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A comprehensive analysis of the performance of Islamic banks, in Comparison with Conventional banks in the GCC region; using The CAMEL model

Ammar Elkhatib
By Ammar Elkhatib
2 years ago
This study compares the financial performance of Islamic banks with their conventional counterparts in the six Gulf co-operation council (GCC). The study examined the association between GCC listed banks’ Corporate Governance represented in “board independence and board leadership” as well as their financial performance and the quality of their narrative reporting and financial performance. The study utilized the CAMEL model in the comparison between both Islamic and conventional banks. In addition both Diction and LIWC software were used in analyzing the quality of their narrative reporting. The sample represents all listed Islamic banks and Conventional banks located in the GCC region during the period 2010-2014.

Ard, Islam, Islamic banking, Mal, PLS, Riba, Salam , Shariah , Credit Risk, Provision

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  1. MSc Management and Finance 2015-16 Dissertation Title : A comprehensive analysis of the performance of Islamic banks, in Comparison with Conventional banks in the GCC region; using The CAMEL model. Student Name: Ammar Mohamed Elkhatib Student Number: S14138070 Supervised by: Dr. Muhammad Surajo Sanusi Submitted in: April-2016 1
  2. Table of Contents Declaration Acknowledgement Abstract Chapter One : Introduction .................................................................................................................... 5 1.1 Corporate Governance of Conventional and Islamic Banks ................................ 6 1.2 Background of the study.......................................................................................................... 9 1.3 Differences between Islamic and Conventional Banks .......................................... 9 Chapter Two: Literature Review .................................................................................................... 12 Chapter Three: Theoretical background & hypothesis development................... 14 3.1 Agency theory ............................................................................................................................. 14 3.2 Concealment Theory............................................................................................................... 17 3.3 Research Hypotheses ............................................................................................................. 18 Chapter Four: Methodology.................................................................................................... 21 4.1 Sample ............................................................................................................................................ 21 4.2 Descriptive statistics .............................................................................................................. 21 4.3 Dependent Variables .............................................................................................................. 25 4.3.1 The CAMEL Ratios ........................................................................................................... 25 4.3.2 CAMEL Graphs and descriptive statistics........................................................... 27 4.4 Multivariate Analysis ............................................................................................................. 33 4.4.1 Board Independence: .................................................................................................... 34 4.4.2 Bank ownership ............................................................................................................... 36 4.4.3 Multivariate Analysis Results ................................................................................... 42 4.4.4 The Analysis of the Narrative reporting of GCC Banks ............................... 45 4.4.5 Narrative reporting Data Analysis (Using DICTION software) .............. 47 4.4.6 Impression management analysis for Islamic banks and Conventional banks (Using LIWC software) ............................................................................................... 48 Chapter Five: Concluding remarks ............................................................................................... 54 References ..................................................................................................................................................... 56 2
  3. Declaration This thesis is a result of my own work . The cited published and unpublished material is credited to authors. Acknowledgement I would like to express my sincere gratitude to my supervisor Dr. Muhammad Surajo Sanusi who assisted and encouraged me all the way through to the completion of this thesis. My gratitude also goes out to Professor Omneya Abdelsalam who gave me advices and helped me to gain a deeper understanding of the subject. Finally, I would like to thank my wife and family for their unwavering support. 3
  4. Abstract This study compares the financial performance of Islamic banks with their conventional counterparts in the six Gulf co-operation council (GCC). The study examined the association between GCC listed banks’ Corporate Governance represented in “board independence and board leadership” as well as their financial performance and the quality of their narrative reporting and financial performance. The study utilized the CAMEL model in the comparison between both Islamic and conventional banks. In addition both Diction and LIWC software were used in analyzing the quality of their narrative reporting. The sample represents all listed Islamic banks and Conventional banks located in the GCC region during the period 2010-2014. Based on 333 bank-year observations, the study provides empirical evidence that there is no significant difference between Islamic and conventional banks in terms of their capital adequacy and credit risk (asset quality). On the other hand, Islamic banks appeared to be significantly less efficient and less profitable but more liquid in comparison to their conventional peers. This is in line with expectation as Islamic banks’ constrained model of finance incur them additional screening and religious governance costs. The higher liquidity ratios kept by Islamic banks confirms the expectation that religious oriented organisations are risk averse. This study has implications to regulators and international investors. Keywords: Islamic Banks, Conventional Banks, Financial performance, Corporate Governance, CAMEL model, DICTION. 4
