Research in International Business and Finance 33 (2015) 75–98

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Research in International Business

and Finance
j o ur na l ho me pa ge : w w w . e l s e v i e r . c o m / l o c a t e / r i b a f

Islamic versus conventional banks in the GCC

countries: A comparative study using
classification techniques
Karim Ben Khediri a,b,c,1, Lanouar Charfeddine d,e,f,∗,
Slah Ben Youssef g
a
CEROS, Université Paris Ouest Nanterre La Défense, France
b
College of Administrative Sciences, Najran University, KSA
c
FSEGN, Université de Carthage, Tunisia
d
Department of Finance and Economics, College of Business and Economics, P.O. Box 2713, Doha, Qatar
e
Institut de préparationà l’administration et à la gestion, 184 Boulevard Saint-Germain, 75006 Paris,
France
f
Institut Supérieur de Gestion de Gabès (ISGG), University of Gabès, Tunisia
g
Faculté des Sciences Economiques et de Gestion de Sfax, route Aéroport km 4, BP N◦ 1088, 3018 Sfax,
Tunisie

a r t i c l e i n f o a b s t r a c t

Article history: This paper contributes to the empirical literature on Islamic

Received 10 December 2013 finance by investigating the feature of Islamic and conventional
Received in revised form 13 May 2014 banks in Gulf Cooperation Council (GCC) countries over the period
Accepted 23 July 2014
2003–2010. We use parametric and non-parametric classification
Available online 1 August 2014
models (Linear discriminant analysis, Logistic regression, Tree of
classification and Neural network) to examine whether financial
JEL classification:
ratios can be used to distinguish between Islamic and conven-
C44
tional banks. Univariate results show that Islamic banks are, on
C45
C25 average, more profitable, more liquid, better capitalized, and have
G21 lower credit risk than conventional banks. We also find that Islamic
G28 banks are, on average, less involved in off-balance sheet activities
and have more operating leverage than their conventional peers.
Keywords:
Results from classification models show that the two types of banks
Islamic finance
may be differentiated in terms of credit and insolvency risk, oper-
GCC banking
Classification techniques ating leverage and off-balance sheet activities, but not in terms

∗ Corresponding author. Tel.: +216 22998570.

E-mail addresses: [email protected] (K.B. Khediri), lanouar [email protected] (L. Charfeddine),
benyoussef [email protected] (S.B. Youssef).
1
Tel.: +966 538384133.

http://dx.doi.org/10.1016/j.ribaf.2014.07.002
0275-5319/© 2014 Elsevier B.V. All rights reserved.
76 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98

of profitability and liquidity. More interestingly, we find that the

recent global financial crisis has a negative impact on the profit-
ability for both Islamic and conventional banks, but time shifted.
Finally, results show that Logit regression obtained slightly higher
classification accuracies than other models.
© 2014 Elsevier B.V. All rights reserved.

