Aaaa

African Islamic Banks Profitability
ISSN 1985-692X

International Journal of Business and Management Science, 3(1): 39-56, 2010 39

Research
Paper

Received 10 August, 2010
Accepted 18 Nov, 2010
SAFA = 0.76

Bank-specific, Industry-specific and
Macroeconomic Determinants of African Islamic
Banks Profitability

a
Ben Khediri Karim,
b
Ben Ali Mohamed Sami
+
and
c
Ben-Khedhiri Hichem

a
CEROS, University Paris Nanterre, France
a
Faculty of Business and Economics of Nabeul, Tunisia
b
IHEC Business School of Sousse, University of Sousse, Tunisia

c
CEROS, University Paris Nanterre, France

Abstract: This paper studies the effect of factors that contribute towards the
profitability of Islamic banks in Africa over the period 1999-2009. Using panel
data techniques, this study estimate several specifications to examine the impact of
bank-specific and country-specific variables on profitability. Results show that
Bank characteristics, financial structure and macroeconomics variables are
important in explaining African Islamic banks profitability. Banks capital and
size increase banks profitability whereas credit risk and operating efficiency
reduce it. With regards to the macroeconomic indicators, higher economic growth
and inflation spur banks profitability. The study also provides evidence for the
positive impact of market concentration on Islamic banks profitability. Finally, the
empirical results show robust supports to suggest that higher bank development
leads to lower bank profitability.

Keywords: Bank Profitability, Islamic Banking, Profit Loss Sharing, Africa

INTRODUCTION

Islamic finance is gaining universal acceptance all over the world and is
nowadays regarded as a serious competitor to conventional finance. During the
last three decades, Islamic banking matured into a viable alternative model of
financial intermediation and gained credibility as witnessed by the establishment
of a large number of Islamic financial institutions all over the world.

+
mohamedsami.benali@ihecso.rnu.tn

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40 International Journal of Business and Management Science, 3(1): 39-56, 2010
The Islamic financing activity is based on the Islamic faith and must stay
within the limits of Islamic Law or the Shariahs compliant in all of its actions
and deeds. The system is different from the traditional one mainly by the fact that
rather than fulfilling the only function of financial intermediation as does the
conventional banking system, it fulfills the role of direct partnership. The main
difference between the Islamic banking system and the conventional one is that
while the latter is guided by a pre-determined interest-based principle, the former
follows the interest-free principle and profit and loss sharing (PLS) principle in
financing activities. Under the PLS principle, the relationship between lender,
borrower, and intermediary are rooted rather on partnership than on credit.
Compared to conventional banks, Islamic banks have no fixed liabilities in their
balance sheets and deposits are considered as shares (Khan, 1996). Shubber and
Alzafiri (2008) argue that deposit accounts of Islamic banks cannot be considered
as a liabilities because they fall within the definition of profit-and-loss sharing
principles.
Banks depositors, who either choose not to be remunerated at all, or place
their savings in investment accounts, obtain variable returns, dependent on the
banks performance. At the end of the period, an Islamic bank has to share its
profits with the depositors who accepted the investment risk. In fact, such an
Islamic bank does not share its entire profits, defined as the wealth transferred
to shareholders, but shares an amount of income one can identify as the income
before cost of funding (IBCF).
The cost of non-equity funds is precisely what distinguishes Islamic banks
from conventional banks. While conventional banks rely on debt and deposits
with mainly fixed interest rates, Islamic banks rely on a funding base whose cost
depends on the return of its assets (Hassoune, 2002). It is necessary to distinguish
between the expressions 'rate of interest' and 'rate of return'. Whereas Islam
clearly forbids the former, it encourages the latter (trading). As the use of interest
rates in financial transactions is prevented, Islamic banks are expected to
undertake operations only on the basis of PLS arrangements or other acceptable
modes of financing. We distinguish four sets of laws that govern Islamic
investment environment: the absence of interest-based (riba) transactions, the
avoidance of economic activities involving speculation (ghirar), the introduction
of an Islamic tax (zakat), and the discouragement of the production of goods and
services which contradict the value pattern of Islamic law (haram).
The rules which have been the cornerstone of Islamic financial system
represent a fundamental departure from conventional banking. Cihk and Hesse
(2008) show that Islamic financing system is stronger and less risky than
conventional banks due to its distinguished balance sheet structure and ability to
absorb exogenous shocks on assets returns through profit and loss sharing.
Studies on the profitability differences between conventional and Islamic banks
show that the profitability of Islamic bank is less volatile over the economic
cycle and that Islamic banks are more profitable than their conventional peers.
The main reason for such a difference is that Islamic banks benefit from a market
imperfection such as the availability of non-remunerated deposits in their books,
which significantly reduce the cost of funding (Srairi, 2009; Olson and Zoubi,

