Review of Literature

Merchant (2012) conducted an analysis of the Islamic and Conventional

banks. The research was based on two tailed test i.e. t-test. The focal point
of the study is to know the efficiency and effectiveness of both Islamic and
conventional banks when there are crises in any form whether financial,
operational and/or ethical. The study was carried out in GCC area in the
year 2008. He inferred that after the crisis Islamic banks increased their
LLR in comparison to conventional banks where they increased not only
their LLR but also EQTA.
Oslon and Zoubi (2008) worked on the Islamic and conventional banks in
the GCC area for a period of five years i.e. (2000-2005). The outcome was
summarized which indicated that although the profit margin earned by both
banks are the same but the efficiency of the Islamic banks were far better
than conventional banks. Moreover it was also reported that operational
risk level of Islamic Banks are higher as compared to conventional banks.
They explained the main elements which raised the level of risk. It was
because of upholding of funds which were intended to be utilized in
situation where loans went bad i.e. not being realizable or difficult to realize
or time barred. In addition to this the conventional banking system allows
pre-defined and almost fixed rate of interest on funds invested by Investors
while the rate flexibility is higher on such funds as subject to numerous risk
which is much real than in conventional banks.
Ansari and Rehman (2011) carried out another research work on the same
pattern i.e. comparing the conventional banking system with that of nascent
Islamic banking system. The study was focused on the efficiency and
performance parameters of both these banks. The study span was from
2006 to 2009 activities of the banks. They found out different ratios which
were mostly related to Financial and operational aspects of banks. Based on
the

ratios

of

Profitability,

liquidity,

solvency,

capital

requirements,

deployment ratio and operational efficiency and effectiveness it was

concluded that liquidity ratio of Islamic Banks are higher than conventional
while the operational efficiency was calculated low for Islamic banking

system. They reported that Risk level of Islamic banking system was also
low as compared to the conventional banking.
Srairi (2013) conducted research on another side of baning systems i.e.
Islamic and conventional. He studied the effect of ownership type on the
risk position of banking systems. Study was carried out in 10 MENA
countries for both Islamic and conventional banking. The ownership was
categorized as Family owned, Company owned and State Owned banks. The
scope of study was for a period of five years i.e. 2005-2009. The study was
aimed at risk-taking patterns of the two systems of banks. They inferred
that there existed a negative correlation between Ownership and allied risk
in banks on overall level. It was also reported that the those banks which
are owned by State were subject to higher risk and were found more prone
to higher degree on non-performing loans as compared to banks owned by
family or company. They concluded that those Islamic Banks which are not
owned by public or not nationalized would be having good stability as
compared to those conventional banks which are owned by state. While
reporting the credit risk of the two banking systems the researchers
narrated that Islamic banks had low credit risk in comparison to
conventional banks.
Gamaginta and Rokhim (2011) worked on the overall stability of Islamic
versus conventional banking system. The sample was selected to include 12
Islamic and 71 conventional banks in Indonesia. The analysis was carried
out using Z-score for a data taken for 6 years. They inferred that the Islamic
banks were less stable than conventional banks. Keeping in view the
financial crunch of year 2008, it was reported that stability level of the two
systems in this particular time was found equal.
Louati et al based his research on the correlation between behavioural
patterns of both banks i.e. Islamic and conventional, and capital adequacy
by considering a number of situations. Sample was selected for 12 MENA
and south East Asian countries where both Islamic and Conventional banks
existed. The data was taken from of 70 conventional and 47 Islamic Banks.

The report concluded that banking behaviour was impacted on a larger

extent by the funding ratio. It also indicated that the competitive conditions
didnt have any reasonable effect on the relationship between weighted
assets ratio and Islamic bank behaviour. Based on this result the researcher
assumed that the Islamic banks might have applied those theoretical models
of banking which were aimed at discouraging interest from banking sector.
Rajhi and Hassairi studied those factors relevant to capital structure and its
enforceability in Islamic Finance by Islamic banks. The report identified that
there was significant difference beween Islamic and conventional banking
system. The researchers worked on the capital capability structure in
relation to Islamic banks. They inferred from interrelationship of risk
management and capital structure for Islamic banking system that the risk
management of Islamic banking had specific risk categories. They provided
risk weights to free investments for Islamic banking system to establish its
own capital requirements in relation to degree of loss tolerance.
Al-Deehani, Rifaat, Murinde (1999) reported that the conventional banking
system was based on the concept of Financial Risk which was derived from
modern structure theories, has nothing to do with the Islamic banking
system. It is stated that there is a binding contract between Islamic Banks
shareholders and investments accounts holders in the light of which the
profts and/or losses are shared. Both parties agree to certain theoretical
models the assumptions of which the increases in the Investment accounts
financing help Islamic banks to modify its market value and its shareholder
rate of return without any further exposure to financial risk to the bank.
Shubber and Alzafiri (2008) based their research on four basic assumptions:
1. Independence of weighted average cost of capital (WACC) from the
level of deposits
2. A larger size of deposits does not entail higher financial risk
3. A larger deposit size entails higher earnings per share
4. A large deposit size increases market share of bank.