1. Introduction

In recent years, many conventional banks have encountered financial difficulties and failure due to
the global financial crisis of 2007–2008. In contrast, Islamic banks have successfully withstood this cri-
sis. In empirical literature, most studies have attributed this success of Islamic banks to their financial
regulation guided by Shariah principles which prohibits the payment or receipt of interest (riba) and
encourage risk sharing (see for instance Willison, 2009; Hasan and Dridi, 2010). As a consequence, the
attention of academics, policy makers and investors on Islamic banking has been largely increased in
the last few years. Actually, there are more than 300 Islamic financial institutions worldwide including
banks, mutual funds and insurance firms. In addition, most Western international banks such as Citi-
group, HSBC and others have opened Islamic windows. Several factors can explain this rapid growth
of interest-free finance, including strong demand for Sharia-compliant products, improvement in the
legal and regulatory framework for Islamic finance, growing demand from conventional investors for
diversification purposes, and the capacity of the industry to innovate and develop a number of financial
instruments that meet the needs of investors (Hasan and Dridi, 2010).
In theory, there are many differences between Islamic and conventional banks. For instance,
interest-bearing contracts in conventional banks are replaced in Islamic bank by return-bearing con-
tracts, where the profits and losses as well as risks are shared between the creditor and the borrower.
Moreover, Islamic banks collect funds through demand deposits (guaranteed and yield no return) and
investment deposits (similar to mutual fund shares and not guaranteed a fixed return). Islamic banks
have developed free financing products based on profit and loss sharing (PLS) and markup principles.
However, since all banks operate in the same competitive environment and are regulated in the same
way in most countries, it is possible that Islamic and conventional banks have similar behavior and
hence adopt similar strategies. In fact, several studies show that Islamic banks are not very different
from conventional banks in the adoption of PLS principle. Siddiqui (2006) argues that Islamic banks
are relying more on markup financing contracts rather than PLS based financing contracts. Chong
and Liu (2009) and Khan (2010) find that only a small portion of Islamic banks financing is based on
PLS and that Islamic deposits are not interest-free. Bourkhis and Nabi (2013) point out that in most
Islamic banks, less than 20% of total assets are dedicated to long term and risk sharing investments.
They observe that Islamic banks are mimicking the commercial strategies of their conventional peers
and diverging from their theoretical business model.
In parallel to the increased interest in Islamic finance, the literature on Islamic banking has been
growing rapidly. The main sizeable body of research has explained the general Islamic principles and
the instruments used in Islamic banking (Bashir, 1983; Khan, 1985; Sundararajan and Errico, 2002;
Siddiqui, 2006). Recent studies have discussed the management, regulatory and supervisory challenges
related to Islamic banking (Murjan and Ruza, 2002; Sole, 2007; Jobst and Andreas, 2007), the efficiency
of Islamic banks using frontier analysis approaches such as Data Envelopment Analysis and Stochastic
Frontier Analysis (Abdull-Majid et al., 2010; Srairi, 2010; Belanes and Hassiki, 2012), the characteristics
and profitability of Islamic Banks (Karim and Ali, 1989; Srairi, 2008; Ben Khediri and Ben-Khedhiri,
2009; Abedifar et al., 2013; Beck et al., 2013), and whether it is possible to distinguish between Islamic
and conventional Banks (Metwally, 1997; Iqbal, 2001; Olson and Zoubi, 2008). Another strand of
literature has studied the soundness, resilience and financial stability of Islamic banks during the
global financial crisis (Cihak and Hesse, 2010; Hasan and Dridi, 2010; Beck et al., 2013; Caby and
Boumediene, 2013; Bourkhis and Nabi, 2013).
 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98 77

The rapid increase of interest on Islamic banking and their resistance to the global financial crisis
make it important to examine whether Islamic and Conventional Banks behave similarly or differently
before, during and after the crisis period. Specifically, we test whether financial ratios can be used to
discriminate between the two types of banks. This paper adds to the empirical literature on Islamic
finance in several ways. First, the current paper focuses on the GCC countries (Bahrain, Kuwait, Qatar,
Saudi Arabia, and the United Arab Emirates). This region is worth studying for several reasons: the GCC
region has one of the world’s largest Islamic banking markets2 ; and the financial sector in the GCC is
relatively developed compared to other countries in the Middle East.3 Second, in contrast to previous
studies on Islamic finance, using only a descriptive analysis to compare Islamic and conventional banks,
we employ more sophisticated and performing quantitative techniques such as the linear discriminant
analysis, Logistic regression, neural network and tree of classification models. Finally, our sample
period allows us to examine the consequence effects of the global financial crisis of 2007–2008 to
both Islamic and conventional banks in term of profitability, liquidity and risk ratios.
We perform a comparison between the two types of banks, using the t-test of equality of means,
and some classification techniques. We find that Islamic banks are, on average, more profitable and
better capitalized than conventional banks. Results also show that Islamic banks have higher liquidity
and lower credit risk compared to their conventional peers. Interestingly, asset structure of Islamic
banks is significantly different from that of conventional banks. Islamic banks have higher operating
leverage and are less involved in off-balance sheet activities. More interestingly, we find that the
financial crisis has a negative impact on the profitability for both Islamic and conventional banks, but
time shifted. Finally, results from classification models show that some financial ratios can be used to
discriminate between Islamic and conventional banks.
The remaining of the paper is organized as follows: Section 2 presents the main features of Islamic
banks. Section 3 presents the literature review and the proposed hypotheses. Section 4 presents data
and univariate analysis. Section 5 reports results of parametric and non-parametric classification
models. Finally, Section 6 concludes.