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2008; Rosly and Abu Bakar, 2003). Nonetheless, Islamic banking seems to suffer
from the lack of liquidity, concentration risks and operational efficiency
(Hassoune, 2002).
Within this framework, countries such as Pakistan, Sudan and Iran gradually
eliminated the conventional Islamic banking system and substituted it with a
complete Islamic one. Others, such as Bangladesh, Brunei, Indonesia, Jordan,
Kuwait, Malaysia and the United Arab Emirates, are making monopolistic status
while in Bahrain, Egypt and Turkey, Islamic banks are numerous (Haron, 1996).
Furthermore, several multinational banks started establishing Islamic branches
and offering Islamic financial products. A recent survey by Fadzlan (2007), states
that more than 160 Islamic financial institutions exist around the world. This
recent flourishing industry is estimated to be worth over a US$1 trillion (Banker,
2007). A long with this, Africa, with a Muslim population of over 400 million, is
not an exception (Moodys, 2008).
While, Islamic products have become increasingly popular and already gained
universal acceptance in many universal banks in developing and developed
countries (Indonesia, Malaysia, Pakistan, Iran, Bahrain, Jordan, Kuwait, UK,
etc) they are currently making significant inroads in Africa. Such Islamic
financial products are likely to be most popular in the parts of Africa with the
highest concentration of Muslims: North Africa, large parts of West Africa and
East Africa.
The relative recent emerging practice of Islamic finance in Africa and the lack
of inclusive data on Islamic banks impeded any comprehensive empirical
analysis. This paper attempts to contribute to the empirical literature on the
profitability of Islamic banks. To our knowledge, this is the first paper to provide
a cross-country empirical analysis of the key factors of profitability of Islamic
banks in three African countries (Tunisia, Egypt and Sudan).
The rest of the paper is organized as follows: literature review section
provides a concise review on the Islamic and conventional banking profitability.
In the following section the data and the econometric models are discussed
followed by the empirical results. Finally the concluding comments are made.

LITERATURE REVIEW

The existing research in Islamic finance and banking can be divided into three
main bodies. Research in the first group, is rather a descriptive one and focuses
on the conceptual issues emphasizing interest-free financing (Abdel-Magib,
1981; Karsen, 1982; Shaikh Mahmud, 1992). The second body of research
examines Islamic institutions from a theoretical point of view by analyzing their
behaviour (Khan, 1986; Haque and Mirakhor, 1986; Bashir, Darrat and Suliman,
1993). A third recently research body focuses on empirical issues in Islamic
finance and banking (Hassan and Bashir, 2003; Haron, 2004; Haron and Wan,
2004; Srairi, 2009; Ben Khediri and Ben-Khedhiri, 2009).
The literature on banking performance is abundant. Nonetheless, it is almost
confined to the study of conventional banking (Demirg-Kunt and Huizinga,

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1999; Demirg-Kunt and Huizinga, 2000; Athanasoglou, Brissimis and Delis,
2008; Ben-Khedhiri, Casu and Sheik-Rahim, 2008; Albertazzi and Gambacorta,
2009). Another stand of the literature focuses on the differences in performance
between Islamic and conventional banks (Rosly and Abu Bakar, 2003; Olson and
Zoubi, 2008; Srairi, 2009). In a comparative studies perspective, Chong and Liu
(2009) have explored the correlation between deposit and investment rates for the
conventional and Islamic banks in Malaysia. Based on an error correction model,
the authors document that changes in conventional deposit rates cause changes in
Islamic investment rates, but not vice versa. Authors findings suggest that the
Islamic investment rates are positively related to conventional deposit rates in the
long-run. They highlighted the fact that the Islamic banking deposits based on
PLS practices are closely associated to the deposit rate setting practices of
conventional banking. They conclude that the Islamic deposits are not really
interest-free, but are very similar to conventional-banking deposits. From a
different point of view, Rosly and Abu Bakar (2003) assess the performance of
banks operating under the Islamic Banking Scheme (IBS) in Malaysia over the
period 1996 to 2000. They report that banks operating under the Islamic
environment have recorded higher return on assets (ROA) as they were able to
use existing overheads carried by mainstream banks. The authors document an
improvement in the performance of mainstream banking under the IBS. Kader,
Asarpota and Al-Maghaireh (2007) investigate the differences on behavior of
Islamic banks and conventional banks of UAE over the period 2000 to 2004.
They show that Islamic banks are relatively more profitable, less risky, less
liquid, and more efficient compared to conventional banks.
Studies on the differences between conventional and Islamic banks are
diverse. Haron (1996) examine the determinants of profitability as a function of
regulation, competition, interest rate, market share, money supply, bank size and
inflation. He reports that Islamic banks in competitive markets earn more than
those which operate in monopolistic ones. The author shows that interest rate,
inflation and size have a positive impact on the profits for both conventional and
Islamic banks. Market share and money supply, are found to have an adverse
effect on profits. However, the study shows no significant difference between the
earnings variation of Islamic and conventional banks in competitive and
monopolistic markets. Regarding to market regulation, the study reveals that
banks in a competitive market are better managed than their counterpart. In a
single country setting, Samad (2004) examine the performance of Bahrain
interest-free Islamic banks and the interest-based commercial banks during the
post Gulf War period with respect to profitability, liquidity risk, and credit risk.
The author uses a sample of 15 conventional banks and 6 Islamic banks for the
period 1991-2001. The study employs three proxy of performance, Return on
Assets, Cost to Income Ratio, and Return on Equity. He reports no major
difference in profitability and liquidity between conventional banks and Islamic
banks. Nevertheless, simulation outcomes based on ROA ratio show that the
Islamic banks are more profitable than the conventional ones. In addition, the
study indicates that Islamic banks enjoy lower credit risk than conventional
banks and higher credit performance than conventional banks. Recently, Srairi