The scope period was selected for study was from 1993 to 1998. They
worked on the relationship which existed among all these four factors. A
correlation coefficient for market capitalization and size of deposits with
banks obtained as ranging from 0.72 for DIB and 0.88 for QIB with average
value of of 0.83. The final result was reported that when the quantum of
deposits moves up with banks then the market value of with also goes up
without placing any impact on the financial stability of bank.
Zimmerman (1996) conducted researched on the factors which affect the
profitability of banks. He took both factors, internally and externally which
impact directly the profit ratio of banks. He inferred that these are
managemenet policies and practices which cause impact on the loan
portfolio concentration and efficiency of bank performance. Moreover the
outcome of quality management is satisfactory bank performance. The
quality of management was assessed on the basis of how much the senior
management was conversant with Bank policies and controls.
Staiouras (1999) focused on only two factors i.e. Banks profitability
determinants and other factors influencing the profitability. Sample was
selected from whole of EU banking sector and period taken from 1994 to
1998. Research tool was taken as OLS models made from data taken. It was
found that the profit ratio of all those banks was influenced by the internal
factors like management decisions and also subject to external elements
like macroeconomic fluctuations. Also it was reported that profit levels were
directly proportional to the extent of equity which the bank had i.e. more
equity result in high profit ration and vice versa. On the other hand the ratio
of loans to total assets is inversely related to Return on asset by the entities.
The results were summarized by saying that those banks which had large
quantum of non-loan earning assets gave more return and contribution to
profit ratio than those banks which had high dependability ratio on assets
for their earnings through loans.
Haslem (1968, 1969) had his research based upon the financial statement
ratios for data taken from member banks of US Federal Reserve System.

The study was conducted for two years. The conclusion indicated that
profitability ratio were mostly worked which were relevant to banking
sector and in particular capital ratio, interest paid and received, salaries
and wages were concerned. He also argued for better management in
banking sector the authority should focus on the management and
monitoring of expenses of banks and subsequent emphasis should be given
to fund management and fund utilization management. Wall(1985) stated
that the assets and liabilities management, funding and non-interest cost
controls and management had a substantial direct impact on profitability of
banks.
Beck et al. (2013) conducted a research on a sample of 510 banks in 22
different countries for a period from 1995-2009. This was based on the
Islamic banking versus the conventional banking systems in the countries.
He found that the models of carrying on business by the two systems of
banking are different from one another. He concluded that the performance
ratio of Islamic banking system is much higher than conventional banks. It
had a higher intermediation ratio and quality of assets with Islamic banks is
higher and these assets were utilized in the best way as compared to
conventional banks. He also proved that whenever the crisis were faced, the
Islamic banks performed better by way of capitalization of assets and its
relevant quality as compared to conventional banks.
Abedifar et al. (2013) took a sample of 553 banks from 24 countries of the
world. The scope period was taken as 199-2009. The main area of research
and study was risk and stability of Islamic banking system in relation to the
conventional banks. They concluded that the profitability ratio and
capitalization rate worked out on average basis was more favorable than
conventional banks. The report also stated that the credit risk of Islamic
banks is lower as compared to conventional banks in those countries where
muslim population was denser than in other countries. The insolvency risk
Islamic banks were also found to be more stable than conventional banks.

Belanes and Hassiki (2012) worked on the performance efficiency of 32

Islamic banks which were selected from MENA countries. The scope period
of the research was 2006-2009. They performed Data Envelopment Analysis
(DEA) method for review and analysis of data in their research. The result
documented that there was no significant difference in the performance and
efficiency of the two systems of banks i.e. Islamic and conventional banks.
Belanes and Omri conducted a research on the main differences between
Islamic and conventional banking systems. The focal point of their study
was capital structure. The sample selected was of 44 banks from Islamic
system of banking and 66 conventional banks for the study. The sample was
taken from markets which were representative of relevant sectors. The
scope period was from 2005-2010. They used Discriminate analysis with
binary logistic regression for determining the scenarios for variables, equity
ratio, profitability ratio which they though would more helpful in forecasting
the nature or type of banking system. Their study suggested that equity to
asset ratio could better explain the difference between Islamic and
conventional banking system rather than using profitability ratios and
analysis. They reported that both Islamic and conventional systems of
banking did not vary on wider extent from one another if it was compared in
terms of profit ratios. However it can be inferred that if the capital ratio for
is found high then there is probability that the institution under review is an
Islamic Bank. It meant the main determinant of an Islamic ban is Capital
ratio. Actually Islamic banks operate in an equity based financing rather
than debt based that is why capital ratio may be more relevant in analyzing
any Islamic banking system.
Metwally (1997) conducted a research on a sample 30 banks in which 15
are Islamic banks. The scope period was 1992-1994. He argued that the
profitability was inversely related to the ratio fo deposits to total assets. It
the ratio of deposits to total is lower the profitability ratio of the bank would
be high. Also it was suggested as an indicator that if the capital to assets
raitio is high then higher were the chances that the institution would be
Islamic rather than conventional.

