nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 SLAM BANS PROFTABLTY N AN NTEREST RATE YLE Anoua Hassoune slamic finance elies on he cadinal pinciple of pofi and loss shaing (PLS) beween sakeholdes aking pa in a isky economic aciviy. Such a ule is also applicable o slamic banks deposios, who eihe choose no o be emuneaed a all, o place hei savings in invesmen accouns, binging vaiable euns, dependen on he bank s pofiabiliy. A he end of he peiod, an slamic bank has o shae is pofis wih he deposios who acceped he invesmen isk. n fac, such an slamic bank does no shae is pofis, defined as he wealh ansfeed o shaeholdes, bu shaes an amoun of wealh one can call an income befoe cos of funding (BF). How slamic banks manage o smooh hei pofiabiliy, measued by hei ROE, is he pupose of his aicle, which comes o hee main conclusions: 1. n heoy, an slamic bank is effecively in a posiion, hanks o pofi shaing, o make is pofiabiliy less volaile ove he cycle. 2. n addiion, empiical evidence ends o show ha slamic banks ae ceainly moe pofiable han hei convenional pees enjoying he same balance shee sucue. The main eason fo such a diffeence is ha slamic banks benefi fom a make impefecion, i.e. he availabiliy of lage amouns of non-emuneaed deposis in hei books, which consideably decease he cos of funding. 3. Finally, slamic banking, in spie of is advanage on he gounds of pofiabiliy, is no a panacea fo bankes in he slamic wold, because hey ae consained by seveal ecuen weaknesses in ems of liquidiy, concenaion isks and opeaional efficiency. noducion Some 180 slamic banks ogehe wih abou 120 slamic non-bank financial insiuions opeae houghou he wold. Thei asses ae close o US$200 billion, and he annual gowh of hei coe business has been sanding a abou 10% ove he las couple of yeas. Accoding o slamic law, he Shaiah, hese banks and financial insiuions ae no allowed o pay o chage inees. Howeve, insead of inees-beaing banking, slamic bankes have developed ove he las wo decades a wide ange of innovaive financial poducs and sevices acively involving boh cliens and banks in economic aciviy ha seeks financing. Such an appoach o banking aciviies implies howeve he pinciple of pofi and loss shaing (PLS), on boh banks asses and liabiliies sides. The asse-side of pofi shaing is no diecly he subjec of he following sudy, which lays paicula sess on he liabiliy side, i.e. an slamic bank s obligaion o shae is pofis wih is deposios, o a leas hose of is deposios who accep o keep hei money in emuneaed invesmen accouns, and no in non-pofi-beaing cuen accouns. ndeed, some Muslims ae sill elucan o ge any eun fom hei deposis, even wihin slamic banks, as hey sill conside his as iba (pohibied usuy).
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 As a mae of fac, slamic banks do no shae hei pofis wih deposios, because pofi is defined as he final amoun of wealh aibuable o shaeholdes in a peiod of ime. Wha is shaed beween shaeholdes and deposios is a vaiable one can define as he bank s income befoe cos funding (BF), equiies being excluded hee fom he scope of funding. The cos of non-equiy funds is pecisely wha disinguishes slamic banks fom convenional banks. While convenional banks ely on deb and deposis wih mainly fixed inees aes, slamic banks ely on a funding base whose cos depends on he eun of is asses. Tha said, he pupose of he following model and empiical evidence is o answe wo main quesions: On he one hand, is an slamic bank s eun on equiy less volaile han ha of a convenional bank hough an inees ae cycle, assuming ha he sucue of hei balance shee is exacly he same? On he ohe hand, is hee any empiical evidence suppoing he asseion ha slamic banks ae, wihin ceain counies and unde he assumpion of equivalen balance shee sucues, moe pofiable han hei pee convenional banks? Secion 1 develops a simple model wih wo banks, one slamic bank and one convenional bank, in ode o make hei especive euns on equiy compaable. n secion 2, he heoeical model s esuls ae subjec o a calibaion based on empiical daa, which allows he inoducion of some cyclicaliy in inees aes and he obsevaion of he behaviou of he wo banks especive ROEs. Secion 3 povides some empiical evidence highlighing highe pefomance a slamic banks, as fa as pofiabiliy is concened. Finally, some concluding emaks lay sess on weaknesses and challenges slamic banks have been ecuenly facing fo yeas, which somewha offse hei pofiabiliy advanage. Secion1: The Theoeical Model Definiion of vaiables Le us assume he exisence of wo banks: one slamic bank, and one convenional bank. Suffix sands fo ime, while and especively efe o convenional and slamic banks. Table 1 is a summay of he vaiables used in he following simple heoeical model. Some vaiables ae common o he wo banks, and some ohes ae specific o each caegoy.