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(2009) assesses the effect of a number of bank-specific, economic conditions,
and financial structure on the profitability of Islamic and conventional banks in
the Gulf Cooperation Council over the period 1999-2006. He reports a negative
relationship between operational efficiency and profitability for all types of banks
and a positive association between financial risk and size. The paper documents a
negative relationship between the liquidity and the profitability of Islamic banks
and purports that this may be due to the surplus of liquid assets that are creating a
cost of opportunity. The ratio of credit risk as proxy by net loans to total assets,
displays a positive sign for Islamic banks and negative sign for conventional
banks as a result of high loan losses provisions and default costs in conventional
banks. The author shows that financial risk (total liabilities/total assets) and
economies of scale increase the profitability of Islamic banks. In addition, the
paper reports supporting evidence on the positive impact of macroeconomic
conditions (growth and inflation) and financial system structure (stock market
development and concentration) on the profitability of conventional and Islamic
banks.
Studies focusing only on Islamic banking profitability are still not copious.
Bashir (1999) studies the determinants of 14 Islamic banks performance for 8
Middle Eastern countries over the period 1993 to 1998. The estimation outcomes
show that Islamic banks profitability measures respond positively to the increase
in capital and loan ratios. The research on banking structure shows that foreign-
owned banks are more profitable than the domestic banks and those Islamic
banks are more profitable than the conventional ones (Bashir, 1999; Olson and
Zoubi, 2008). Following his previous investigation, Bashir (2003) perform
regression analyses to determine the underlying determinants of 14 Islamic banks
performance in the Middle East. His findings show that the profitability of banks,
in terms of profits, is mostly determined by non-interest earning assets, overhead,
and customer short term funding. Moreover, he reports a positive relationship
between banks liquidity, stock market development, GDP growth and inflation.
Later on, Hassan and Bashir (2003) examine the performance of Islamic banks in
21 countries over the period 1994 to 2001. They find that implicit and explicit
taxes affect negatively the banks performance and that GDP growth affects
positively banks outcomes. Moreover, the researchers examine the relationship
between banks performance (profit margin, net non-interest margin, returns on
equity and returns on assets) and banks internal characteristics, after controlling
for economic and financial structure indicators. They indicate the importance of
consumer and short-term funding, non-interest earning assets and overhead in
enhancing banks profitability. In addition, the authors point out the existence of
a positive impact of the macroeconomic environment and the regulatory tax
factors on the profitability of banks. The study also documents a negative
correlation between the size of the banking system and bank profitability.
Using co-integration and error-correction techniques, Haron and Wan (2004),
investigate the existence of a relationship between internal and external
determinants and profitability of Islamic banks over the years 1984-2002 in five
countries. Internal variables include capital structure liquidity, financing and
deposits structures, and expenditure. External variables incorporate money