Toumi et al (2011) took a sample of 50 Islamic and 59 conventional banks

for the research. The period selected was 2004-2008 for four years. They
proved that leverage in case of Islamic banks is smaller or lower as
compared to conventional banks. Their research revealed that the Debt to
equity ratio in case of Islamic banks moves up on an average basis with a
value of 7.8 while the same ratio variates on average basis for conventional
banks at 11.8.
Pappas et al (2012) conducted a research on Islamic banking system by
taking a sample of 106 Islamic banks and 315 conventional banks out of 20
countries. The study was conducted for period from 1995 to 2010. The
conclusions reported were like these:

The Islamic banks has a lower leverage, based on equity to asset ratio
with a percentage calculated value of 21.7 % and the same was

worked out to be 10.8 % for conventional banks.

They also reported that there was a substantial difference in both
system of banking in terms of their sensitivity of failure risk to
numerous variables and elements.

Short (1979) and Bourke (1989) worked on the relationship of size of bank
and regarded it as external factor for different decisions. The management
can establish further branches by extending the operations to new location
through acquiring new assets and taking further liabilities against it.
Generally there are two main factor affecting a bank operations viz; internal
and external factors. The internal factors can further be classified into
financial statement and non-financial statement variables. The financial
statement variables are those which have direct impact on the Balance
sheet and income statement while non-financial statement factors are those
involve which are indirectly related to the balance sheet and income
statement. In case of banking sector the non-financial variables are number
of branches, status of a branch, location and size of branch of particular
type of banking system. All the aforementioned factors are called

controllable factors as the decision of these things is in the hands of

management.
The external factors are usuall those on which management cannot exercise
any control. These are called un-controllable factors or variables. Among
such factor some are business comptitiors, market share, ownership, capital
scarcity, money supply, inflation and national or international regulations
like the one issued by the State Bank of Pakistan which are called
Prudential Regulations for financial institutions.
Hester and Zoellner (1996) carried out a research on the relationship
balance sheet items and profits of banks. The sample consisted of 300 banks
of USA in cities of Kansas and Connecticut. They reported that the variation
in the balance sheet items had a substantial impact on the profits of a bank.
Assets have direct influence on profits i.e. the profit gets increases when the
assets of the banks increase while the liabilities have an inverse impact on
the profits of a bank.
Boruke (1989) has been regarded as the first research analyst who
considered the internal variables in the explaining the earnings of banks.
For the purpose of research the overall country data was taken. He applied
capital ratios, liquidity ratios and staff expense variations analysis in his
study. Net profit after tax was taken as dependent variable in the study. He
inferred that all the internal factors have a direct and positive relationship
with profitability of the banks.
Philip

(1964)

studied

the

relationship

of

public

regulation,

private

organizations and institutional market characteristics and the sensitivity of

market structure. Such situation has made the competition complex and its
not easy to analyse the competition regarding a bank. Emery (1971) was the
first person who calculated the impact of competition on bank profitability.
He argued that competition has no significant impact on the profits of a
bank.

Rhoades (1980) worked on the aspect when a new entry is introduced into
the market thereby creating the competition. He stated that there was no
relation between the entry and competition in business or grabbing a
market share.
Fraser and Roase (1972) worked on the fact that what was the impact on
profitability and growth in the light of competition created by any new
entrant into market. He argued that the study had proved the slow growth
rate and the profitability of institutions like Islamic banks were affected by
the opening of new branches of the banks but it effect or impact is not
worse.
Mullineaux (1978) conducted research and reported that the promulgations
of the regulations had important and significant implications on the profit
ratio of financial institutions. Actually the research of Mullineaux, McCall
and Peterson (1977) had supported the research results of Vernon and
Emery (1971). Through another study conducted by Smirlock (1985) also
provided same results and confirmed the work of all researchers i.e.
Mullineaux, McCall and Peterson, Emery and Vernon.
According to the concept of Structure conducted performance (SCP) theory
when the concentration of market increases the agreement among firms
also increases. Hence it has a direct impact or relationship with the
competition among firms. The costs which relates to the agreements
become lower and it motivates or makes the explicit and/or implicit
agreements by firms. Resultantly; the firms in the market enjoys monopoly.
This theory was first applied in research by taking data from different
sources i.e. manufacturing concerns in 1960s. This study was continued in
research till 1980s. Heggested in 1979 analysed the research already
conducted from 1961-1976. He noted that the concentration factor of the
theory had very meager impact on the dependent factor of profitability
ratio, loans, deposit and financing rates by banks.
On the same pattern Gilbert (1984) conducted the study to probe impact
the concentration factor of Structure conducted performance (SCP) theory.