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 onvenional bank Equiy (f Non equiy liabiliies L (f Asses A = Leveage τ = Non-inees expenses N Reun on equi Goss eun on asses ncome befoe cos of funding os of fundin Efficiency aio Table 1. Vaiables.,,.L L BF = ε = oelaion index beween cedi and debi inees aes α [0;1] wih :, = α. A, is assumed ha he wo banks have exacly he same balance shee sucue. n paicula, apializaion (/A) is he same fo he wo eniies and assumed o be invaian ove ime. Non-inees expenses (NE ) ae also equivalen fo he wo banks, bu vay ove he cycle. slamic and convenional banks asses pay he same aveage inees ae A,. Only funding coss ae diffeen. The convenional bank pays L,. L in peiod, while he slamic bank pays λ.bf, meaning ha he lae shaes is BF beween shaeholdes and deposios a a ae λ, ha we assume, fo he momen, o be vaiable. Finally, debi and cedi inees aes especively paid and chaged by he convenional bank ae linealy coelaed, a a ae α. Expessing eun on equiy fo he wo banks The convenional bank: s ne pofi can be expessed in he following way:,. = ( A,.A - NE ) - = BF -,.L L,.L L This gives:, = -1.(BF -,.L) L
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 The slamic bank: s ne pofi can be expessed in he following way : This gives:,. = BF - λ. BF = BF.(1 - λ ), = -1.BF.(1 - λ ) Unde wha condiion is he slamic bank moe pofiable? The condiion unde which he slamic bank is moe pofiable han he convenional one is simply:, >, nequaliy (5) has o be eeaed as follows: -1.BF.(1 - λ ) > -1.(BF - λ.bf < L,.L L,.L λ < BF L,. L λ < A,. A NE L,. L λ < NE A,. A. A A L,. L λ < A,. A ε. A L L, λ < A A, ε á. A, λ < ô A, å,.l) L
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 Two heoeical scenaios can be discussed: λ is.1 an exogenous vaiable, pefecly conolled by he slamic bank. n his case, he slamic bank can always be moe pofiable han is convenional pee fo given values of εand 1, which ae common o he wo eniies. 2. λ= λ, which means ha λis fixed. The slamic bank povides is deposios wih he same pecenage of income befoe cos of funding ove ime. n his case, he slamic bank is moe pofiable if: A, å ë ôá < ë onclusions fom he heoeical model Accoding o inequaliy (7), one can conclude ha: if euns on asses ae high and non-inees chages ae low (which is he case when he cycle is in is upwad phase), he pobabiliy of he slamic bank being moe pofiable han convenional banks is low ; l bu on conay, if he cycle ends downwad, is low while ε ends upwad (essenially because of inceasing povisioning needs) ; hus inequaliy (7) is moe likely o be ue, meaning ha slamic banks ae, in his case, moe pofiable. n sho, if we assume ha slamic banks pefecly conol he ae a which hey shae pofis, hen hey ae ceainly always moe pofiable. f, on he conay, i is assumed ha his ae is fixed (λ = λ), hen slamic banks ae chaaceized by anohe ineesing feaue : hei pofiabiliy, ove he cycle, is appaenly less volaile han ha of convenional banks, hanks o he cushioning ole played by pofi and loss shaing. Secion 2. Simulaion by alibaion of he Theoeical Model n ode o illusae, on an applied basis, he lowe volailiy of slamic banks pofiabiliy, we shall adop he echnique of calibaion. This consiss of assigning values o ceain paamees of he model, afe esimaing hem fom empiical daa. Table 1 summaizes ou esimaion of hese calibaed paamees. Table 2. alibaion. Paamees τ A/ α λ Esimaed values 0.9 10 0.66 0.7 6.35 A