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supply, interest rate, market share, inflation, size of the bank. Three variables
were used as proxies for profitability: total income as a percentage of total assets,
banks fraction of income as a percentage of total assets, and net profit after taxes
as a percentage of capital and reserves. The study indicates evidence of a
significant long-run relationship between profitability of Islamic banks and
liquidity, deposits, inflation, assets structure and money supply. Similarly, Haron
(2004) reports a high correlation between external factors such as interest rates,
market share and size of the bank and banking profitability. Internal factors such
as total expenditures, liquidity, invested funds in Islamic securities, and the
percentage of the profit-sharing ratio between the bank and the funds borrower
increases the Islamic banks total income. On one hand, factors such as total
capital and reserves funds deposited into current accounts, the percentage of
profit-sharing between bank and depositors, money supply highly influences the
profitability of Islamic banks. On the other hand, the study indicates that money
supply, market share tend to have adverse effect on profitability contrary to the
findings of earlier studies. Finally, inflation seems to have a positive impact on
the profits of Islamic banking.
In a recent paper, Ben Khediri and Ben-Khedhiri (2009) investigate the
determinants of Islamic bank profitability in the MENA region, during the years
19992006. They estimate several specifications to examine the impact of bank-
specific and country-specific environment, including macro-economic
conditions, market structure and institutional development, on bank profitability.
The results provide evidence suggesting that capitalization and management
efficiency enhance bank profitability. The study also reports a negative
relationship between banks operational efficiency (measured by cost-income
ratio) and profitability. Moreover, the regression outcomes show that increased
bank concentration leads to higher bank profitability. The results also indicate
that bank profitability is positively associated with, economic growth, inflation.
Finally, the study shows, for the first time, the importance of the improvement of
institutional factors, such as the quality of legal system and socioeconomics
conditions on the profitability of Islamic banks in the MENA region.

METHODOLOGY

In this section, we have discussed the variables used in our model to assess
factors that drives African banks profitability: the bank-specific, industry-
specific and Macroeconomic variables. We also described the data used and the
model formulation.

Variables

In its broad meaning, bank profitability means the net after-tax income or net
earnings of a bank, usually divided by a measure of the bank size (Rose, 1998).
Two main strand of research can be highlighted when measuring profitability. In
a typical strand, a number of financial ratios such as return on equity (ROE),

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return on assets (ROA), cost to income ratio (COSR), and net interest margin
(NIM), are usually used to assess a bank performance (Hassoune, 2002, Hassan
and Bashir, 2003; Srairi, 2009; Ben Khediri and Ben-Khedhiri, 2009).
Computing theses financial ratios usually provide a broader idea on the banks
financial situation since they are constructed from the banks balance sheet and
financial statement accounting data. The second strand of research goes beyond
the financial ratios analysis and focuses rather on the productive efficiency and
productivity change of banks (Casu, Girardone and Molyneux, 2004; Fadzlan
2007; Ben Naceur, Ben-Khedhiri and Casu, 2008).
Our actual research focuses on the performance of banks as measured by the
Return on Average Assets (ROAA), defined as the net after-tax income to
average total assets. The ROAA reflects the ability of a banks management to
generate profits from the banks assets. The ROAE which is measured by the
equity to total assets can also be formulated by the ROAA times the banks
equity multiplier (total assets-to-equity ratio). The equity multiplier reflects the
level of banks financial leverage. The relationship between ROAA and ROAE
(Return on Average Equity) indicates the basic trade-off banks face between risk
and return, whereas the equity multiplier reflects the leverage or financing
structure (debt or equity) preferred to finance the bank activities. Subsequently,
we measure banks profitability by the ROAA. Along with this, two main subsets
of determinants of profitability are usually expressed: internal also called banks
specific determinants and external determinants, called, country specific
determinants. In the following section, we present the banks internal
characteristic and external parameters (industry-specific and macroeconomics
conditions) that may influence the profitability of the selected Islamic banks in
Africa.

The bank-specific variables
The bank-specific characteristics reflect the micro functioning of banks. The
study considers four measures of bank internal features; Capital adequacy which
is defined as the equity to total assets (EQTA), asset quality as the net loans to
total assets (NLTA), operating efficiency as the cost to income ratio (CIR) and
bank size as the log total assets (SIZE).
The EQTA is used to provide information on the capital structure. It expresses
the proportion of total assets financed by the bank's equity capital. High equity-
to-asset ratio reflects the low need to external funding. Well-capitalized banks
face lower costs of funding and financial distress and hence higher profits
(Berger, 1995). Ben Khediri and Ben-Khedhiri (2009) provide empirical
evidence that for the Islamic MENA banks there is a positive relationship
between bank profitability and capital strength.
Credit risk as measured by the NLTA is considered a significant determinant
of profitability since it is related to the presence of bank failures. In fact, poor
allocation assessment of funds by Islamic banks has a direct impact on the
returns. Recently, Srairi (2009) documents a positive association between the
NLTA and profits for Islamic banks in the Gulf Cooperation Council. Thereby,
we anticipate the NLTA to be positively linked to banks profitability.