He revealed that out of 56 research papers only 27 resulted in the fact that
concentration

affected

the

performance

indicator

in

the

forecasted

direction.
The analysis of Islamic and conventional banks by using CAMEL approach
for knowing the profitability of these institutions is used in many studies.
Banks plays an important role in the economy development of a country.
Several studies are conducted with a view to enhance profits and its
determinants and the factors affecting bank performance. Different
characteristics, structures, macroeconomic variables of banking institutions
are used in researches in different countries.
Bashir (2000) carried out study about the determeinants of the profitability
in the Islamic banks, some from Middle East. Regression analysis was used
to analyse the relationship in characteristics of banks and the financial
performance of Islamic banks. He took the data from throughout the
country to know the overall impacts. As a sample 14 Islamic banks were
taken from 8 different countries. The dependent variables of studies were;
Return of Equity, Return on Assets and greater loans to assets ratios which
were related to GDP growth. These variables are vital in determing the
financial performance of Islamic banks.
He reported that there was direct favourable relationship between increase
in capital and loan ratios of banks. Secondly he stated profitability
determinants have a positive relationship with overhead costs. This meant
that the banks would get more profits if the salaries, wages and
investements costs are high. Also it was revealed that ownership was an
insignificant factor and argued that those banks were resulted in better
results which had a foreign ownership rather than local one. Hence foreign
ownership was considered fruitful for Islamic bank profits. Tax impacts
were also taken to deliberation in study and it was proved that the
government taxes had an unfavourable impact on the profitability of Islamic
banks. He also argued that reserve ratio had negative relevancy to the

performance of Islamic banks. Similarly Economic growth plays a direct role

in improving the profitability determinant and loan ration to assets ratio.
Capital structure means a particular mix of debt and equity which is used by
the institutions in financing its operations. There are four different theories
which are generally used in the decision making of capital structure. Their
basis are different information including tax benfits linked with the
utilization of debt, cost incurred on bankruptcy and agency costs. When the
finance is from internal sources then the information which they will get will
more than equity holders who usually expect a higher rate of return on the
investment. It is also implied that when new equity is called from public
then the firm will incur more cost as compared to the internal sources of
funds. Conculsively it can be stated that the firms are firstly dependent
upon internal sources of funds rather than outside funds and later it will
turn towards debts when more finance is required and ulitimately if more
funds are required the firms will have to resort to issue new equity to public
for getting more funds for operations. Myers & Majluf (1984) stated that
accorind to Pecking Order hypothesis have good operational results and are
profitable are optimistically rely on the internal sources of funds in
comparison to those firms who dont have high profits to cater for the funds
requirements of the firm. Capital structure and taxation are also related to
one another in terms of utilization of debt. It is also argued that taxation
policy has significant impact on the capital structure decisions by the firms.
As per taxation laws and procedures the interest paid on debt is allowable
expense in arriving at taxable income of the firm. Hence it is an advantage
which firms can use the source of getting funds through debts wholly or
partly. As tax is deducted from dividends when it is paid to equity holders
against shares held by public. Now as tax is not allowed as deductible
expense in arriving at the taxable income of a firm when funds are acquired
through equity issue while in case of finance through debt, cost or interest
is allowable or deductible expense for firms. Therefore a firm will
necessarily opt for availing debt rather than issue of new shares. Modigliani
& Miller (1963) and Miller (1977) stated that the benefit of tax exemption in

taxable income, the investors get that portion of interest as profit through
their dividends. But the same income is again subject to tax deduction at
source and the personal tax impact becomes negative.
Myers (2001) stated in a report that supply of debt will increase on the
pleas by the investor in a chase to look for higher rate of interest so that to
get more of income rather taking it in the form of capital gains which are
subject to tax implications. Similarly when the debt increase result in higher
rate of interest and as a result of this the firms or companies have higher
costs related to debt in comparison with the cost of equity.

Merchant (2012) examines to analyze the performance of Islamic banks and

conventional banks during the crisis and after the crisis. He studied the
Islamic and conventional bank in GCC area during 2008 -11. He applied 2
tailed t-test to the data and found that after crisis Islamic bank increased
their LLR, while conventional banks increased their LLR and EQTA.
Olson and Zoubi (2008) studied and compared the Islamic and conventional
banks in the GCC over a period of 2000 2005. Their study found that
profitability between Islamic and conventional banks is almost the same.
However, their study says that Islamic banks are less efficient and are
operating with higher risk. The reason behind their operating under higher
risk is that Islamic banks uphold funds that are to be used in case of bad
loans. On the other hand conventional banks offer deposits fund that are
completely predetermined by interest rates whereas Islamic banks offer
deposit funds that are similar to equity as they share diverse types of risk.