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 The pinciple of calibaion n pinciple, calibaion consiss of aibuing consisen and plausible numeic values o ceain paamees of he model, in ode o make hem sick, as closely as possible, o he obseved ealiy. Then, by inoducing some cyclicaliy ino boh he ae of eun on asses ( A, ) and he banks efficiency aio (ε ), we will be able o examine he behaviou of he wo banks pofiabiliy ove he cycle. To achieve his aim, one specific and epesenaive banking make has o be chosen o calibae he model. Saudi Aabia is undoubedly he lages, deepes and mos sophisicaed make whee we can find boh slamic and convenional banks wih close balance shee sucues, efficiency aios and euns on asses. Esimaing calibaed paamees in he Saudi banking make Bank capializaion in Saudi Aabia is close o 10% fo almos all commecial banks. onsequenly, i is legiimae o assign o τ= L/A a value of 0.9, meaning ha A/ = 10. n he Gulf egion, banking secos ae sill no highly sophisicaed, and wihin convenional commecial banks, cedi and debi aes ae vey closely coelaed. is assumed ha debi and cedi aes ae linealy linked, a a ae of α. Such an assumpion has o be esed, and if valid, αhas o be evaluaed. To achieve ha, a linea egession is implemened on wo seies of daa: on he one hand, he aveage euns on eaning asses fo Saudi commecial banks; and on he ohe hand, efinancing coss as a pecenage of non-equiy liabiliies fo he same Saudi banks. Daa ae ecoded fo he pas 10 yeas, i.e. fo he 1992-2001 peiod, and ae aken fom Sandad & Poo s daabase. The esuls of he egession ae given in gaph 1. Gaph 1. Esimaing αwih a simple linea egession. Souce : Sandad & Poo s. The egession gives: α= 0.66.
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 The vaiable λcan be moe easily deemined: an appoximaion fo λis he aveage emuneaion povided o slamic deposios as a pecenage of slamic banks BF in Saudi Aabia. Given ha hee is only one fully slamic bank in he ingdom, we can only obseve his bank s aio, which has hisoically sood a abou 70%. onsequenly, we calibae λa 0.7. The especive means and sandad deviaions of A and εhave been calculaed fom daa conained in he annual epos of six ou of he en Saudi commecial banks. These six banks ae chaaceized by a balance shee sucue ha is close o ha of hei single slamic pee. These seies have been buil fo he 1994-2001 peiod (i.e. 8 yeas). Hee is a summay of he calculaions: Yeas 2001 2000 1999 1998 1997 A () 6.15% 7.00% 6.57% 6.42% 6.18% A 6.35% σ A 0.45% Souce : Sandad & Poo s Souce : Sandad & Poo s Simulaing cyclicaliy We hen y o epoduce cyclicaliy in he eun on asses A () and he efficiency aio (). ε Fo he sake of simpliciy, we assume ha hee is no dif in hese seies. Fo ha pupose, we expess A () and () ε wih igonomeic elaions, knowing ha A is pocyclical and εis conacyclical. onsequenly, o be in confomiy wih able 2, we wie ha: A () = 6.35% + 0.45%.[ 2 cos() ] = 6.35 ε() = 0.92% - 0.08%.[ 2 cos() ] = 0.92%
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 Gaph 2. yclical behaviou of A () and (). ε Gaph 2 shows us ha A () and () ε behave in opposie phases. n addiion, equaions (8) and (9) effecively imply ha σ = 0.45% and σ A ε = 0.08%. As a consequence, we can expess in he cycle. We know ha: and as funcions of ime () only, and epesen hei behaviou () = -1 [ A ().A-ε().A- L ().L] = A [A ()-ε()-ατ A ()] = A [A ()(1-ατ)-ε()] n addiion : () = -1 [ A ().A-ε().A](1-λ) = A [A ()-ε()](1-λ)