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Banks operational efficiency could be measured by the banks costs to its total
income (net interest and non-interest). The lower the cost to income ratio the
more efficient and profitable the bank is. Numerous studies have confirmed the
negative association between banks efficiency and profitability. Srairi, (2009)
and Ben Khediri and Ben-Khedhiri (2009) document an inverse relationship
between the cost income ratio and bank's profitability. Likewise, we expect a
negative correlation between CIR and the profitability of banks.
One of the issues underlying bank policy is which size improves bank
performance. Economic theory suggests that if banks are subject to economies of
scale, they are able to reduce the costs of gathering and processing information
(Boyd and Runkle, 1993), or economies of scope that result in loan and product
diversification, and provide access in markets that smaller banks cannot access
(Heggestad, 1977; Smirlock, 1985). However, the evidence of the effects of such
economies on the profitability of banks has not been fully resolved. While,
Akhavein, Berger and Humphrey (1997) and Smirlock (1985) have found a
positive significant relationship between size and bank profitability, others have
found weak evidence (Altunbas and Molyneux, 1996). Eventually, Berger,
Hanweck and Humphrey (1987) emphasize that little cost saving can be achieved
by increasing the size of a banking firm, which, implies that ultimately very large
banks could face scale inefficiencies. In our study, we use the log of total assets
to capture the effect of banks size on banks profitability.

Industry-specific
In order to assess the relationship between the country financial structure and
profitability, we exploit three proxies; Bank Concentration (BC), total assets of
deposit money bank to GDP (DMBA), total assets of the Central Bank to GDP
(CBA).
On one hand, the theory behind the Structure-Conduct-Performance (SCP)
claims that certain markets are conducive to monopolistic behavior. It states that
the structure of an industry (of the degree of concentration) determines conduct
(collusion and monopolistic pricing) which determines performance (abnormal
profitability/rate of return). The ability to collude is assumed to be inversely
related to the number of firms and their market shares in an industry, and thus is
positively correlated with concentration. Successful collusion leads to abnormal
profits and a loss of social welfare and potential economic growth. In this
framework, banks would be able to extort monopolistic rents in concentrated
markets by their ability to offer lower deposit rates and higher loan rates. On the
other hand, the market efficiency structure hypothesis argues that the relationship
between market structure and performance of any firm is defined by the
efficiency of the firm. Firms with superior management or production
technologies have lower costs and therefore higher profits. Studies linking
market concentration to banks performance have shown that market
concentration increases banks profitability (Demirg-Kunt and Huizinga, 1999;
Ben Naceur, Ben-Khedhiri and Casu, 2008; Ben Kedhiri and Ben-Khedhiri,
2009).

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Demirg-Kunt and Huizinga (1999) argue that higher bank development is
linked to lower bank profitability and interest margins. DMBA measures the
overall size of the banking sector. Developed countries tend to have larger
banking sectors. CBA represents the claims on domestic real non-financial sector
by the Central Bank as a share of GDP. The size of central bank assets is likely to
low for developed countries since in developing countries, the central bank plays
a relatively large role in credit provision. We expect a negative relationship
between countries financial development and profitability,

Macroeconomic conditions
Kaminsky and Reinhart (1999) assert that the macroeconomic stability is a
key determinant of dissemination of the banking system. The macroeconomic
indicators, such as, the domestic gross product growth (GDP) and the inflation,
reflect the overall economic conditions in which banks operate.
Studies linking real GDP growth to banks profitability have shown a robust
positive relationship (Demirg-Kunt and Huizinga, 2000; Srairi, 2009). Bank
loans are expected to be the main source of revenue, and are expected to
influence profits positively. Nonetheless, as most of the Islamic banks loans are
on the form of profit and loss sharing, the loan-performance relationship depends
significantly on the expected change of the economy. Throughout a strong
economy, only a small fraction the PLS loans will default, and the banks profit
will increase. The bank could be severely damaged during adverse economic
conditions, because several borrowers are likely to default on their loans.
Therefore, we expect the relationship between the economic growth and banks
profit to be positive.
The effect of inflation on bank profitability was first examined by Revell
(1980). He asserts that the effect of inflation on banks depends on whether banks
expenses increase at a faster rate than does inflation. A long with this, Perry
(1992) argues that the degree to which inflation affects bank profitability depends
on whether inflation expectations are fully anticipated. An accurate and early
anticipation of inflation rates would provide banks managers with the opportunity
to adjust interest rates quicker and therefore to generate higher revenues. On the
contrary, unanticipated inflation could lead to inappropriate adjustment of
revenues and hence to the possibility that costs could increase faster than
revenues. Several studies (e.g. Athanasoglou et al., 2008; Ben Kedhiri and Ben-
Khedhiri, 2009) have revealed a positive relationship between either long-term
interest rate or inflation and profitability. As Islamic banks pay zero interest rates
on demand deposits only a share of returns on saving accounts, a rise in inflation
would be mostly adjusted through the bank's assets. Therefore, we expect a
strong relationship between inflation and the profitability of Islamic banks.