Ansari and Rehman (2011) conducted a study on the performance analysis

of Islamic and conventional banks in Pakistan for the period of 2006
2009.They studied the following financial ratios i.e. profitability, liquidity,
risk and solvency, capital adequacy, deployment ratio and operational
efficiency, their study found that Islamic banks were highly liquid and less
operational efficient as compared to conventional banks. They also said that
Islamic banks were less risky than conventional banks.
Srairi (2013) studied the impact of ownership structure on bank risk. He
studied risk-taking behaviour of conventional and Islamic banks in 10
MENA countries under three types of bank ownership i.e. Family-owned,
Company-owned and State-owned Banks from 2005-2009. His results
showed a negative relationship between ownership concentration and risk.
The study further shows that state owned banks showed higher risks and
had significantly greater proportions of non-performing loans as comparing
to Family-owned banks. By comparing conventional and Islamic banks, the
study reveals that private Islamic banks are as stable as private
conventional banks. However, Islamic banks have a lower credit risk than
conventional banks.
Gamaginta and Rokhim (2011) studied the stability of 12 Islamic banks and
71 conventional banks in Indonesia using the Z-score indicator from 2004 to
2009. Their results showed that the stability of Islamic Banks was generally
lower than that of conventional banks. The paper further analyzed that
during financial crisis of 2008, the Islamic banks showed the same level of
stability as of conventional banks.
Louati et al wanted to find out the behavior of Islamic and conventional
banks in relation to the ratio of the capital adequacy in different competitive
circumstances. They used data from 12 MENA and South East Asian
countries characterized by the coexistence of Islamic and conventional
banks. The study concluded that the funding ratio has a significant impact
on the behavior of 70 conventional banks and 47 Islamic banks. The study

also reveals that competitive conditions have no significant effect on the

relationship between the weighted assets ratio and Islamic bank behavior,
which means that this type of banks is applying theoretical models based on
the prohibition of the interest.
Rajhi and Hassairi analyzed the issues of capital structure and enforcement
in Islamic finance only to the degree that Islamic financial Institutions vary
from their conventional peers. They study showed that there is significant
differences exist between in Islamic and conventional banks. The study
presents the capital capability structure for Islamic banks compared to the
setting up of the Basel II capital capability structure. They found that the
risk profile of an Islamic banking and on the relationship between risk
management and capital structure, it overviews specific risk categories for
Islamic banks as an initial step in risk management, and bring to light the
differences and similarities in importance of these causes for Islamic banks.
They present appropriate risk weights to free investments in order to
defining their own capital requirements with regard to loss tolerance.
Al-Deehani, Rifaat, Murinde (1999) stated that the concept of financial risk,
is not pertinent to Islamic bank, on which modern capital structure theories
are based. Given the contractual obligation binding the Islamic bank's
shareholders and investment account holders to share profits from
investments, they recommend a theoretical model in which, under certain
assumptions, an increase in investment accounts financing enables the
Islamic bank to increase both its market value and its shareholders' rates of
return at no other financial risk to the bank.

Shubber and Alzafiri (2008) study found that four assumptions 1.

Independence of the WACC from the level of deposits; (2) a larger size of
deposits does not entail higher financial risk; (3) a larger deposit size entails
higher earnings per share, and (4) a large deposit size increases a banks
market value. The authors used 1993 to 1996-1998 data, for four
institutions, and consider correlations between the costs of equity, deposits,

and the WACC. The data appears to support the four assumptions. The
correlation coefficient between markets Capitalization and size of deposits
ranged between .72 for DIB and .88 for QIB with an average of .
83.Accordingly, the authors concluded that a larger deposit base increases
market value without affecting financial stability.
Determinants of bank profitability can be divided into internal and external.
Internal determinants of bank profitability are those factors that are
affected by the banks management decisions and policy objectives.
Management effects are the results of differences in bank management
objectives, policies, decisions, and actions reflected in differences in bank
operating results, including profitability. Zimmerman (1996) found that
management decisions, especially regarding loan portfolio concentration,
played an important role in bank performance. Researchers frequently say
that good bank performance is the result of quality management.
Management quality is assessed in terms of senior officers awareness and
control of the banks policies and performance.
Staiouras (1999) studied the bank profitability determinants and factors
influencing this profitability.