  5. Chapter One : Introduction Banking is a major sector, which affects the economic development of countries (Siraj & Pillai, 2012). It is a crucial indicator of their financial stability and growth. The developmental role of banks cannot be achieved without the requisite high quality and credible financial reporting needed to give stakeholders a true image of their bank performance (Barro and McCleary, 2003; Callen and Fang, 2013). The Gulf Cooperation Council (GCC) is one of the most attractive and fastest growing regions for investment and banking. Many banks in the GCC have been ranked from the top 100 banks in the world (The bankers, 2016). Banks are playing an important role in the GCC’s economy because capital markets are weak. Furthermore, corporate governance is a newly adopted concept in the region with corporate governance codes having been introduced after 2008. A notable feature of the GCC banking system is the high concentration of banks with religious adherence (Islamic banks) in addition to conventional banks (Thomson’s Reuters Zawya, 2016). Previous literature has emphasized the importance of religion in shaping organisations’ economic behaviour (Leventis et al., 2015; Abdelsalam et al., 2016). Religiosity is considered as an additional control mechanism that influences companies’ managerial and financial reporting decisions (Callen and Fang, 2013 cited in Abdelsalam et al., 2016). This study will investigate the impact of bank religiosity on their financial performance and the quality of their narrative reporting in the six GCC countries during the period from 2010-2014. In particular the study will examine the five CAMEL financial performance indicators. In addition the study will assess the quality of narrative reporting and the language used by banks’ chairmen in their annual statement to shareholders. The language and verbal tones of reports are examined using both the DICTION1 and LIWC2 software. 1 DICTION is a software that converts words of reports to numbers and measures the verbal tones used in these reports. 2 LIWC a licensed software that is used for the measurement of quality of reports 5
  6. This study aims to fill a gap in the literature concerning the impact of corporate governance and religiosity on banks financial performance and quality of reporting in the GCC region . In particular the study will answer the following research questions: 1) Is there a difference between Islamic and Conventional banks in their financial performance and narrative reporting? 2) What is the impact of corporate governance (represented by board independence and board leadership) on GCC Banks financial performance? 3) What is the impact of corporate governance (represented by board independence and board leadership) on GCC Banks’ narrative reporting? 4) Is there an association between GCC banks financial performance and the quality of their narrative reporting? The study enriches the understanding of the impact of religiosity on bank performance and financial reporting quality. The study’s implications are of great importance to global banking regulators and investors The study is comprised of four sections; the first section is a review of past literature on the performance of Islamic and Conventional banks and the specifications of corporate governance of Islamic Banks. Section two, describes the theoretical background of the study and develops hypothesis. Section three, represents the data selection and methodology. Section four deals with the analysis and the empirical findings. The final section concludes the study. 1.1 Corporate Governance of Conventional and Islamic Banks The rapid increase in the number of Islamic banks necessitates an in-depth understanding of their corporate governance. The Organization for Economic Co-operation and Development (OECD) has defined corporate governance as a “set of relationships between a company’s management, its board, its stakeholders and other stakeholders” (OECD, 1999). 6
  7. Corporate governance is crucial for banks and is expected to have a favourable impact on the performance of firms (e.g. Lee et al., 1992). There is a considerable association between the board of directors’ composition and the performance of financial institutions. For instance, Sierra et al. (2006), Andres and Vallelado (2008), Wintoki et al. (2012) and Francis et al. (2012), have reported that the composition of the board of directors positively affects the performance of the firm. In addition, Andres and Vallelado (2008), Ho, Lai, & Lee, (2013); Combs et al., (2007) have stated that the independence of the board of directors has a positive effect on its performance. Conversely, it has been reported by Pathan and Faff (2013) that the independence of the board of directors has a negative effect on companies’ performance. There might be due to information asymmetry between the independent directors and the insider circumstances of the firm, which might lead to inferior performance. Corporate governance is even more important for Islamic financial institutions due to their religious orientation. According to Abdelsalam et al., (2016), the constrained model of finance that is followed by these institutions, due to their religious adherence, implies higher agency costs. Due to the prohibition of dealing with “Interest”, depositors in Islamic banks are contracted as “Investment Accounts Holders” (IAHs hereafter). The IAHs deposit funds are invested by the banks’ managers. The depositors / IAHs have little or no direct way of monitoring of their deposits due to lack of board of directors representation. This leads to an expected increase of agency costs between the depositors and the managers of Islamic banks (Abdelsalam et al., 2016). In addition, these banks, have to appoint a Sharia Supervisory Board (SSB), which represents an extended layer of governance and represents a vital role in governing Islamic Banks. Members of this board must be scholars in Islamic jurisprudence and have a duty to ensure the banks compliance with their moral values. They issue an annual SSB report, which is included in the bank’s annual report. Moreover, they indicate any violation of Sharia principles in the bank’s transactions. Their main duty is to ensure that any new product or financial tool of the Islamic bank is in compliance with Sharia. It is expected that the extra layer of SSB governance represent a constraint that incurs extra costs on these banks. However it is expected that the additional governance reduces agency 7
  8. costs in Islamic banks , improves their performance and serves as a deterrent against risk taking by these banks. In addition, according to the social norms theory, the strict religious adherence of Islamic banks will impact their financial and reporting performance (Leventis, S. et al., 2016). It has been argued by (Stulz and Williamson, 2003; Abdelsalam et al., 2016) that religion has a big role in shaping the economic behavior of firms. Previous research provided evidence that religiosity has a significant impact on corporate’s managerial and financial reporting practices (Callen and Fang, 2013; Abdelsalam et al., 2016). Belal, A., et al (2015) found that Islamic financial institutions are more likely to be conservative than their conventional peers and therefore more risk averse. McGuire et al. (2012) found that firms with headquarters located in religious areas tend to have lower financial reporting misstatements. Therefore, it is expected that managers of Islamic banks are less likely to embark on high-risk activities or to suppress bad news for self-interest (Callen and Fang, 2013; Elnahass et al., 2014). It is also expected that religiosity constraints in Islamic banks are expected to lead to better narrative reporting and disclosure. Some scholars (i.e. (Ahmad, 2000; Mirakhor, 2000; Warde, 2000) argued that Islamic banks have a religious accountability towards stakeholders and this moral code would lead to better corporate governance and hence better reporting by Islamic banks. It is also expected that the extra layer of governance and the religious adherence of these banks will serve as a deterrent against questionable behaviour such as impression management. According to (Smith & Taffler, 2000; Sydserff & Weetman, 2002), managers can use impression management to manipulate and shape the shareholders’ perception of the company’s performance. (Cho,et al, 2010) used DICTION software to analyse firms reports and argued that the companies with worse performance tend to use more “Optimistic” and less “Certain” language than their well-performing counterparts. In this study, a similar approach is used to test the optimism and certainty levels of Islamic and Conventional banks Chairmen reports. It is hypothesised that Islamic banks 8