Data Used in the Study
Our sample is an unbalanced panel dataset of 9 Islamic banks operating in
Africa over the period 19992009 consisting of 66 observations. We use annual
bank level and macroeconomic data from 3 countries (Egypt, Sudan, and

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Tunisia). The bank-specific variables are obtained from the BankScope database,
maintained by Bureau Van Dijk. The macroeconomic variables (including
inflation and Real DGP growth) are obtained from the IMFs International
Financial Statistics (IFS). The industry-specific variables were drawn from the
updated Thorsten Beck database (2009) which is published by the World Bank.
Table 1 provides the definitions and sources of variables. Tables 2 and 3 present
descriptive statistics for the variables used in this study for overall sample and by
country, respectively, while Table 4 presents correlation matrix for explanatory
variables.

Table 1: Variables, definitions and sources
Variables Definitions Sources
Dependent variables
ROAA Net after-tax income to average total assets BankScope
Determinants
Bank-specific
EQTA Equity to total assets BankScope
NLTA Net loans to total assets BankScope
CIR Cost income ratio BankScope
SIZE Natural logarithm of total assets BankScope
Industry-specific
BC The three largest banks' assets to total banking
sector assets
Work Bank
DMBA Total assets of deposit money bank to GDP Work Bank
CBA Total assets of the Central Bank to GDP Work Bank
Macroeconomic
GDPG The real gross domestic product (GDP) growth IMF
INF The annual inflation rate IMF

As shown in Table 1, our dependent variable is the net after-tax income to
average total assets. We use equity to total assets, net loans to total assets, net
loans to total assets; cost income ratio, natural logarithm of total assets as bank-
specific determinants. Industry-specific determinants consists of a set of three
variables: the three largest banks' assets to total banking sector assets, total assets
of deposit money bank to GDP, and total assets of the Central Bank to GDP.
Macroeconomic determinants used are the real gross domestic product (GDP)
growth and the annual inflation rate.


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Table 2: Descriptive statistics for the all sample
variable Mean Min Median Max SD
ROAA 1.48 -6.09 1.32 6.11 2.09
EQTA 13.10 1.68 11.82 33.95 7.66
NLTA 39.89 0.02 38.49 83.43 23.66
CIR 67.91 30.25 54.69 268.5 45.58
SIZE 5.51 3.27 5.30 7.90 1.18
BC 63.99 43.81 65.39 80.68 11.08
CBA 13.12 0.24 5.47 58.14 16.32
DMBA 32.03 1.84 13.30 82.83 32.41
GDPG 5.94 1.71 5.79 11.28 2.10
INF 7.04 1.96 7.84 15.99 3.69

Before we present the analysis of our results, we briefly describe some
statistical properties of the data, focusing primarily on the characteristics of our
variables descriptive statistics for the all sample by presenting their respective
means and medians, minimum and maximum values and standard deviation as
reported in Table 2. Also, we present a descriptive statistics, of the mean and the
standard deviation for each of the three countries of our sample (Table 3).

Table 3: Descriptive statistics by country
variable
Sudan Egypt Tunisia
Mean SD Mean SD Mean SD
ROAA 1.82 2.53 0.35 0.29 1.76 0.54
EQTA 12.73 3.99 5.29 1.82 26.36 7.11
NLTA 32.05 19.59 54.05 31.20 50.85 8.71
CIR 80.53 53.96 46.53 8.06 48.22 6.65
SIZE 4.93 0.88 7.11 0.71 5.48 0.38
BC 70.18 8.50 56.94 0.96 49.15 7.91
CBA 8.78 14.06 33.46 7.65 0.39 0.11
DMBA 7.43 4.35 79.15 3.52 62.19 4.23
GDPG 6.72 2.12 4.45 1.23 4.95 1.34
INF 8.95 2.91 4.48 2.53 3.08 1.02

An important issue, relevant to the estimation of the inflation regressions, is
the potential co-linearity between the regressors. For instance, Equity to total
assets is a variable that is very likely to be highly correlated with other variables
such as Net loans to total assets or the total assets.


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Table 4: Correlation matrix for explanatory variables
Item EQTA NLTA CIR SIZE BC CBA DMBA GDPG
NLTA -0.02 1
CIR -0.05 -0.18 1
SIZE -0.41
***
0.49
***
-0.46
***
1
BC -0.27
**
-0.16 0.03 -0.09 1
CBA -0.63
***
0.12 -0.10 0.39 -0.14 1
DMBA -0.07 0.46
***
-0.38
***
0.73
***
-0.61
***
0.41
***
1
GDPG 0.07 -0.21
*
0.06 -0.19 0.43
***
-0.51
***
-0.46
***
1
INF -0.26
**
-0.25
**
0.12 -0.24
**
0.60
***
0.17 -0.63
***
0.10
Note: *, **, *** significant at the 10%, 5%, and 1% level respectively

Table 4 reports pair-wise correlation coefficients for profitability and its
determinants. Therefore, in our estimations we are especially careful when
including all variables at the same time, checking for robustness of our included
variables.