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 Equaions (8) and (9) ogehe wih expessions (10) and (11) give: () = 0.1[1.658+0.372cos()] () = 0.1[1.629+0.225cos()] Funcions (12) and (13) ae shown in gaph 3. Gaph 3. () and () ove he cycle. The slamic bank s ROE is less volaile han ha of he convenional one. Such a smoohing effec comes fom he abiliy of he slamic bank o absob shocks on asses euns hough pofi and loss shaing. This echnique plays he ole of a cushion, o an insuance agains cyclicaliy in euns, which he convenional bank canno ely on, because i has o pay inees chages, which ae less flexible.
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 Secion 3. Ae slamic Banks Moe Pofiable han Thei onvenional Pees? Empiical evidence. A ciical vaiable: λ. As a mae of fac, he vaiable λis ciical. λdeemines he elaive posiion of he wo cuves and. f emuneaed deposis epesen small amouns of oal deposis a he slamic bank, λ will be small and shaeholdes will capue a high poion of he BF. n his case, he slamic bank will be moe pofiable han is convenional pee. Fo example, if λis calibaed a 0.65 ahe han a 0.7, gaph 3 becomes: Gaph 3. () and () in he cycle when λ=0,65. Howeve, empiical evidence of highe pofiabiliy a slamic banks sill needs o be povided. A simple case sudy is undoubedly legiimae in his espec. The following gaph 5 epesens aveage ROEs of slamic and convenional commecial banks in hee of he six counies of he Gulf oopeaion ouncil (G), fo he yeas 2000 and 2001.
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 Gaph 5. ompaed aveage ROE fo slamic and convenional banks in he Gulf (2000-2001). Gaph 5 shows ha, on aveage, fo hee ou of he six counies consiuing he G, slamic banks pofiabiliy, as measued by ROE, was highe han ha of convenional commecial banks. The eason fo ha seems quie clea: slamic banks ely, fo hei funding, on high amouns of non-pofi beaing deposis, o non-emuneaed cuen accouns. Thei λis consequenly vey low, and hei BF is hus mainly dieced owad shaeholdes emuneaion. Funding cos is he main elemen diffeeniaing beween slamic and convenional banks as fa as pofiabiliy is concened. This is a make impefecion, which consiues a fee lunch slamic banks end o exploi. onclusion All in all, no only does slamic banks pofiabiliy seem less volaile han ha of convenional pees, bu i is also highe on aveage, a leas in he G egion. These wo elemens ae essenial fo assessing he soundness of slamic banks financial pofile and cediwohiness. slamic banks hus seem less vulneable o he cyclical naue of euns on asses and coss of liabiliies. Does i mean ha slamic financial pinciples ae he panacea fo all bankes in he slamic wold? Of couse no, fo mainly wo easons. On he one hand, no all bank cliens ae necessaily willing o ean no eun on hei deposis. Making slamic banks a geneal model fo an enie banking indusy in a given couny would ceainly lead he vas majoiy of deposios o ask fo invesmen deposis wih euns close o hose pevailing in non-slamic makes, and he compaaive advanage of slamic banks (i.e. cos of funds) would consequenly vanish. slamic banking could no easily be genealized o a whole banking seco, even in a couny like Saudi Aabia. slamic banks can benefi fom he funding subsidy as long as hey opeae a niche saegy, capuing a ceain caegoy of cliens and deposios, who ae pepaed o accep only moal benefis, no economic angible euns consideed as iba.