  9. have higher quality reports than conventional banks due to their organisational religiosity , double layers of governance and moral accountability constraints (Leventis, S., et al, 2015). 1.2 Background of the study Islamic banking is a relatively young industry with no more than 45 years performing in the banking sector, whilst conventional banks have over 300 years of experience. The industry of Islamic finance is approximately worth $2.5 trillion and is tremendously fast-growing (Ernst and Young, 2015). According to Khan (2010), the growth rates of Islamic Banks were approximately 15% p.a. during the period (1998-2005). Moreover, the Islamic banks assets grew by 111% p.a. whereas Conventional Banks have an only 6% annual asset growth (Benaissa et al., 2005). The GCC consists of six countries; Saudi Arabia, Bahrain, Qatar, Oman United Arab Emirates, and Kuwait. The GCC countries’ economies grew at phenomenal rates in the last 4 decades due to the boom in oil prices. They concentrated on attracting foreign investments which brought about modern technologies, as well as visible and non-visible financial resources (Al-Shamali & Denton, 2000). On the other hand, the GCC region has the highest concentration of Islamic banks and is considered one of the major hubs of Islamic finance in the world (PwC, 2012; Thomson Reuters, 2015). The reason the GCC region was chosen for this research is that it has a high growth rate of Islamic assets, a high number of Islamic Banks and is financially sound. This high concentration of Islamic banks in the GCC was attributed, according to (Jouini & Pastré, 2008), to several factors. For instance, the religious needs for Islamic financial institutions and products in addition to the savings and liquidity associated with the Oil trends (Obeid, H., 2011) 1.3 Differences between Islamic and Conventional Banks 9
  10. It is important to distinguish between the operations of Islamic banks and Conventional banks so as to recognise the Islamic Bank ’s performance environment. There are five main differences between Conventional and Islamic banks; the philosophy and the values, the interest and interest free provision, financial products and instruments, the focus on development and social activities and goals. These differences are (see table 1): first, all transactions must be interest-free, which means it is free from Riba. Second, the transactions should avoid speculation (Gharar). Third, Islamic banks cannot invest in prohibited or illegal activities or products (i.e. Alcohol, Pork and Gambling) (Elnahass, M. et al, (2014). Moreover, Islamic banks are different form Conventional banks in the way of collecting funds. They have two categories; the demand and the investment deposit. The demand deposit is guaranteed; however it gives no return. The investment deposit is designed to share risk between the bank and the investment account holder with no fixed rate of interest. The products and transactions of Islamic banks must be reviewed by the Sharia Supervisory Board (SSB) to ensure Sharia compliance. Finally, Islamic banks pay Zakat, which is the Islamic tax (AbdusSamad, 2004). The fundamental differences between the two types of banks leads to an expectation of varying levels of performance, risk and financial reporting which is covered in the current study. Table 1 summarise the main difference of both types of banks. 10
  11. Table 1 : A comparison between Islamic and Conventional banks Characteristics Constraints on Conventional Banks Islamic Banks finance No constraints Constrained finance model that prohibits Interest (Riba), model Speculation (Maysir), Excessive risk (Gharar). Profit and loss are shared with investors. Prohibited activities No prohibited activities except In addition to illegal activities, Sharia prohibit products illegals. that are contrary to Islamic norms and principles. For example, Alcohol, tobacco, Pork, Weapons and Gambling). Depositors Normal depositors receive fixed In returns (interest). Islamic Banks depositors are contracted as Investment Account Holders (IAHs). They share profit and losses. Corporate governance Accountability constraints Board of Directors. (One Layer of Board of Directors + Sharia Supervisory Board (SSB) governance) (Two layers of governance) Legal accountability. Legal, Adopted from Abdelsalam et al. (2016) 11 moral and religious accountability.
  12. Chapter Two : Literature Review In spite of the extensive literature investigating the banking industry’s performance; there is only a small subsection focused on comparing the performance of Islamic banks with their conventional peers (Bashir, 2001). The Islamic finance industry is growing at phenomenal rates and is approximately worth $2.5 trillion in (Ernst and Young, 2015) and there are more than 300 Islamic financial institutions all over the world (Hasan & Dridi, 2010). Theoretically, Islamic banks are expected to provide lower financial profitability as compared to their conventional counterparts. This is because Islamic banks operate using a constrained model of finance that prohibits certain activities such as (Alchol, Gambling, Pork, Weapons and other illegal activities), and embeds social objectives. These constraints lead to extra costs such as screening costs of activities and projects and the costs of an extra layer of religious governance. Abedifar et al. (2013) argued that Islamic banks’ complex business model, which is limited and constrained with Sharia3, is expected to cause additional risk in their finance and investment. However prior empirical evidence provides mixed results. According to Beck et al. (2013) and Bourkhis and Nabi (2013), Islamic banks generally have higher capital asset ratios and are more risk averse than Conventional banks. In addition, Khediri et. al, (2014) compared the performance of conventional and Islamic banks in the GCC region in the period 2003-2010 and found Islamic banks were more profitable and more liquid than their conventional counterparts. Moreover, Ali (1996) examined the efficiency of Islamic banks in Bangladesh and compared them with their conventional counterparts. The findings revealed that Islamic banks were more efficient than their conventional peers. The same results were reported by Samad (1999) for Islamic banks’ efficiency in Malaysia during the period 1992-1996. Javadi et. al. (2014) compared the performance of Islamic and conventional banks in Europe, The USA and the world during the period 3 Islamic Jurisprudence 12