He collected data of whole EU banking

industry from 1994 to 1998 and constructed OLS fixed effects models. He
found that the profitability of European banks is affected not only by factors
related to their management decisions but also to changes in the external
macroeconomic environment. Equity to assets ratio has consistently the
same sign and level of significance suggesting that banks with greater
levels of equity are relatively more profitable. The loans to assets ratio
appears to be inversely related to banks return on assets. This implies that
banks which have large non-loan earning assets are more profitable than
those which depend more heavily on assets. The results are in contrast to
studies that have examined the structure performance relationship for
European banking and find a positive effect of the concentration and/or
market share variables on bank profitability.
Compensate

Haslem (1968, 1969) computed balance sheet and income statement ratios
for all the member banks of the US Federal Reserve System in a two-year
study. His results showed that most of the ratios were significantly related
to profitability, particularly capital ratios, interest paid and received,
salaries and wages. He also stated that a guide for improved management
should first emphasis expense management, fund source management and
lastly funds use management. Wall (1985) concludes that a banks asset and
liability management, its funding management and the non-interest cost
controls all have a significant effect on the profitability record.
Beck et al. (2013) examine the difference between conventional and Islamic
banks on a sample of 510 banks across 22 countries over the period 1995
2009. They found few significant differences in business models. However
their study revealed that Islamic banks were less efficient, but had higher
intermediation ratios, and higher asset quality, and were better capitalized
than conventional banks. They also found that Islamic banks performed
better during crises in terms of capitalization and asset quality and were
less likely to disintermediate than conventional banks.
Abedifar et al. (2013) investigates a sample of 553 banks from 24 countries
between 1999 and 2009. They study risk and stability features of Islamic
banking and compare them to conventional banking.

They found that

Islamic banks were, on average, more capitalized and profitable than

conventional banks. Their study also suggested that small Islamic banks
that were leveraged or based in countries with predominantly Muslim
populations had lower credit risk than conventional banks. In terms of
insolvency risk, small Islamic banks also appeared more stable.
Belanes and Hassiki (2012) examine the efficiency of 32 Islamic and
conventional banks from the MENA countries over the period 20062009.
They used Data Envelopment Analysis (DEA) method and found no
significant difference in the efficiency scores between these two types of
banks.

Belanes and Omri examined the differences across Islamic and conventional
banks, with a special focus on capital structure. As most studies dealing
with capital structure focus on non-financial firms and conventional banks
and because of less empirical evidence and absence of theoretical research
specific to Islamic banking industry, they applied recognized concepts of
classical capital structure theories including trade off theory, pecking order
theory, agency theory and signaling theory.
They applied Discriminate analysis followed by binary logistic regression to
identify which variable, equity ratio or profitability ratios, better predicts
the kind of bank. They took the sample of 44 Islamic and 66 conventional
banks that related to the seven core markets in Islamic finance during 20052010. Their study suggests that unlike profitability variables, namely Net
income margin, ROE and ROA, equity-to-asset ratio better distinguished
Islamic banks against conventional peers. Their study provides empirical
support for the fact that Islamic and conventional banks do not widely differ
in terms of profitability. However, the higher capital ratio is, the more
relevant likelihood that bank is Islamic. Such findings are actually the base
of Islamic finance which prevents debt-based funding and urges banks to
focus rather on shareholders equity than debt.
Metwally (1997) studies a sample of 30 banks of which 15 are Islamic
during 1992-1994. His study argues that the lower total deposits-to-assets
ratio; the higher probability that bank is Islamic. It also suggests that the
upper capital-to-asset ratio, the greater likelihood that bank is Islamic. The
study emphasizes that capital-to-asset ratio strongly differentiate between
Islamic banks and conventional peers.
Toumi et al. (2011) studies a sample of 50 Islamic and 59 conventional
during 2004-2008.

They conclusively confirm that leverage at Islamic

banks is significantly smaller for Islamic banks. Debt-to-equity ratio

increases on average 7.8 times in Islamic banks versus 11.48 times in
conventional peers. They also suggest that debt can also decrease by
treatment of PLS investment accounts as off-balance sheet items by several
Islamic banks.

Pappas et al. (2102) study reveals that Islamic banks are characterized by a
lower leverage, as suggested by equity-to assets ratio at 21.7% for Islamic
banks against 10.8% for conventional banks. Their study further reveals the
significant difference between Islamic and conventional banks in the
sensitivity of failure risk to various factors. The analysis is carried on 106
Islamic banks and 315 conventional banks from 20 countries observed
between 1995 and 2010.
The literature divides the determinants of conventional bank profitability
into two categories that are internal and external. Internal determinants of
profitability, which are within the control of bank management, can be
divided into two categories, i.e. financial statement variables and nonfinancial statement variables. Financial statement variables are related to
the decisions which directly involve items in the balance sheet and income
statement; non-financial statement variables involve factors that have no
direct relation to the financial statements. The examples of non-financial
variables within this category are number of branches, status of the branch
(e.g. limited or full service branch, unit branch or multiple branches),
location and size of the bank. Number of branches, status of branches and
location are considered controllable variables since decision on those
matters are within the decision power of management. In the case of a
decision to establish new branches or services available where the locality
is bound by regulations, these variables are considered external to the
bank. Similarly, the size of the bank is considered an internal determinant
on the assumption that management of the bank is responsible for
extending their organization by getting additional assets and liabilities.
Some researchers (Short, 1979 and Bourke, 1989) considered size as an
external variable.
External variables are those factors that are considered to be beyond the
control of the management of a bank. Among external variables are
competition, regulation, concentration, market share, ownership, scarcity of
capital,

money

supply,

inflation

and

size

are

widely

discussed.