2. Islamic banking features

In the last thirty years, the interest in Islamic banking has been growing rapidly in both Muslim
and non-Muslim countries. In some countries, Sudan, Iran, and Pakistan, the entire banking system is
currently based on Islamic finance principles. In other countries Islamic banks operate side-by-side
with conventional banks. Currently, all Islamic banks are concentrated in the Middle East and Southeast
Asia. Recently, large international banks in Europe and the United States have introduced Islamic
offices that offer separate Islamic or Sharia-compliant products within an otherwise conventional
banking structure.
There are five principles of Islamic finance. These principles are determined by the Sharia or Islamic
law which provides guidelines and legal framework for all aspects of life. (1) The profit and loss
sharing (PLS) principle is one of the most important features of Islamic finance. The provider of capital
funds (lenders) and the entrepreneur (borrowers) share business risk in return of sharing profits
and losses. This PLS principle contradicts those of conventional finance where the rate of return of
financial assets is fixed before transaction. (2) The principle that all transactions have to be backed by
a real economic transaction that involves a tangible asset. (3) The prohibition of riba (usury, which is
generally defined as interest or excessive interest) is the most prominent features of Islamic finance.
The Sharia interprets riba as a premium that must be paid by the borrower to the lender along with
the principal amount as a condition for the loan or for an extension in its maturity. (4) The prohibition

2
Islamic banks constitute an important source of financial intermediation, controlling on average 24% of the region’s banking
system assets (Al-Hassan et al., 2010).
3
The last 30 years have been characterized by a significant structural change in the GCC financial system by implementing
several policies that stimulate financial liberalization and financial restructuring in order to make the banking sector more
competitive (Maghyereh and Awartani, 2012). Furthermore, banks in the GCC region have been subject to extensive reforms,
such as the removal of interest rate controls, the strengthening of banking regulations and supervision, and the compliance
with Basel Accords for capital adequacy (Maghyereh and Awartani, 2014).
78 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98

of gharar (excessive uncertainty) and maysar (excessive risk or gambling).4 (5) The prohibition on
financing for illicit sectors. Islamic finance prohibits some business activities that are not in compliance
with Islamic law. These prohibited business activities can relate to food (production and sales of
alcoholic beverages, pork products, tobacco), gambling (casinos, on-line gambling, lottery schemes),
entertainment (video, magazines, on-line material, strip clubs), immoral and illicit trades (prostitution,
drugs).
There are a large number of different products in Islamic financing. Some of them are based on PLS
such as mudharaba (trustee finance or profit sharing) and musharaka (equity participation or joint
venture) and some other financial instruments are based on mark-up such as murabaha (cost-plus
financing), ijara (leasing), and istisnaa (commissioned manufacture).
In order to ensure that products and business operations comply with Sharia principles in all
aspects, Islamic bank is required to establish a Sharia Committee. The members of this Committee
shall have the necessary qualification and knowledge on Islamic jurisprudence (Usul al-Fiqh) and/or
Islamic transaction law (Fiqh al-Mu’amalat). Good reputed and accepted personalities are also required
to be appointed to this position.

3. Literature review and hypothesis

3.1. Literature review

In banking literature, researchers have focused on the determinants of bank performance in terms of
profitability and efficiency. The majority of studies examine the internal and external factors that affect
the performance of Islamic and conventional banks using financial ratios and frontier approaches. So
far, few studies have compared between Islamic and conventional banks. In this paper, we focus, in
particular, on studies which cover the banking sector in a panel of countries, including some countries
from the GCC region. Metwally (1997) examines the differences between the financial characteristics
of 15 interest-free banks and 15 conventional banks over the period 1992–1994. He finds that the
two groups of banks may be differentiated in terms of liquidity, leverage and credit risk, but not in
terms of profitability and efficiency. Using data from 24 banks including 12 Islamic banks for the
period 1990–1998, Iqbal (2001) find that Islamic banks are better capitalized and more profitable
than conventional banks. Olson and Zoubi (2008) examine whether financial ratios can be used to
distinguish between conventional and Islamic banks in the GCC region over the period 2000–2005.
They find that non-linear techniques are able to correctly distinguish between the two categories
of banks at about a 92% success rate. Moreover, their results indicate that Islamic banks are more
profitable but less efficient than conventional banks. Recently, Beck et al. (2013) examine the difference
between conventional and Islamic banks on a sample of 510 banks across 22 countries over the period
1995–2009. They find few significant differences in business models. However, they find that Islamic
banks are less efficient, but have higher intermediation ratios, have higher asset quality, and are better
capitalized than conventional banks. They also find that Islamic banks perform better during crises in
terms of capitalization and asset quality and are less likely to disintermediate than conventional banks.
In another recent study, Abedifar et al. (2013) investigates risk and stability features of Islamic banking
using a sample of 553 banks from 24 countries between 1999 and 2009. They find that Islamic banks
are, on average, more capitalized and profitable than conventional banks. They also find that small
Islamic banks that are leveraged or based in countries with predominantly Muslim populations have