  13. 2000-2011 . The study found that, during the financial crisis, the Islamic banks’ performance, based on financial risk time variation, outperformed conventional counterparts. The study added that the crisis effect on the Islamic banks was less than conventional peers. Jaffar et al.(2011) tested the differences between Islamic banks and Conventional banks in Pakistan in the period 2005-2009 using the CAMEL model. The study found that the Islamic banks outperformed Conventional banks in the capital adequacy and the liquidity ratios. However, Conventional banks performed better in management quality and earning ability. AbdusSamad (2004) evaluated the financial performance differences between Islamic banks and Conventional banks in Bahrain during the post-Gulf war period 1991-2001. The study measured the profitability, liquidity and credit risks of both industries. They found differences in the credit risk of the two types of banks but no major differences in the liquidity performance between Islamic banks and their conventional peers. Similarly, Johnes, et al (2014) examined the efficiency of both bank types during the period 2004-2009 and it was found that Islamic banks outperformed conventional counterparts in the net efficiency. One the other hand, their type efficiency was significantly lower than conventional counterparts. Abdelsalam et al (2016) investigated MENA (Middle East and North Africa) banks’ financial reporting quality during the period 2008-2013 covering 500 year-observations. According to them Islamic banks are more conservative and less likely to manipulate earnings. The study argued that the religiosity of the MENA Banks is positively associated with their financial reporting quality. 13
  14. Chapter Three : Theoretical background and hypothesis development This section, discusses the theories that shape the hypothesis of this study. Islamic banks are different from conventional banks in terms of their financial models and investment approaches. These differences have an impact on the costs of agency conflict according to the agency theory. In addition, the organizational religiosity of Islamic banks is expected to have an impact on the behavior of these banks according to the social norms theory (Abdelsalam et al., 2016). This will be reflected in their financial performance, risk taking and narrative reporting. In particular these banks are expected to have lower financial performance due to the additional costs of their constrained finance model (i.e. screening costs and SSB costs). On the other hand these banks are expected to be risk averse according to the social norms theory on religious organizations (Abdelsalam et al., 2016). Moreover, due to the extended moral accountability constraints in these banks, it is expected to deter their bank managers and directors from using earning and impression management (see figure 1 adopted from Abdelsalam et al., 2016). 3.1 Agency theory Agency theory is “a contract under which one or more persons [The Principal(s)] engages another person (The Agent) to perform some service on their behalf which involves delegating some decision making authority to the Agent” (Jensen & Meckling, 1976). In this context, it is predictable that the separation between ownership and management would cause a sort of conflict because, arguably, management (Agent) may have self-interest that may conflict with the owner’s (principle) goals and objectives and this is called the agency cost (Combs, Ketchen, Perryman, & Donahue, 2007; Jensen & Meckling, 1976; McIntyre, Murphy, & Mitchell, 2007; Wang & Hsu, 2013). In addition, there is another type of conflict, termed “Agency costs type 2”, which arises when the majority of shareholders hold the control and monitor the 14
  15. management on instead of the minority of shareholders (Perryman, & Donahue, 2007). Arguably, this could result in the major shareholders exercising their private benefit at the expense of the minority shareholders (Laeven & Levine, 2008). Therefore, corporate governance, represented in board of directors have a major role to play to minimise the shareholder-manager and majorityminority shareholders conflicts and to ensure corporations’ efficiency and continuity. According to the agency theory, better governance reduces agency costs and leads to better financial performance. Corporate governance is the combination of rules and principles that govern the corporation to ensure that it is successfully run. In addition, it ensures that they secure, monitor and control the firm operations (Abu-tapanjeh, 2009). There are four outcomes of good corporate performance on institutions overall performance derived by Claessens (2003). First, it helps to gain access to external finance because it draws a healthy picture that attracts investors to invest in well-governed companies. Second, good corporate performance lowers the cost of capital by minimising the risk of holding the company’s shares which then leads to shareholders’ acceptance of lower returns. Third, it leads to a better operational performance. Finally, it helps to protect the corporation from external financial distress (Grais & Pellegrini, 2006). 15
  16. Adopted from Abdelsalam et al . (2016) 16
  17. Figure 1 shows that Islamic banks have two directions regarding agency cost . The first direction represents higher agency cost because in Islamic banks depositors are contracted as Investment Account Holders (IAHs) through an equity-based investment contract due to the prohibition of interest (usury). In essence, managers are controlling the investment process with an absence of IAHs in the board of directors, which result in increase in agency cost and increases the risk of exploitation of IAHs by Islamic banks managers (Abdel Karim and Archer, 2002). Therefore, IAHs in Islamic banks are in great need to high quality financial reports to be able to indirectly monitor their investments. With respect to the other direction, according to (Leventis, S., et al, 2015) managers and the board of directors of Islamic banks have moral accountability constraints and an additional layer of governance represented by the Sharia Supervisory Board (SSB) (Beekun and Badawi, 2005; Belal et al., 2015). The extra governance and extended accountability are expected to reduce agency costs and to impact the Islamic banks financial reporting and performance in a positive manner. In this study, we argue that the corporate governance represented in board independence and separate board leadership (Chairman of the board is separate from CEO) would lead to better corporate financial performance as explained later in the hypotheses section. 3.2 Concealment Theory A common practice of impression management that is adopted by firms is to conceal bad news and emphasize good news in terms of the concealment theory (see figure 2 adopted from Cho et al., 2010). The concealment theory has a strong association with the agency theory as it is connected with the conflict between managers and shareholders’ interests when management disclose discretionary information to manipulate outsiders’ perceptions (Aerts, 2005). Based on the concealment theory, it is expected that the financial performance of banks will be reflected in the use of language and verbal tones (i.e. optimism & certainty as will be explained later) by management in their reports. 17
  18. Figure 2 : The Concealment Theory of impression management (Adopted from Cho et al., 2010 & Merkl-Davies and Brennan, 2007) 3.3 Research Hypotheses Based on the previous discussion of theories and prior literature, the study has raised five main hypotheses and their expectations. Comparison between Islamic and conventional banks: 1) Islamic banks financial performance is lower than their conventional counterparts (more risk averse and operate a constrained finance model) 2) Islamic banks narrative reporting is higher than their conventional counterparts (due to their extra layer of governance) From the above discussion of theory and prior literature, the following expectations are formed concerning the first two hypotheses: 18
