k + Pt-1
(2)

defines the impact matrix, which relates the change, Pt to the levels, Pt-k of k periods earlier. The rank of determines the number of distinct cointegrating vector, r. If the rank of is zero, then there are no combinations of the variables which are stationary, i.e. there are no cointegrating vectors. Hence, equation (2) is reduced to a standard VAR model of the first difference. If is of full rank, then all variables are stationary. If the rank is r such that (0 < r < n), then there is cointegration between the variables with r cointegrating vectors. The trace and maximum eigenvalue statistics are calculated to test for the presence of r cointegrating vectors. If cointegration is found, error correction models are constructed. However, if no cointegration is found, the analyses will be based on the regression of the first differences of the variables using a standard VAR model. Error

where t-1 represents the error correction term which captures the adjustment toward the long-run equilibrium and 2 is the shortrun adjustment coefficient.

Data Description
The data for this study are pooled time-series cross-sectional data taken from the annual reports of Islamic banks from various countries. The banks chosen are Bank Islam Malaysia Berhad (Malaysia), Islamic Bank of Bangladesh (Bangladesh), Dubai Islamic Bank (United Arab Emirates), Jordan Islamic Bank (Jordan) and Albaraka Islamic Investment Bank (Bahrain). Sample period for this study is from 1984 to 2002. In line with previous studies on bank profitability, this study also divides profitability determinants into two categories, namely, internal and external variables. The summary of the in-

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dependent variables used in the study is given in Table 1. Haron (1996a) argued that Islamic banks are indeed commercial banks but operate on an interest-free basis. Hence, internal variables such as liquidity, capital structure, deposits structure, financing structure and expenditure items which influence the profitability of conventional banks are hypothesised to have similar impact on the performance of Islamic banks. The variable LIQ is expected to have a positive relationship with profitability (Molyneux and Thornton, 1992; Steinherr and Huveneers, 1994; and Haron, 2004). The ratio CRTA is used as a proxy for measuring the impact of capital structure on profitability. It is posited that the higher amount of capital injected, the more confident customers will be and the more deposits that will be placed at the bank. Bourke (1989), Molyneux and Thornton (1992), Steinherr and Huveneers (1994) and Haron (1996a) found a positive relationship between capital structure and profitability measures ratios which where deflated against total assets. Deposit structure is represented by three variables, i.e. current (DECA), savings (DESA) and investment (DEIA) accounts. Hester and Zoellner (1966) and Heggested (1977) found that savings and time deposits were inversely related to profitability, while a positive relationship has been found for current account deposits by Smirlock (1985). Under assets structure, the two variables for earning assets used in this study are FIPS and FIMK. The findings of previous research indicated that asset items have a positive relationship with profitability. However, Haron (1996a) found that for Islamic banks, where a relationship existed, asset items had an inverse relationship with profitability measures. In the case of expenditure items, total operating expenditures (TEXP) is used as a proxy. TEXP is hypothesised to be inversely related with profit. External variables, on the other hand, are variables outside the control of bank management. The external variables used in this study are market share, money supply, interest rate, inflation and size of the bank. Market share is considered as one of the determinants of profitability since the bigger the market, the larger is the banks potential profits. Market share is represented by the ratio MKTSH. According to Short (1979) and Smirlock (1985), market share is positively related to profits. However, Heggested (1977) and Mullineaux (1978) found otherwise. As in Bourke (1989), money supply was used as a proxy for market growth. The author believed that growth in total market may be considered as a potential variable in the sense that an expanding market would produce an environment for increasing profits. In his study, Haron (1996b) reported a positive relationship between money supply and the profitability of Islamic banks. Although interest is prohibited in Islamic banking, Islamic banks operate in an environment where interest rates do exist. Hence, it is proposed that the interest rate variable (INT) be included in this study so as to observe whether INT have any indirect impact upon Islamic banks profits. Haron (1996b) observed that INT is closely related to the profitability level of Islamic banks. This paper uses Consumer Price Index (CPI) as a proxy for inflation. Studies by Bourke (1989) and Molyneux and Thornton (1992) established a significant positive relationship between inflation and profits. Similarly, Haron (1996b) found that CPI had a positive relationship with all profitability measures but the relationship

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Table 1: Independent variables used in the study


Variables Represented By
Total financing as a percentage of total deposits (LIQ) Capital and reserves as a percentage of total assets (CRTA)

Source
Samples annual report Samples annual report

INTERNAL
Liquidity Capital Structure Deposits Structure

Total deposits in current accounts as a percentage of Samples annual report total assets (DECA) Total deposits in savings accounts as a total assets (DESA) percentage of Samples annual report

Total deposits in investment accounts as a percentage Samples annual report of total assets (DEIA) Assets Structure Total funds in profit-loss sharing principles as a per- Samples annual report centage of total assets (FIPS) Total funds in mark-up principles as a total assets (FIMK) Expenditure Item Total expenditure (TEXP) as a percentage of percentage of Samples annual report total assets Samples annual report