4
Islamic law forbidden also gharar and maysar. Many Hadiths of the prophet (pbuh) explicitly prohibited gharar sales. For
example, the sale of fish in the sea, birds in the sky, an unborn calf in its mother’s womb, un-ripened fruits on the tree, etc., are
forbidden in Islam. An important example of gharar is insurance contract. The interdiction of that’s types of contract follows
from the non respectability of the PLS because only the insurance company acquire all the profits when claim is not made. The
principal reason behind this interdiction is that gharar is a synonym of “risk” or “uncertainly”. Moreover, this ban on gharar
is considered as the complete disclosure of information. Its interdiction is also viewed as an elimination of any asymmetrical
information in a contract. In the other hand, the prohibition of maysar is explicitly prohibited in Quaran Sura 2:119, and 5:90.
The term often used in Islamic law is qimar. The maysar is defined as all activities involving betting for money or property or
undue speculation.
 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98 79

lower credit risk than conventional banks. In terms of insolvency risk, small Islamic banks also appear
more stable. Another strand of literature compares between conventional and Islamic banks using
the frontier analysis approach. Srairi (2010) uses a stochastic frontier approach to investigate the cost
and profit efficiency levels of 71 commercial banks in GCC countries over the period 1999–2007. He
finds that in terms of both cost and profit efficiency levels, the conventional banks are more efficient
than Islamic banks. Abdull-Majid et al. (2010) investigate the efficiency of a sample of Islamic and
conventional banks in 10 countries for the period 1996–2002, using an output distance function, and
find that Islamic banks have moderately higher return to scale than conventional banks. Belanes and
Hassiki (2012) examine the efficiency of 32 Islamic and conventional banks from the MENA countries
over the period 2006–2009 and find no significant difference in the efficiency scores between these
two types of banks using Data Envelopment Analysis (DEA) method. All these studies cited above
and their results are presented in Table 1. It should be noted that the use of different methodologies,
measures, sample and period in these studies may explain some of their contradictory results.

3.2. Hypothesis

Our study investigates the differences between Islamic and conventional banks in terms of financial
characteristics. Our first hypothesis is about bank profitability. Hassoune (2002) shows that Islamic
banks are more profitable than their conventional peers. He explains the outperformance of Islamic
banks by the fact that they rely, for their funding, on high amounts of non-profit bearing deposits,
or non-remunerated current accounts. He considers these lower costs of funding as a market imper-
fection, which constitutes a “free lunch” for Islamic banks. Hence, given the larger equity base and
current account deposits,5 Islamic banks interest bearing liabilities to liabilities are generally lower
than conventional banks. Thus, Islamic banks are able to operate with strong net interest margin in
a high interest rate environment because of their funding advantage, and so are more likely to be
more profitable. Abedifar et al. (2013) point out that the PLS arrangement provides pro-cyclical pro-
tection to banks in the event of adverse conditions. They also argue that the religious depositors may
be more loyal and prepared to take lower returns, refusing from withdrawing deposits even if the
performance of the bank deteriorates. Therefore, the Islamic bank’s profitability is less volatile than
that of the conventional one. Moreover, Abedifar et al. (2013) argue that the religiosity can also influ-
ence the bank’s performance by encouraging borrowers to fulfill their obligations under Islamic loan
contracts. Indeed, clients with religious beliefs are more likely to prefer Islamic to conventional bank-
ing and to be prepared to pay rents for receiving financial services compatible with their religious
beliefs (Abedifar et al., 2013). That is, Islamic banks may exploit the religiosity of their clients and
charge higher rates to borrowers and give lower rates to depositors. The extra rent is considered as
the price of offering Sharia-compliant products and services. Another strand of literature shows that
banks with higher equity to assets ratio will normally have lower needs of external funding. Further,
banks with higher capital ratio have reduced cost of funding since they have lower insolvency risk.
Indeed, an increase in equity can lower moral hazard problems and increase the monitoring incentives
of banks (Diamond, 1984), and also can increase the banks’ risk-taking capacity (Abedifar et al., 2013).
A positive relationship between profitability and bank capital has been reported in previous empir-
ical studies (for instance, Hassan and Bashir, 2003; Lin et al., 2005; Pasiouras and Kosmidou, 2007;
Ben Khediri and Ben-Khedhiri, 2009). Hence, given that Islamic banks employ more capital than their
conventional peers in funding their assets, we expect higher profitability for the former. Therefore,
bank profitability is more likely to be higher for Islamic banks. We use the return on assets (ROA) and
the return on equity (ROE) as proxies for bank profitability. These two proxies are widely used in the
empirical banking literature (for instance, Iqbal, 2001; Olson and Zoubi, 2008; Abedifar et al., 2013;
Beck et al., 2013; Bourkhis and Nabi, 2013). The main empirical results of previous studies showed
that Islamic banks are more profitable than conventional banks (for instance, Olson and Zoubi, 2008;