  19. When compared with conventional banks , Islamic banks are expected to have  Higher capital adequacy (more conservative)  Lower credit risk / Higher asset quality (more conservative)  Lower efficiency (constrained business model)  Lower profitability (constrained business model)  Higher liquidity (more conservative)  Better narrative reporting (moral accountability constraints) The impact of corporate governance on the banks’ financial performance and narrative reporting (regardless of type): 3) Banks with better corporate governance (represented by board independence and board leadership) will demonstrate better financial performance 4) Banks with better corporate governance (represented by board independence and board leadership) will demonstrate better narrative reporting 5) Banks with better financial performance will demonstrate higher quality of narrative reporting From the above discussion of theory and prior literature, the following expectations are formed concerning the last three hypotheses: As better governance improves performance and financial reporting, banks with better governance are expected to have  Higher capital adequacy  Lowe credit risk / Higher asset quality  Higher efficiency  Higher profitability  Higher liquidity  Better narrative reporting 19
  20. Financial Performance & Narrative reporting It is expected that lower financial performance will lead to lower quality of narrative reporting represented in:  Higher optimism (Cho et al., 2010)  Lower certainty (Cho et al., 2010)  Shorter length (Merkl-Davies et al., 2011)  Fewer negative emotion words (Merkl-Davies et al., 2011)  More positive emotion words (Merkl-Davies et al., 2011)  Fewer self-references (Merkl-Davies et al., 2011)  Fewer references to others (Merkl-Davies et al., 2011)  Fewer words indicative of cognitive complexity (Merkl-Davies et al., 2011) 20
  21. Chapter Four : Methodology 4.1 Sample This study focuses on all listed banks in the six GCC countries. The financial ratios and corporate governance data (i.e. board of directors and ownership structure) were collected from DataStream and the banks’ annual reports. The sample of this study is restricted to the listed Islamic and Conventional banks located in the GCC region. The aforementioned criteria yielded 70 banks, out of which 28 are Islamic and 42 conventional banks. Due to non-availability of some variables, 17 observations, with the final number of banks being 69, translated into 333 observations. The following Table 2 summarizes the distribution of banks into the 6 GCC countries, as per specialization. Table 2 Geographical dispersion of sample into the 6 GCC countries Country Country Code Islamic Conventional Bahrain BH 6 5 Kuwait KW 7 5 Oman OM 1 5 Qatar QA 3 5 Saudi Arabia SA 4 8 United Arab Emirates AE 6 14 27 42 Total 4.2 Descriptive statistics 21
  22. This section presents the descriptive statistics of the sample , presenting the dependent variables, namely total assets (TA); total non-interest operating income (TOT_NI_INC) and net fees and commissions (NFEES). The rest of the table presents the five CAMEL ratios; capital adequacy ratio (CAR); impaired loans to gross loans (NPLtoGR); cost to income ratio (CStoIN); return on average equity (ROAE) and liquidity assets to total deposits and borrowing (LAtoTD). As shown in tables 3 and 4, the average size of Conventional banks (26 million US$) is nearly double the size of Islamic banks (13 million US$). The average ratio of independent non-executive directors in Islamic banks is 36% while the ratio was 23% in conventional peers. The average ratio of government ownership in Islamic banks is 19% as compared with 30% in conventional banks. Most of the other independent variable characteristics of the sample are not significantly different between both types of banks. The study investigates the financial performance of these banks using the CAMEL model ratios (capital adequacy, credit risk, and profitability, efficiency, and liquidity ratios). In addition, the language quality of these banks’ financial narrative reports are analysed using DICTION and LIWC software. The chairmen’s statements were extracted and imported to these software and the findings will be discussed later in this study. 22
  23. Table 3 Descriptive Statistics of Islamic Banks sample (CAMEL variables & Independent variables) 23
  24. Table 4 Descriptive Statistics of Conventional Banks sample (CAMEL variables & Independent variables) 24
  25. 4 .3 Dependent Variables This section discusses the two dependent variables, which are examined for both Islamic and conventional banks: 1) Financial performance (measured by CAMEL ratios). 2) The quality of narrative reporting in the chairman’s reports. 4.3.1 The CAMEL Ratios: The CAMEL model was widely used in prior literature and continues to be used by existing ones to analyse the performance of banks. In 1979, the US Federal Financial Institutions Examination Council (FFIEC) adopted the CAMEL rating system to be used by banking agencies (, 2016). It is not easy to evaluate the performance of the banking sector because it is complex and many factors need to be taken into consideration. Therefore, the CAMEL model is considered as one of the most comprehensive models because it is an effective internal supervisory tool and it analyses and assesses five factors; Capital Adequacy (C), Assets Quality (A), Management Efficiency (M), Earning Quality (M) and Liquidity (L). The evaluation of these factors measures the financial stability, the risk profile of the bank (, 2016). The CAMEL is a valuable tool that measures banks’ financial soundness. Additionally, it is internationally used and has standardised ratios which provide flexibility and thus it is a well-established model for measuring banks’ performance (Dang, 2011). Therefore, The CAMEL model will be used to measure the financial performance of the banks in this study. Table 5 lists the five CAMEL ratios, how they are measured and the expected result. 25
  26. Table 5 : CAMEL ratios Expected directions for both Conventional and Islamic banks Variable What it means How it is measured Expected result Capital - The ability of -Capital adequacy Islamic banks adequacy banks to sustain ratio expected to customers’ (CAR) keep more confidence and capital than avoid Conventional bankruptcy. banks (more conservative) Credit Risk - assessing /Asset quality banks - Non performing Islamic banks loans / gross loans expected to performance as screen their it serves as an customers indicator for carefully and banks hence hold less profitability credit risk Management - It is the ability -cost to income Islamic banks capability of management expected to (cost and Board of have more costs efficiency) directors of an than entity to identify, Conventional measure, banks due to monitor and their constraint control the risks business model that could face (extra screening their institution costs + SSB cost Earning -The profitability -Return on equity quality ratio also expected to be measures banks’ less profitable 26 Islamic banks