Model formulation

Our empirical framework extends the studies first addressed by Demirguc-
Kunt and Huizinga (1999), and Demirguc-Kunt and Huizinga (2000) on the
determinants of bank profitability but is extended to a panel setting. Then, to
examine the effect of bank-specific, industry-specific and macroeconomic
variables on bank profitability, we estimate a linear regression model in the
following forms:

) 1 (
4 3 2 1 0 it i it it it
SIZE CIR NLTA EQTA ROAA c | | | | o + + + + + + =

) 2 (
3 2 1
4 3 2 1 0
it i
it it it
DMBA CBA BC
SIZE CIR NLTA EQTA ROAA
c
| | | | o
+ + + +
+ + + + + =

) 3 (
2 1
4 3 2 1 0
it i
it it it
INF GDPG
SIZE CIR NLTA EQTA ROAA
c o o
| | | | o
+ + +
+ + + + + =

Where
o
is a constant,
i
is the individual effect of bank i and
ijt
is the error term.

According to Hsiao (1986), pooled OLS yields biased and inconsistent
coefficient estimates because omitted cross-section specific variables may be
correlated with the explanatory variables. Thus, the assumption of zero

ISSN 1985-692X

unobservable individual effect is too strong given that there is large heterogeneity
across countries and across banks within the same country. Therefore, we
statistically test which empirical model is most suitable for estimating bank
profitability. The Lagrangian Multiplier test (LM test) (Breusch and Pagan, 1980)
is used to test the random effect model versus the pooling regression. The null
hypothesis is that the individual effect, i, is 0. The chi-square statistics is equal to
53.64. Thus, the null hypothesis is rejected at the 1 percent significance level for
both measures of profitability. The results suggest that the individual effect is not
zero and that the pooling regression is not suitable in this case.
To control for individual bank heterogeneity, we employ a random effect as
well as a fixed effect model. To compare the fixed effect and the random effect
models, we conduct the Hausman specification test (Hausman, 1978). If the
model is correctly specified and if individual effects are uncorrelated with the
independent variables, the fixed effect and random effect estimators should not
be statistically different.
The statistics of Hausman test are reported in Table 5 and the null hypothesis,
that the individual effect is uncorrelated with the independent variable, is not
rejected at the 10 percent significance level. This result indicates that the
difference between fixed effect and random effect is not systematic, providing
evidence in favor of the random effect.
We also use the Breusch-Pagan / Cook-Weisberg test for heteroscedasticity.
The result rejects the hypothesis that the variance of each models residuals is
equal across banks (Chi
2
(1) = 5.72 and P-value = 0.016). Therefore, the models
are estimated using Whites transformation to control the cross-section
heteroscedasticity of the variables. Furthermore, we examine the multicolinearity
of independent variables using the variance inflation factor (VIF) statistics test
and find no serious problem of multicolinearity in all three models.

EMPIRICAL RESULTS

The regression results are shown in Table 5. This table provides the empirical
results of the effects of bank-specific, industry-specific and macroeconomic
variables on bank profitability (ROAA).
The columns correspond to different model specifications. Model 1
concentrates on the bank-specific variables, while models 2 and 3 test the impact
of internal factors in conjunction with the macroeconomic and the financial
structure on the profitability of banks. Concerning bank characteristics, we find
that bank capital strength affects positively and significantly the bank
profitability in all specifications. This result suggests that well-capitalized banks
are more profitable because of lower expected bankruptcy costs and reduced
costs of funding. This result is consistent with the findings of Demirg-Kunt
and Huizinga, 1999 and 2000), Hassan and Bashir (2003), Pasiouras and
Kosmidou (2007), Ben Khediri and Ben-Khedhiri (2009) and Abdennour and
Ben Khediri (2010).