EXTERNAL
Market Share Money Supply Interest Rate Inflation Size Total deposits of the Islamic banks as a percentage of Samples annual report and a countrys total deposits (MKTSH) IMF Financial Statistics Growth in money supply (M2) for each country for IMF Financial Statistics each year (MON) The discount rate for each country for each year IMF Financial Statistics (INT) Percentage increase in consumer price index for each IMF Financial Statistics country for each year (CPI) Total assets in common currency (US dollar) in loga- IMF Financial Statistics rithm (LogSIZE)

was not statistically significant. It is also hypothesised that inflation will have a positive impact on Islamic banks. This study considers the size of bank in logarithm (LogSIZE) as an external variable. Short (1979) found that

LogSIZE was positively and significantly correlated to profitability. On the contrary, Steinherr and Huveneers (1994) found this to be insignificant. Harons (1996b) study indicated that the larger the banks size, the higher is the

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total income accruing to the bank. In addition to the above independent variables, this study replicates the work of Haron (1996a, 1996b, 2004) and thus, uses the following variables as proxies for profitability: Table 2: Proxies of profitability a time trend. The stationarity test results are presented in Table 3. The test is applied to both levels as well as to the first differences of the series. For series levels, the null hypothesis cannot be rejected at the 5% significance level. However, when the data are differenced, non-stationarity can be rejected for all data series. This finding is not sensitive to the inclusion of a deterministic trend variable in the ADF regression equation. Hence, the results imply that each data series are integrated of order one, i.e. I(1). Given that all the data series are I(1), the next stage in the study is to test for the presence of cointegration. In this analysis, the JJ procedure of cointegration test based on the maximum likehood estimation of the VAR model is employed. Table 4 and 5 present the results of the cointegration tests. In all cases, a single cointegrating equation is observed from both the trace and maximum eigenvalue statistics. The findings imply that a single-long-term relationship exists among the variables under consideration. Therefore, it can be concluded that the profit models are cointegration regressions. Having established the presence of a single contegrating vector, we tested whether each of the variables enter the cointegrating vector significantly by way of imposing restrictions and likelihood ratio tests which are asymptotically distributed as a chi-squared distribution with one degree of freedom. Table 6 reports results of the Johansens cointegration test for internal variables.

Variable TITA BITA

Proxy Total income as a percentage of total assets Banks portion of income as a percentage of total assets Net profit after taxes as a percentage of capital and reserves

ATCR

The first ratio, TITA, is used to capture the effects of internal and external determinants on a banks profitability. Similarly, BITA ratio will also capture the effect of these determinants on profitability. It is expected that all determinants will have similar impacts on both TITA and BITA. On the other hand, the ATCR ratio measures the effects of profitability determinants on returns to shareholders. Hence, TITA and BITA capture the effects of determinants on profitability, while ATCR measures the effects of determinants on the potential incomes to shareholders.

Empirical Findings
In line with Granger (1986), a necessary but not sufficient condition for cointegration is that each of the series should be integrated of the same order. Accordingly, each series is tested for stationarity. The null hypothesis for the presence of a unit root (non-stationarity) is tested using ADF test both with and without

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Table 3: The ADF test statistics for a unit root

Note: * indicates the 5% level of significance

Table 4: Cointegration test statistics of the internal variables

Note: * indicates rejection of the null hypothesis at the 5% level of significance

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Profitability Determinants of Islamic Banks: A Cointegration Approach

Table 5: Cointegration test statistics of the external variables

Note: * indicates rejection of the null hypothesis at the 5% level of significance

Table 6: Cointegration results for internal variables

*, ** and *** denotes significant at 1%, 5% and 10% level.

This study found that liquidity had a significant positive relationship with TITA and BITA, but not significant with ATCR. The positive relationship between profitability ratios and liquidity is in line with the findings of Haron (1996a) and the conventional banking theory which postulates that an increase in financing is followed

by an increase in profits. A significant relationship was also found between capital structure and BITA, but not with TITA and ATCR which implies that additional capital will not generate more income for the bank. In the case of BITA, for every 1% increase in capital the percentage of BITA would increase by 0.1%.

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Amongst the deposit structure variables, DEIA was the only variable which had a significant relationship with all three profitability ratios. For DECA, a positive relationship was found with BITA. The result indicates that a 1% increase in current account holdings will increase the banks 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. Intriguingly, DECA had no significant relationship with TITA implying that an increase in current accounts does not generate more income to the bank, but only function as a cost saving measure. On other words, Islamic banks do not pay any rewards to their depositors. These results are in line with the findings of Haron (1996a, 2004). DESA was found to have a significant positive relationship with TITA. Every 1% rise in savings account, total income will increase by 0.26%. This is 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. As for assets structure variables, both FIPS and FIMK were found to have a significant but inverse relationship with profitability measures. For every 1% increase in FIPS, total income will decrease by 0.092%. This finding could support the existing perceptions and attitudes of Islamic bankers, whereby profit sharing principles (musyarakah and mudharabah) are considered the most risky principles in Islamic banking business. Lack of monitoring programs could also lead to the high occurrences of non-performing loans for loans given based on profit sharing principles. In the case of FIMK, it had negative relationship with TITA and BITA. Each 1% increase in