  27. ability to due to higher generate profit costs from assets and revenues Liquidity -Banks ’ ability to -Liquid assets/total Islamic banks pay its short term deposits expected to hold liabilities and to more liquidity be able to cover (more any troubles to conservative) its cash flow 4.3.2 CAMEL Graphs and descriptive statistics: This section presents a graphical representation of the five variables in our CAMEL model. In order to distinguish across sub-samples and years, the mean value of each variable is taken at a yearly basis per sub-group and create the following graphs. In all graphs Islamic banks are annotated with a blue line, whilst conventional banks are annotated with red. Capital adequacy [Tier 1 ratio] Capital adequacy is an important ratio that determines the ability of the bank to sustain customers’ confidence, avoid bankruptcy and to act as a buffer to meet expected losses. Moreover, it reflects the management’s abilities to meet any additional capital needs (Ravinder, 2012). Furthermore, it demonstrates a bank capital expressed as a percentage of its weighted risk exposures (Reserve Bank, 2007). It is expected that institutions should hold equivalent capital to compensate and absorb losses and to cope with extent of risks. (, 2016). In addition, small banks are forced by The Capital Adequacy Ratio is being assessed based upon the following ratio: Capital Adequacy Ratio (CAR) CAR = (Tier-I Capital + Tier-II Capital)/Risk Weighted Assets Or Capital to Risk-weighted Assets ratio and the ratio of capital to assets. 27
  28. Figure 3 shows the capital adequacy ratio of the sample of Islamic and the conventional banks for the years 2010-2014 . Figure 3 shows that Islamic Banks on average hold a higher CAR than Islamic banks. Figure (3) Capital Adequacy (CAR) 35 30 25 20 Islamic 15 Conventional 10 5 0 2010 2011 2012 2013 2014 The Capital Asset Ratio is confirming our expectations that Islamic bank managers’ risk aversion will drive them to keep a higher capital adequacy ratio as compared to conventional banks. Islamic banks, as organizations with strict religious adherence have constraints towards risk taking and they will follow a more conservative approach by keeping higher capital. Asset quality (Credit Risk) [Non Performing Loans to Gross Loans] The asset quality ratio is one of the fundamental ratios used in assessing banks’ performance as it serves as an indicator of a bank’s profitability (Dincer et al., 2011). The ratio represents the quantity of potential credit risk that is accompanying investment portfolios, loans, real estate, off-balance sheet items and other assets (, 2016). The loan portfolio is one of the most important asset categories in banks thus loan losses represent the greatest risk facing banks. According to Grier (2007) “poor asset quality is the major cause of most bank failures” (, 2016). 28
  29. Non-performing loans ratio refers to the loans that the borrowers are not paying interest or the principle amount back to the lender (Bank). It has to be the gross loan amount that is recorded on the balance sheet and not only the overdue amount (World Bank, 2016). When these loans become bad debt, most of banks set aside some amounts to cover these loans losses (Financial Times Lexicon, 2016). To evaluate the asset quality of banks, the nonperforming loans are divided by the total value of the loan portfolio (World Bank, 2016). The Non-performing Loans (NPLs) are widely used as the proxy of Asset Quality and credit risk. Loans are classified into 5 categories: standard, special mention, substandard, doubtful and loss. The NPLs are considered for the lowest three categories (, 2016). Although it is expected that Islamic Banks are careful in selecting their customers to avoid high credit risk as part of their risk averse behaviour, the descriptive statistics of the sample shows that Islamic banks had a higher ratio of non-performing loans to gross loans (See Figure 4) Figure (4) Asset Quality (NPLtoGR) 14 12 10 8 Islamic 6 Conventional 4 2 0 2010 2011 2012 2013 29 2014
  30. 4 .3.2.3 Management capability (Efficiency) [Cost / Income] The management capability is the third ratio in the CAMEL model and it assesses the cost efficiency of Banks. It is the ability of management and the board of directors of an entity to ensure the efficiency and soundness of the institution and in compliance with rules and regulations (, 2014). Although, managers are expected to be involved in lowering the risks, they need to establish policies and regulations to guide others when dealing with accepted risk exposure levels (, 2014). Islamic banks are expected to be less cost efficient due to their extra costs. The descriptive results show that, as expected, Islamic banks’ cost are higher than conventional banks which is expected as Islamic banks have to screen their activities to exclude prohibited activities so they have a higher screening cost. They also have a two Tier board (an additional Sharia Supervisory Board) which leads to additional costs. Moreover, as hypothesized, constraints imposed by the Islamic finance model will lead Islamic banks to incur higher costs (See Figure 5). Figure (5) Efficiency (CStoIN) 100 90 80 70 60 50 40 30 20 10 0 Islamic Conventional 2010 2011 2012 2013 30 2014
  31. 4 .2.3.4 Earnings [Return on Average Equity] The earning factor is used to measures the banks profitability in order to help in building public confidence and to provide rewards for shareholders as well as absorb loan losses (Grier, 2007). The profitability ratio also measures banks’ ability to generate profit from assets and revenues. In the study, we use the Return on Average Equity (ROAE) to assess the selected banks’ earning ability. The ratio is expressed with the formula (Net Interest income/ Shareholder’s equity growth rate). This variable is considered as an indicator for the historical profitability record for banks and the possibility for future failure. As a result of the higher costs of Islamic banks which was discussed in the previous in the Management capability (Cost to Income) section, the ROE ratio of Islamic banks is lower in average than conventional banks. The higher the cost the lower the profit; as expected, we find Islamic banks’ profit is lower than conventional banks as shown on ROAE form (2010-2014). Thus, our descriptive statistics confirm this hypothesis as well (See Figure 6). Figure (6) Earnings (ROAE) 16 14 12 10 8 6 4 2 0 -2 -4 -6 Islamic Conventional 2010 2011 2012 2013 31 2014
  32. 4 .2.3.5 Liquidity [liquid assets to total deposits] The liquidity ratio is an indicator of the banks’ ability to pay its short term liabilities and to be able to cover any troubles faced by its cash flow (Dincer et. al, 2011). The liquidity variable in our study in underlined by the ratio of Liquid assets to total deposits. It is hypothesized that Islamic banks are more liquid than Conventional banks. The descriptive statistics confirm the expectation, we find Islamic banks are keeping higher liquidity as a result of their more conservative approach and the constraints of their business model which lead to lower risk taking, so these banks keep higher ratio of liquid asset to total deposit (See Figure 7). The descriptive results are in line with Samad and Hassan (2000) who reported that Bank Islam Malaysia was more liquid than counterparts. Figure (7) Liquidity (LAtoTD) 30 25 20 Islamic 15 Conventional 10 5 0 2010 2011 2012 2013 2014 In summary, the descriptive statistics are in line with the expectations set out in table 5 for four CAMEL measures except the asset quality (credit risk ratio). The descriptive statistics reveal that on average, Islamic banks hold more capital, and more liquidity confirm their risk-averse attitude. The results show also that these banks are less efficient and less profitable as expected due to their constrained model of finance. 32