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 On he ohe hand, slamic banks lose on he gounds of liquidiy, asses and liabiliies concenaions and opeaional efficiency wha hey end o win in he field of pofiabiliy. Neveheless, slamic banks abiliy o smooh hei eun on asses by absobing shocks emains a posiive elemen, paiculaly in a banking seco ha is chaaceized by is sysemic naue, whee he collapse of one eniy could spu conagion o he whole indusy. slamic banking could be a fuhe guaanee, howeve sill maginal, agains sysemic isks in ceain emeging financial makes. Refeences Abdel aim R.A. [2001], Defining Sound Accouning Sandads, Aab Banke 16(2). Abdul Gafoo A.L.M. [1999], slamic Banking and Finance: Anohe Appoach, Revised vesion of a pape pesened a he slamic Hineland onfeence on iical Debaes Among anadian Muslims, Toono, anada. Abdul Gafoo A.L.M. [2000], nees-fee ommecial Banking, A.S. Nodeen, uala Lumpu, Malaysia Allali B.E. [1990], Poliiques de financemen des banques islamiques: le cas de la Banque slamique de Développemen, in L enepeneuia en Afique fancophone, Ed. AUPELF-UREF, John Libbey Euoex, Pais, Fance (1999-204). Al Rajhi Banking & nvesmen opoaion [2001], slamic Banking: an n-deph nsigh, hp:// www.alajhibank.com.sa/islamicbanking.hm Bacha O.. [1999], Financial Deivaives: Some Thoughs fo Reconsideaion, nenaional Jounal of slamic Financial Sevices 1(1). lyde & o nenaional Law Fim [1999] (Measues P.), slamic Banking and Finance, London, Unied ingdom. Da H.A. and Pesley J.R. [2000], Lack of Pofi-Loss Shaing in slamic Banking: Managemen and onol mbalances, nenaional Jounal of slamic Financial Sevices 2(2). Da H.A. and Pesley J.R. [2000], slamic Finance: a Wesen Pespecive, nenaional Jounal of slamic Financial Sevices 1(1). El Gamal M.A. [1997], an slamic Banking Suvive? A Mico-Evoluionay Pespecive, Social Sysems Reseach nsiue Woking Pape, Univesiy of Wisconsin, Madison, Unied Saes of Ameica. Eico L. and Faahbaksh M. [1998], slamic Banking: ssues in Pudenial Regulaions and Supevision, nenaional Moneay Fund Woking Pape 98/30. qbal Z. and Miakho A. [l987], slamic Banking, nenaional Moneay Fund Occasional Pape 49. han M.S. and Miakho A. [1986], The Famewok and Pacice of slamic Banking, Finance and Developmen (Sep.).
nenaional Jounal of slamic Financial Sevices, Vol.4, No.2 Maens A. [2001], La finance islamique: fondemens, héoie e éalié, ene de Recheche e Développemen en Economie, ahie 20-2001, Univesié de Monéal, anada. Meawa S.A. and Al Mossawy M. [1988], Banking Behaviou of slamic Bank usomes: Pespecives and mplicaions, nenaional Jounal of Bank Makeing 16(7). Nienhaus V. [l983], Pofiabiliy of slamic PLS Banks ompeing wih nees Banks: Poblems and Pospecs, Jounal of Reseach in slamic Economics 1(1). Pesley J.R. and Sessions J.G. [1994], slamic Economics: The Emegence of a New Paadigm, The Economic Jounal 104. Van Schaik D. [2001], slamic Banking, The Aab Bank Review 3(1). Wilson R. [2001], Thee Decades of Moden slamic Banking, Aab Banke 16(2). Noe: n Table 2, he sign is used fo he mean of a vaiable, while σ epesens