5
Islamic banks receive deposits mainly in the following two forms current accounts that bear no interest but are obliged to
pay principal to holders on demand, and investment (or savings) accounts that generate a return based on profit rates. Deposits
are received by Islamic banks in the form of “Qard Al-Hasan” or “Amanaa”.
 80
Table 1
Existing literature.
Authors Sample Methodology Variables Main results
Metwally (1997) 15 Isl. banks Logit model Liquidity: cash to deposits The two groups of banks may be differentiated in
15 conv. banks Probit model Leverage: deposits to assets; equity to assets terms of liquidity, leverage and credit risk, but not
1992–1994 Descriminant Credit risk: funds channeled to direct investments to loanable funds; loans in terms of profitability and efficiency
analysis used to finance durable to total loans; personal loans to total loans
Profitability: gross income to assets; average return on deposits

K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98
Efficiency ratios: operating expenses to assets
Iqbal (2001) 12 conv. banks T-test for Profitability: return on asset (ROA); return on equity (ROE) Islamic banks are better capitalized and more
12 Isl. banks equality of Bank capital: capital to assets profitable than conventional banks
1990–1998 means Liquidity: cash and accounts with banks to total deposits
Deployment ratio: total investment to total equity and total deposits
Efficiency: cost to income ratio
Olson and Zoubi 28 conv. banks T-test for Profitability: ROA; ROE; profit margin; return on deposits; return on Accounting ratios are good discriminators between
(2008) 16 Isl. banks GCC equality of shareholders’ capital; net operating margin Islamic and conventional banks. Islamic banks are
region means Efficiency: interest income to expenses; operating expense to asset; operating more profitable but less efficient than conventional
2000–2005 Logistic income to assets; operating expenses to revenue; asset turnover; net interest banks
regression margin; net-non interest margin
Neural networks Asset quality: provision to earning assets; adequacy of provisions for loans;
k-means nearest write off ratio; loan to assets; loans to deposits
neighbors Liquidity: cash to assets; cash to deposits
Risk: deposits to assets; equity multiplier; equity to deposits; total liabilities
to equity; total liabilities to shareholder capital; retained earnings to assets
Srairi (2010) 48 conv. banks stochastic Profitability: net profit to average total assets Conventional banks are more efficient than Islamic
23 Isl. banks GCC frontier analysis Capital adequacy: equity to total assets banks
region T-test for Credit risk: loans to total assets
1999–2007 equality of Operation cost: cost to income
means Size: natural logarithm of total assets
Belanes and Hassiki 19 conv. banks Data Profitability: ROA; ROE; net Interest margin There is no significant difference in the efficiency
(2012) 13 Isl. banks MENA envelopment Liquidity: short-term assets to short-term loans scores between these two types of banks
region analysis Risk: total debts to assets; reserves for losses on credits to total credits
2006–2009 Wilcoxon
rank-sum test
Beck et al. (2013) Sample of 510 banks T-test for Business model: Fee income to operational income; nondeposit funding to There are few significant differences in business
across 22 countries equality of total funding; loans to deposit models. Islamic banks are less efficient, but have
1995–2009 means, Efficiency: cost to income ratio; overheads to assets higher intermediation ratios, have higher asset
regression Asset quality: loss reserves to gross loans; loan loss provisions to gross loans; quality, and are better capitalized than
nonperforming loans to gross loans; conventional banks
Stability: z-score; ROA; equity to assets; liquid assets to deposit
Abedifar et al. (2013) 553 banks from 24 T-test for Credit risk: loan loss reserves to gross loans; impaired loans to gross loans; Islamic banks are more capitalized and profitable
countries equality of loan loss provision to average gross loans than conventional banks. Islamic banks have lower
1999–2009 means, random Insolvency risk: z-score credit risk than conventional banks, specifically
effect regression Bank interest rate: net interest margin; interest income rate; interest expense small, leveraged, or those operating in countries
rate; loan rate; deposit rate with more than 90% Muslim populations. In terms
Financial ratio: equity capital to asset ratio; ROA; ROE; net loans to total of insolvency risk small Islamic banks are more
earning assets; cost to income ratio; total assets stable than small conventional banks
 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98 81