Hester and Zoellner (1996) examined the relationship between balance

sheet items and the earnings of 300 banks in Kansas City and Connecticut
USA. Their study revealed that the changes in balance sheet items had a
significant effect on a banks earnings. While all asset items get positive
results, liability items such as demand, time and saving deposits badly
affected profits.
Bourke (1989) was the first researcher to include internal variables in a
profitability study involving cross-country data. The internal variables used
were capital ratios, liquidity ratios and staff expenses; while the dependent
variables were consist of the net profit before taxes against total capital
ratio and net profit before taxes against total assets ratio. He found that all
internal variables were positively related to profitability.
Although competition is considered in the literature as one of the significant
determinants of profit for conventional banks, discussion in this area has
not been fully resolved. Philips (1964) study reveals that public regulation,
private organization and institutional market characteristics made industry
performance insensitive to differences in market structure and made
competition difficult to examine. In view of the difficulties of measuring the
effect of competition, most banking researchers in favor to incorporate this
aspect within the scope of market structure or regulations. Emery (1971)
was among the first researchers to measure the effect of competition on
bank profitability. He used entry into the market as a substitute for
competition. Emerys were found that the competition had no important
impact on profits. Rhoades (1980) examined the impact of new entry on
competition. His result showed that there was no link between entry and
competition.
Fraser and Roase (1972) studied whether the opening of new institutions
had any important adverse impact on the growth and profitability of
competing institutions. Their study reveals that some evidence of slowing
growth rate of deposit, the profitability of existing institutions was not badly
affected by the opening of new branches by their competitors. Similarly, the
Mullineaux (1978) study shows that regulations on the setting-up of banks
had an important impact on profitability.

Concentration means that the number and size of firms in the market. The
term has appeared from the structure-conduct-performance (SCP) theory
which is based on the proposition that market Concentration encourages
agreements

among

firms.

The

assumption

is

that

the

degree

of

concentration in a market puts a direct influence on the degree of

competition among its firms. Highly concentrated market will lower the cost
of agreement and encourage implicit and/or explicit agreement on the part
of firms. As a result of this agreement, all firms in the market earn
monopoly rents. This theory was first used by researchers using data of
manufacturing firms and achieved popularity among researchers in banking
studies in the 1960s. The effect of concentration on the banking structure
were further extended in the 1970s and continued into the 1980s.
Heggested (1979), in his survey of the literature from 1961-1976, found that
concentration had either a important or a small effect on dependent
variables such as profitability, loan rates, deposit rates and the number of
bank offices in only Fraser and Roase (1972) studied whether the opening of
new institutions had any significant unfavorable effects on the growth and
profitability of competing institutions. Their result suggest that instead of
some evidence of slowing growth rate of deposit, the profitability of existing
institutions was not adversely affected by the opening of new branches by
their competitors. The finding of Fraser and Rose, however, was not
supported by McCall and Peterson (1977). Similarly, Mullineaux (1978)
found that regulations on the setting-up of banks had a significant effect on
profitability. The Findings of McCall and Peterson (1977) and Mullineaux
(1978) confirmed the studies of Vernon (1971) and Emery (1971). A same
approach was used by Smirlock (1985) and his results also confirmed
Vernons and Emerys findings. Concentration is defined as the number and
size of firms in the market. The term has emerged from the structureconduct-performance (SCP) theory which is based on the proposition that
market concentration fosters collusion among firms. The assumption is that
the degree of concentration in a market exerts a direct influence on the
degree of competition among its firms. Highly concentrated market will

lower the cost of collusion and foster implicit and/or explicit collusion on the
part of firms. As a result of this collusion, all firms in the market earn
monopoly rents. This theory was first used by researchers using data of
manufacturing firms and gained popularity among researchers in banking
studies in the 1960s. The impacts of concentration on the banking structure
were further extended in the 1970s and continued into the 1980s.
Heggested (1979), in his survey of the literature from 1961-1976, suggest
that focus had either an important or a small impact on dependent variables
such as profitability, loan rates, deposit rates and the number of bank offices
in only 26 of the 44 banks studied. Similarly, Gilbert (1984) summarized the
reply of bank performance measures to a change in market concentration
and found that in only 27 of the 56 studies reviewed reported that focus
significantly affected performance in the predicted direction. Similarly,
Gilbert (1984)