  33. 4 .4 Multivariate Analysis To test the hypotheses more rigorously, multivariate analysis is conducted. In this study the following model is tested:
  34. Table 8: Analysis of pooled sample CAMEL model 41
  35. 4 .4.3 Multivariate Analysis Results: Table 8 shows the pooled sample regression results for both Islamic banks and Conventional banks for the five CAMEL ratios, where each ratio is represented in one column. In addition to the bank type (main test variable), the model includes the board characteristics (i.e. CEO separate role dummy, number of board members, ratio of independent directors to the total number of board), types of ownership and ownership ratios (foreign & government), net fees, total assets, GDP growth, inflation and the corruption index of the country (taken from the world bank website) (See Table 7 for variables definition). Banks were classified as either Islamic bank with a dummy 1 or conventional as 0. The results in Table 8 show that there is no significant difference between Islamic and conventional banks in the GCC in terms of capital adequacy or asset quality. The results also show that, as hypothesised, Islamic banks have a significantly higher costs to income ratio at (P<0.10) and a significant lower profitability ratio. This confirm our hypotheses that Islamic banks’ constrained model of finance incur higher costs and hence less efficient, which leads to lower profitability also. Moreover, the results show significantly higher liquidity ratio than conventional banks. The results confirm the hypothesis that Islamic banks are more risk averse and hence kept more liquidity. The results also show that the Number of board members have an impact on raising the efficiency and profitability of the banks. Higher ratios of non-executive board members show a significant impact on both credit risk and profitability. Corporate ownership has a significant association with the higher ratio of nonperforming loans to gross loans in Islamic banks. In addition, the results show that larger banks have lower CAR ratios and lower efficiency. 42
  36. Table 9 Analysis of CAMEL within the Islamic banks subsample : -1 CAR -2 NPLtoGR -3 CStoIN -4 ROAE -5 LAtoTD Separate_Role_Dummy 6.4637 -1.63 -14.1861 (-1.53) 8.8225** -2.15 -3.1590* (-1.69) 5.4852 -0.69 No_of_BoD_Members -0.2432 (-0.42) -1.0228 (-0.99) -1.1321 (-0.80) -0.1663 (-0.35) 2.5632* -1.97 R_Independent 1.5285 -0.33 8.356 -1.59 government_ownership corporate_ownership 19.0805* -10.4778* -15.6452 -1.67 (-1.68) (-1.10) -5.2191 25.3286*** 10.3535 (-0.76) -3.76 -0.74 -15.5698 -38.1083* (-1.40) (-1.74) -11.7949** 16.4218** 49.9695** -12.4648 (-2.13) -2.31 -2.17 (-1.66) -21.2247 (-1.40) private_ownership -11.0483 (-1.14) 2.9721 -0.49 -3.1716 15.0492*** -10.7921 (-0.23) -2.79 (-0.68) Foreign 4.2739 -1.07 -5.639 (-0.87) 4.0484 -0.45 -7.8725* (-1.75) -15.0549 (-1.30) Ln_TA -5.3162* (-1.75) -1.3288 (-0.83) -5.9306 (-1.56) 2.0719** -2.13 -0.3748 (-0.07) NFEES 0 -0.52 0 -1.06 0 (-0.59) 0.0000* -1.71 -0.0001 (-1.34) INF 0.5035 -0.66 -1.6113 (-1.31) 0.9727 -0.9 -0.9113* (-1.91) -1.4583 (-0.92) GDP_RG 0.1635 -1.04 -0.402 (-1.30) 0.0874 -0.27 0.1466 -1.12 0.1001 -0.27 _cons 98.6807** -2.2 54.798 -1.1 111.6856* -1.93 -4.6619 (-0.34) 33.6391 -0.45 N R-sq pseudo R-sq 95 0.3617 94 0.5028 101 0.7605 102 0.6277 59 0.5315 t statistics in parentheses ="* p<0.10 ** p<0.05*** p<0.01" Table 9 shows that Islamic banks that have chairman and CEO separate role have a lower cost to income ratio. In addition, it shows that higher ratio of independent non-executive directors is associated with low costs to income ratio as well. This confirms that within the subsample of Islamic banks, board independence leads to better efficiency. However it does not positively affect 43
  37. the profitability , which could be related to the constrained model of finance in Islamic banks. Islamic banks that have governmental ownership shows lower liquidity ratios and this could be due to the banks dependence on bailout if they face problems. 44
  38. 4 .4.4 The Analysis of the Narrative reporting of GCC Banks Previous studies (e.g., Smith & Taffler, 2000; Sydserff & Weetman, 2002) reported that management tends to use certain languages and extensive disclosure to positively shape the perceptions of their stakeholders. Moreover, it has been noted that some corporations design their narrative reports to manipulate their stakeholders’ perceptions. The framework includes the use of positive tones to persuade narrative report readers in addition to the use of complex verbal tones obfuscate bad news. According to Merkl-Davies and Brennan (2007, p. 126) the attribution is defined as a ‘‘defensive framing tactic that shifts the blame for negative outcomes away from themselves”. On the other hand, the positive and good performance is attributed to internal management. In other words, according to the framework, management is advised to refer to the good performance as an internal success and to blame external factors for any defects. Narrative Reporting and Performance signalling It was found, in previous reserearch, that the reports use the complex technical accounting terms to obfuscate the negative performance whilst the good performance was introduced using straight forward cause-effect words. It was reported by Nelson and Pritchard (2008) that when disclosing high risk information management tends to use cautionary (less certain) language to reduce the expected cost of that risk. Prior literature (i.e. Cho et al., 2010) has investigated whether or not the environmental performance of companies is associated with optimism and certainty. They found compelling evidence that US companies’ use verbal tones and language to manage their stakeholders’ impressions. DICTION software has been used to test two hypotheses. In particular, they found that companies with worse environmental performance provide language tone in their narrative reports that is more optimistic and less certain. 45
  39. Table 10 : Results of Impression Management Analysis for Islamic banks and Conventional banks in the GCC (Using DICTION): -1 -2 -3 Self_presentational_dissimulatio Optimism_DICTION Certainty_DICTION IB 0.2425 -0.58 -1.1902** (-2.34) 0.1198 -0.24 ROAE 0.0063 -0.29 0.0001 0 -0.0172 (-0.81) NFEES -0.0000* (-1.80) 0 -1.5 0 -0.67 Separate_Role_Dummy -0.3918 (-0.66) 0.3716 -0.48 -1.7262** (-2.35) No_of_BoD_Members -0.1069 (-0.92) -0.161 (-1.06) 0.1161 -0.66 R_Independent 2.5385** -2.19 -0.0408 (-0.03) -1.294 (-0.96) government_ownership 2.7028*** -2.63 -1.8123 (-1.43) -0.5055 (-0.48) corporate_ownership 1.5116 -1.17 -2.6298* (-1.97) -0.7022 (-0.51) private_ownership 0.6264 -0.66 -2.3104* (-1.75) -1.1087 (-0.87) Foreign 1.275 -1.05 2.5707** -2.53 1.1862 -1.06 Ln_TA 0.5012 -1.53 -0.1755 (-0.47) -0.0543 (-0.14) INF -0.0331 (-0.31) -0.0739 (-0.54) 0.1077 -0.61 GDP_RG 0.0825*** -2.65 0.0409 -1.17 -0.0856*** (-2.83) _cons -8.6600* (-1.76) 59.2771*** -10.35 48.9130*** -9.02 N R-sq pseudo R-sq 182 0.2562 182 0.236 182 0.1723 ** p<0.05 *** p<0.01" t statistics in parentheses ="* p<0.10 46