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We also find that the relation between net loans to total assets and bank
performance is negative, and statistically significant in both models 2 and 3
(Coefficients are respectively equal to -0.013 for the Model 2 and -0.012 for
Model 3). This result is consistent with the documented evidence in Demirg-
Kunt and Huizinga (1999).
The coefficient of the cost income ratio is negative and significant (negative
values as reported in Table 5). This result indicates that improved operating
efficiency of management leads to higher profits. This finding supports the
results of Pasiouras and Kosmidou (2007), Srairi (2009), Ben Khediri and Ben-
Khedhiri (2009) and Abdennour and Ben Khediri (2010).
Our results show that the impact of size is positive and statistically significant
in both models 1 and 2, suggesting that the bank size has a positive impact on
bank profitability. This result is consistent with the argument of economies of
scale. It also confirms the findings of Akhavein et al., 1997 and Srairi, 2009).
An important finding of this study is that financial structure development as
measured by the overall size of the banking sector and central banks assets erode
banks profits. The former is explained by the fact that increased competition
between banks reduces banks profits and the latter by the fact that relatively
large role of central banks in credit provision, in Africa, diminishes banks
returns. The results are consistent with the findings of Demirg-Kunt and
Huizinga (1999) and Pasiouras and Kosmidou (2007).
The empirical result finds evidence to support the SCP hypothesis. The sign
of size is positive and statistically significant in both models 1 and 2, suggesting
that the bank size has a positive impact on bank profitability. This result confirm
the findings of Demirg-Kunt and Huizinga (1999), Pasiouras and Kosmidou
(2007) and Ben Khediri and Ben-Khedhiri (2009).
As regards macroeconomic variables, the relation between inflation and
ROAA is positive and statistically significant. This suggests that banks tend to be
more profitable in inflationary environment. This also indicates that during the
period of our study the levels of inflation were anticipated by Islamic banks. This
result is consistent with the documented evidence in Hassan and Bashir (2003),
Pasiouras and Kosmidou (2007), Ben Khediri and Ben-Khedhiri (2009) and
Abdennour and Ben Khediri (2010).
The results also report a positive and significant coefficient on GDP growth,
suggesting that economic growth is a significant determinant of bank
profitability. This empirical finding is consistent with Hassan and Bashir (2003),
Pasiouras and Kosmidou (2007), Srairi (2009), and Ben Khediri and Ben-
Khedhiri (2009). This provides further support to the argument of positive effect
of economic growth on financial sector performance.


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Table 5: Determinants of bank profitability (66 observations)
Item Model 1 Model 2 Model 3
FE RE FE RE FE RE
Intercept 0.207 1.562 0.086 0.500 0.771 1.210
(0.880) (0.219) (0.964) (0.717) (0.586) (0.342)
EQTA 0.071* 0.065* 0.048* 0.047** 0.057 0.056***
(0.083) (0.052) (0.081) (0.019) (0.111) (0.003)
NLTA -0.005 -0.009 -0.013** -0.013*** -0.007 -0.012*
(0.372) (0.189) (0.017) (0.010) (0.177) (0.079)
CIR -0.039*** -0.038*** -0.041*** -0.037*** -0.041*** -0.036***
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
SIZE 0.585*** 0.381** -0.092 0.443** 0.669*** -0.019
(0.006) (0.023) (0.684) (0.016) (0.010) (0.902)
BC 4.435* 3.392*
(0.072) (0.082)
CBA -2.226** -2.262**
(0.014) (0.036)
DMBA 6.468** -2.741***

(0.012) (0.004)

GDPG -0.011 0.261***
(0.872) (0.000)
INF -0.080* 0.150***
(0.074) (0.000)
F-statistic 51.54 23.62 27.64
Wild 139.48 358.4 274.45
P-value 0.000 0.000 0.000 0.000 0.000 0.000
R 0.458 0.516 0.226 0.868 0.383 0.750
Hausman
Test
(4)
=1.96

(7)
=0.34

(6)
=0.34

p> = 0.743 p> = 0.999 p> = 0.999
Note: *, **, *** significant at the 10%, 5%, and 1% level, respectively. P-values are given in
parentheses below the coefficient estimates.

CONCLUSION AND POLICY RECOMMENDATIONS

This paper examined the factors that influence the profitability of Islamic banks
in Africa over the period 1999-2009. The empirical findings of this study suggest
that bank profitability is affected by both internal characteristics and external
factors.
This study finds that capital is important in explaining bank profitability.
Also, Size positively affects bank profitability, providing evidence of economies

ISSN 1985-692X

of scale. Furthermore, net loans to total assets and cost income ratio exhibit
negative and significant impact on bank profitability.
As regards macroeconomic indicators, we find that higher economic growth
and inflation have a positive and significant effect on the profitability of Islamic
banks in Africa.
Regarding industry-specific variables, we find a positive and significant
relation between bank concentration and bank profitability, providing evidence of
the SCP hypothesis. On the contrary, the size of banking sector, as measured by
the total assets of Central Bank to GDP and the total assets of deposit money of
the bank to GDP, has a negative effect on profitability of Islamic bank in Africa.
Drawing on the empirical research, Islamic banks in Africa are ought to
reinforce their equity in order to decrease the likelihood of bankruptcy and
increase their size to benefit from the economies of scale. Moreover, banks
should improve the management of their loans with respect to total assets via
better screening and monitoring of credits. Islamic banks should manage their
costs efficiently with respect to income to get the best return on assets. As the
financial system stability is one of the main preoccupations of countries, the
authorities should foster economic growth and set up the appropriate
macroeconomic policies which encourage competition within the financial sector
and fast adjustment of anticipated inflation.

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