Abedifar et al., 2013; Beck et al., 2013; Bourkhis and Nabi, 2013). Hence, we formulate our hypothesis
as follows:
H1. Islamic banks are more profitable than conventional banks.
Our second hypothesis is about liquidity. In general, banks face liquidity problem due to excess
withdrawal from current and savings accounts and bank run. If withdrawals significantly exceed new
deposits over a short period, then banks get into liquidity trouble. Cash ratios measure the bank’s
ability to meet its short-term obligations. Thus, higher liquidity ratios are generally associated with
less risk. Islamic bank does not have enough investment opportunities since it is allowed to invest only
in Sahria approved projects. Islamic banks also have restricted access to the inter-bank market and
the central bank (as lender-of-last resort), which challenges liquidity management. Therefore, Islamic
banks are likely to maintain high capital buffers to mitigate liquidity risk. Moreover, Hasan and Dridi
(2010) explain this higher liquidity buffers by the fact that managing liquidity is more challenging in
Islamic banks, given the limited capacity of many Islamic banks to attract profit sharing investment
accounts since the return on these accounts is uncertain. Previous empirical studies showed that
Islamic banks maintain higher level of liquidity ratios compared to conventional banks (for instance,
Metwally, 1997; Olson and Zoubi, 2008; Bourkhis and Nabi, 2013). We measure liquidity by the cash
to assets ratio, and the cash to deposits ratio. These two proxies are widely used in the empirical
banking literature (for instance, Iqbal, 2001; Metwally, 1997; Olson and Zoubi, 2008; Beck et al., 2013;
Bourkhis and Nabi, 2013). Higher ratios denote higher liquidity. Hence, we formulate our hypothesis
as follows:
H2. Islamic banks hold higher liquidity than conventional banks.
Our third hypothesis is about credit and insolvency risks. Credit risk is the possibility that a borrower
or counter party will fail to meet its obligations for repayment in accordance with the conditions
stipulated in the contract. A failure to repay leads to a loss for the creditor and therefore becomes a
risk for the bank. Moreover a bank is considered insolvent if its total assets value is lower than its
liabilities. The assumption that Islamic banking involves lower credit risk than conventional banking
could be attributable to contractual arrangements (Olson and Zoubi, 2008; Baele et al., 2012; Beck
et al., 2013). Indeed, the PLS mechanisms allow Islamic banks to maintain their net worth and avoid
the deterioration of their balance sheets under difficult economic situations. Given that neither the
principal nor the return of the investment deposits is guaranteed, any loss which occurs on the asset
side could be totally absorbed on the liability side. Thus, the PLS allows Islamic banks to transfer the
credit risk from its asset side to its liability side (the investment deposits). Consequently, if the value of
the assets decreases, the value of the liabilities should decrease respectively. Olson and Zoubi (2008)
also point out that the default risk of not paying a return to depositors is eliminated under the PLS
principles. This suggests that Islamic banks may have a greater capacity to bear losses compared to
conventional banks (Abedifar et al., 2013). Further, The PLS principle promotes equity participation
which in turn encourages due diligence in managing investment and active monitoring. The other types
of Islamic financial modes based on mark-up (e.g. Murabaha, Ijaras, and Istisnaa) require investors to
engage in the real economy and hence that a real asset underlies the financial transaction. This feature
allows the Islamic banks to have a clearer view on the allocation of its funds and to reduce their
exposure to speculative behavior. Furthermore, Islamic banks may have lower credit risk compared
to conventional banks due to the religiosity of clients that enhances loyalty and mitigates default
and/or due to their special relationship with their depositors (Abedifar et al., 2013). Siddiqui (2006)
explains the reduced credit risk by the fact that these Islamic contracts which are based on equity
participation minimize the adverse selection and moral hazard problems. Indeed, Islamic finance
requires symmetry of information and transparency in transactions since Islam prohibits excessive
uncertainty (gharar). Further, gambling (maysir) is banned, meaning that excessive risk taking is not
permitted. The tangibility of assets reduces the problem of assets substitution by engaging in other
activities with a higher risk. Respect of these principles should decrease the moral hazard problems.
Therefore, the risk level should be lower for Islamic banks than for their conventional peers. Cihak
and Hesse (2010) argue that the more difficult access to liquidity put pressures on Islamic banks to be
more conservative (resulting in less moral hazard and risk taking).
82 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98