summarized the response of bank

performance measures to a change in market concentration and found that

in only 27 of the 56 studies reviewed reported that concentration
significantly affected performance in the predicted direction.
The comparative analysis of Islamic and Conventional Banks in terms of
profitability determinants which is based on CAMEL approach is very
important. All banks are playing a vital role in contribution to the growth of
the economy. Many studies are done to improve the profitability indicators
and bank characteristics. Recent paper works have employed different
characteristic, structures, macroeconomic variables of bank level data
across countries.
Bashir(2000), his research was about determinants of profitability in
Islamic Banks, some evidence from Middle East. He used Regression
Analysis, in order to see the association between banks characteristics and
measure of financial performance in Islamic Banks. He used cross country
panel data to conduct the estimation and showed that profitability measures
of Islamic Banks react positively in relationship with increase capital and
loan ratios. Financial ratios are employed to measure the performance

measures of Islamic Banks. 14 of Islamic banks are taken 23 across 8

countries. He has taken as dependent variables: Return on Equity, Return
on Assets and Profit before Tax over total assets. His research reveals that
the larger the total equity to assets and greater loans to assets ratios
interrelated with GDP growth which increases profit margins. These results
are playing a significant role in explanation of financial performance of
Islamic Banks. Secondly Bashir (2000) found that profitability determinants
are having positive relationship with OVERHEADS, that is to say the higher
the salaries, wages and investment costs that can be explained the banks
earn more. Findings and results are consistent with previous studies.
Moreover, he regress the ownership as dummy variable on profitability
determinants as well, and come up with that foreign ownership contributed
significantly to Islamic Banks, that is to say there is statistically significant
positive relationship between foreign ownership and profitability indicators.
He used tax factors as well, and results showed that the financial repression
by using taxes on Islamic banks profitability indicators influenced
negatively, in other words the tax structure of government has negative
connection with financial performance of Islamic Banks. In addition to,
Bashir(2000) had found that reserve ratio has been negatively related to
performance measure of Islamic Banks. Good economic growth will improve
the profitability determinants and loan to assets ratio positively related to
profitability determinants.
Capital structure is defined as the specific mix of debt and equity a firm
uses to finance its operations. Four important theories are used to describe
the capital structure decisions. These are based on asymmetric information,
tax benefits associated with debt use, bankruptcy cost and agency cost. The
first is rooted in the pecking order framework, while the other three are
explain in terms of the static trade-off choice. These theories are discussed
in turn. For example, an internal source of finance where the funds provider
is the firm will have more information about the firm than new equity
holders, thus these new equity holders will expect a higher rate of return on
their investments. This means it will cost the firm more to issue fresh equity

shares than to use internal funds. Similarly, this argument could be

provided between internal finance and new debt-holders. The conclusion
drawn from the asymmetric information theories is that there is a certain
pecking order or hierarchy of firm preferences with respect to This
pecking order theory reveals that firms will firstly rely on internally
generated funds, i.e., undistributed earnings, where there is no existence of
information asymmetry; they will then turn to debt if more funds are
needed, and finally they will issue equity to cover any remaining the
financing of their investments (Myers &Majluf, 1984). Capital requirements.
The order of preferences reflects the relative costs of various financing
options. Clearly, firms would prefer internal sources to costly external
finance (Myers & Majluf, 1984). Thus, according to the pecking order
hypothesis, firms that are profitable and therefore generate high earnings
are expected to use less debt capital than those that do not generate high
earnings. Capital structure of the firm can also be explained in terms of the
tax benefits associated with the use of debt. Others observe that tax policy
has an important effect on the capital structure decisions of firms.
Corporate taxes allow firms to deduct interest on debt in computing taxable
profits. This recommended that tax advantages derived from debt would
lead firms to be completely financed through debt. This benefit is created,
as the interest payments relate with debt are tax deductible, while
payments associated with equity, such as dividends, are not tax deductible.
Therefore, this tax effect encourages debt use by the firm; as more debt
increases the after tax proceed to the owners (Modigliani & Miller, 1963;
Miller, 1977). It is important to note that while there is corporate tax
advantage resulting from the deductibility of interest payment on debt;
investors receive these interest payments as income. The interest income
received by the investors is also taxable on their personal account, and the
personal income tax effect is negative. (Miller, 1977) and (Myers ,2001)
argue that as the supply of debt from all corporations spread out, investors
with higher and higher tax brackets have to be attract to hold corporate
debt and to receive more of their income in the form of interest rather than

capital gains. Interest rates increase as more and more debt is issued, so
corporations face rising costs of debt relative to their costs of equity.

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