FIMK will decrease TITA by 2.686% and BITA by 0.042%. This finding is in contradiction to the standard banking practices. In general, additional financing would increase banks revenue. However, there is a possibility that because of the high concentration of funds in FIMK led to less charges imposed to customers and thus, resulting in an inverse relationship with TITA and BITA. Total expenditure is found to have an inverse relationship with TITA and BITA and a positive relationship with ATCR. However, a significant relationship is only found with TITA. This is hard to explain because expenditure items usually have a positive relationship with total income. One possible reason for this is that the expenses incurred did not contribute to the income generated activities. The cointegration results for external variables are presented in Table 7 below. MKTSH and LOGSIZE were found not to have any significant relationship with all three profitability measures. These findings are not in line with findings of Haron (1996b). In most cases market share and size of bank have direct positive relationship with revenues. This study found that interest rate (INT) is only positively significant with ATCR. CPI was found to have a positive significant relationship with all profitability measures, confirming to the findings of Bourke (1989) and Molyneux and Thorton (1992). The study also found a positive relationship between money supply and TITA and BITA. This finding confirmed to the work of Haron (1996b) and concludes that growth in the economy as proxies by money supply is shared by Islamic banks. Since all the profitability measures and their corresponding explanatory variables exhibit cointegrating relationships, VECM were esti-

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mated to model short-run dynamics. The size of the error-correction term (ECT) measures the speed at which profitability measures adjust to the change in equilibrium conditions. Results from the VECM tests are reported in Table 8 and 9. Table 7: Cointegration results for external variables

*, ** and *** denotes significant at 1%, 5% and 10% level

Table 8: Error-correction models for internal variables

Table 9: Error-correction models for external variables

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The results in Table 8 reveal that the ECT is negative and statistically significant for all profitability measures in the case of internal variables. This implies that TITA, BITA and ATCR are adjusting to any deviations in the long run equilibrium relationship. In other words, negative deviations are rectified by increases in profitability. The coefficients of ECT, however, are found to be small in magnitude. The findings demonstrate a slow adjustment process towards a change in the equilibrium conditions. However, it can be observed from Table 8 that Islamic banks profitability as measured by BITA adjusts in the short-run in response to a reduction in the funds in profit-sharing financing activities. For the external determinants, the corresponding error correction terms for all profitability measures are highly significant and have the correct negative sign as shown in Table 9. Alike results from the previous table, the profitability measures were also found to have a slow speed of adjustment towards long-run equilibrium. However, contemporaneous change in inflation rate and money supply significantly influence changes in BITA and ATCR.

ever, with regards to net profit, variables that have significant influence are funds deposited in the investment account, inflation and money supply. Finally, this study also measures the speed of adjustment process towards the long-run equilibrium. Although the above mentioned variables were found to have a long run relationship with profitability, Islamic banks profitability as measured by TITA, BITA and ATCR adjust slowly in the short-run to deviations in the cointegrating relationship. In other words, profitability of Islamic banks does not respond speedily to changes in the explanatory variables in the short-run. One of the possible reasons that can be linked to the insignificant short-term relationship is that the operations of Islamic banks are based on Shariah principles.

REFERENCES Ahmad, Ausaf (1987), Development and Problems of Islamic Banks, Jeddah (Saudi Arabia, IRTI, Islamic Development Bank. Ahmad, Ziauddin (1983), Comments on Volker Nienhaus: Profitability of Islamic banks Competing with Interest Banks. Journal of Research in Islamic Economics, Vol. 1, No 1 (Summer), 66-68. Ahmad, Ziauddin (1994), Islamic Banking: State of The Art. Islamic Economic Studies, Vol 2 No 1, December, 1-33. Al-Baraka Islamic Investment Bank of Bahrain, Annual Report, various issues, Manama (Bahrain). Bahrain Islamic Bank, Annual Report, various issues, Manama (Bahrain). Bank Islam Malaysia Berhad, Annual Report, various issues, Kuala Lumpur (Malaysia).

Conclusion

This study employed cointegration approach in measuring the relationship between determinants variables and profitability measures of Islamic banks. Since this is the first attempt to investigate such relationship using advance time-series technique, we believe the findings of this study could be used to compare previous findings of similar studies. This study could serve as impetus for future works related to Islamic banking literature. One of the important findings from this study is that some of the determinants have significant influence on profitability. Factors such as liquidity, deposit items, assets structure, inflation and money supply must be closely monitored by banks managers. This is because all of these items are statistically significant which implies that any changes in the variables will have a long term impact on profitability. How-

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Profitability Determinants of Islamic Banks: A Cointegration Approach


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Profitability Determinants of Islamic Banks: A Cointegration Approach


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