  40. As shown in Table 10 , after controlling for profit and net fees, the results show that conventional banks are significantly higher than Islamic banks in Optimism. It indicates that they tend to use positive words to impress their shareholders more often than Islamic banks. 4.4.5 Narrative reporting Data Analysis (Using DICTION software): After using DICTION software to calculate the “Optimism” and “Certainty” for the data of Islamic banks and Conventional banks, the mean of each type of banks was calculated and showed in the following Table 11 and graph 8. Table 11: Optimism and Certainty in Islamic and Conventional banks IBs (Mean) StD Median Optimism Certainty 54.50 48.68 2.62 1.98 54.8 48.92 CBs (Mean) StD Median Optimism Certainty 56.02 48.04 2.45 2.69 55.88 48.25 47
  41. Graph (8) As shown form Graph 8 and Table 11, Islamic banks is using less optimistic words as compared to conventional banks in their narrative reporting languages represented in Chairmen’s statements to shareholders. In terms of certainty, there is no significant difference. 4.4.6 Impression management analysis for Islamic banks and Conventional banks (Using LIWC software): In this study the term “Self-presentational dissimulation” is adopted from Merkl-Davies et al. (2011). This term entails “the managerial construction of public images of managerial actions and events that are inconsistent with the way management may view these actions and events” (p. 319). In other words, self-presentational dissimulation describes the case when the management’s image of the bank’s organizational outcome is different than the one held by the public. It stands for an inaccurate public view of the bank’s organisational performance (See Table 12). 48
  42. Table 12 : Linguistic Indicators of Self-presentational dissimulation in chairmen’s statements Linguistic indicator Examples Data source Word count – LIWC Extreme negative words Extreme positive dictionary in text Custom Percentage of total word count dictionary in text Custom Percentage of total word count dictionary in text Custom Percentage of total word count shareholders dictionary in text Wrong, useless, weak, LIWC Emphatically, marvelous, Self-reference I, we, us, our, ourselves Positive emotions They, Confidence, government, agreement, beneficial LIWC Tentative Maybe, perhaps, guess LIWC Certainty Certain, definitely, proof LIWC Cause, know, ought LIWC Markers of cognitive complexity count in text Percentage of total word count outstanding Negative emotions Natural logarithm of total word Custom Awful, fatal, calamitous words Reference to others Measurement Percentage of total word count in text Percentage of total word count in text Percentage of total word count in text Percentage of total word count in text Percentage of total word count in text Note: The Linguistic Inquiry and Word Count software (LIWC 2007) has been employed in this study 49
  43. Following prior literature (Mohammed and Timothy, 2008; Merkl-Davies et al., 2011), the chairmen’s statements will be characterized by self-presentational dissimulation (i.e. low level of veracity) if it shows the following linguistic characteristics: 1. Fewer negative emotion words; 2. More positive emotion words; 3. Fewer self-references; 4. Fewer references to others; 5. Fewer words indicative of cognitive complexity and 6. Shorter length The six dimensions have been calculated from LIWC4 software. The measures for each linguistic indicator are standardized; in other words, they are converted to Z-scores. More specifically, these scores are estimated by subtracting the sample mean from each value and then dividing by the standard deviation. Therefore, the following formula has been employed in the study: Self-presentational dissimulation = zNegative emotions -zPositive emotions zSelf-reference – zReference to others + - zComplex - zWC Results are shown in Table 13. 4 The Linguistic Inquiry and Word Count software (LIWC 2007) has been employed in this study. 50
  44. Table 13 summarizes the linguistic indicators of Self-Presentational dissimulation , providing examples, data sources and measurement for (Islamic banks). 51
  45. Table 14 summarizes the linguistic indicators of Self-Presentational dissimulation , providing examples, data sources and measurement for (Conventional banks). The results shown in Table 13 and 14 and Graph 9 indicate that when comparing both banks self-presentational dissimulation scores, the above tables show that Islamic banks Median is (-0.18) as compared to (0.165) for Conventional banks which indicates that Islamic banks are not using impression management. However, both banks are almost using the same negative, positive and complex words in their financial reports. 52
  46. Graph 9 : Self-Presentational dissimulations between Islamic banks and Conventional banks (Using LIWC). The Graph 9 shows obviously that conventional banks self-presentational gradually increasing over time. Conversely, Islamic banks self-presentational line is showing a steady decline in recent years, which indicate that Islamic banks are not using impression management. 53
  47. Chapter Five : Concluding remarks This study compared the financial performance and narrative reporting of both Islamic and listed banks in the GCC. Islamic banks are significantly different from conventional banks in their business model where banks are expected to serve wider range of stakeholders given their religious adherence. In addition, Islamic banks operate a constrained finance model due to their organisational religiosity. Using 333 bank year obserbations, it was found that these constraints incur Islamic banks additional costs and hence make them less efficient and less profitable than conventional banks. On the other hand, Islamic banks show high levels of risk averse as indicated by the significantly higher liquidity. Although the descriptive statistics showed Islamic banks having higher capital adequacy than conventional banks, which was interpreted by their risk averse, the multivariate regression analysis showed no significant difference in that aspect between the two types of banks in the GCC countries. Corporate governance of banks has shown significant positive impact on bank performance especially the board of directors’ independence represented by the ratio of independent non-executive directors and separate role for both the chairman and the CEO. In particular it was found that in the subsample of Islamic banks board independence is positively associated with higher cost efficiency. It is recommended that these banks should hire higher more independent boards. Narrative reporting quality was assessed using two softwares (Diction and LIWC). They have shown that organisational religiosity has been found to have a significant effect on the quality of narrative reporting. In particular, it was found that the median of impression management variable (self-presentational dissimulation) and optimism variables are lower for Islamic banks than conventional banks. This support our hypothesis that Islamic banks organisational religiosity and double layer governance serve as a deterrent again financial reporting manipulation. This study is of great importance to regulators and investors as well as other stakeholders in the global banking industry. 54 Cultural factors such as
  48. organisational religiosity are proving to be important factors for researchers in the international finance industry . Word counts excluding References = (9,390) Total number of words = (11292) 55
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