Previous empirical results suggest that the two groups of banks may be differentiated in terms of
risk (Metwally, 1997). Moreover, most empirical studies suggest that Islamic banks are less risky than
conventional banks (for instance, Abedifar et al., 2013; Beck et al., 2013).
We use four indicators of credit risk. Specifically, we use the ratio of loan loss reserves to gross
loans (LLR) as a proxy for credit risk. This variable represents managers’ assessment of the quality of
the loan portfolio, including performing and non-performing loans. LLR takes into account the past
performance and the expectation for future performance of the existing loan portfolio. We also employ
the ratio of non-performing loans to gross loans (NPL). We also use the ratio of loan to deposit (LTD),
and the ratio of loans to total assets (LTA) as proxy for credit risk exposure. All ratios decrease in
asset quality and credit risk. For insolvency risk, we use the ratio of equity to assets (ETA), the ratio
of debt to assets (DA), the ratio of deposit to assets (DTA), and the ratio of deposit to equity (DTE).
ETA is a measure of capital strength and capitalization. High equity to assets ratio is assumed to be
indicator of low leverage and therefore lower risk. On contrary high debt to assets ratio, deposit to
assets ratio, or deposit to equity ratio is assumed to be indicator of high leverage and therefore higher
risk of insolvency. Hence, a high (low) value of ETA (DA, DTA, or DTE) implies that the bank is more
capitalized and so more solvent. All these proxies are widely used in the empirical banking literature
(for instance, Olson and Zoubi, 2008; Abedifar et al., 2013; Beck et al., 2013; Bourkhis and Nabi, 2013).
Hence, we formulate our hypothesis as follows:

H3. Islamic banks are less risky than conventional banks.

4. Data and variables

4.1. The GCC banking sector

In the GCC countries, the banking sector is relatively young compared to other countries. The first
bank dates back to no earlier than the 1950s. The GCC region has one of the world’s largest Islamic
banking markets. The depth of banking sector, as measured by domestic private credit by banks to
GDP ranges from 39.26% for the Saudi Arabia to 76.26% for the Kuwait in 2010. Overall, the credit to
the private sector in all GCC countries progressively increased from 2003 to 2010. Although a majority
of banks is privately owned, the foreign ownership is limited and the role of the public sector remains
substantial. Except for Bahrain, all GCC countries have limits on foreign ownership (Al-Hassan et al.,
2010). The GCC banking sector is fairly concentrated. The three largest banks control more than a
half of the total banking sector assets in the GCC, and the market share of the big three remains high
between 2003 and 2010. The highest concentrated market is the Kuwait with the three largest banks
account for 89.58% of total banking sector assets in 2010. The lowest concentrated market is the Saudi
Arabia, where the big three hold 51.8% of assets in 2010. This reflects entry barriers and licensing
restrictions on foreign banks, including GCC banks. The GCC Banking sector is well capitalized and
profitable. The capitalization of the banks, as measured by the bank capital to risk-weighted assets,
is relatively high. The solvency ratio is above the minimum regulatory capital ratio required by Basle
II and national standards in all countries. The profitability of the GCC banking sector, as measured by
the return on equity (ROE) and return on assets (ROA) is also relatively high. The banks in the GCC
show good practices of credit risk. The nonperforming loans (NPL) are low and well provisioned. The
NPL ratio ranges from 1.7% for Qatar, followed by the Saudi Arabia (3%), to 8.9% for Kuwait in 2010. For
countries with lower levels of non-performing loans, the provisioning rates are relatively high. The
ratio of provisions to NPL in 2010 is 33.9% for Kuwait, 86.3% for Qatar, and 115.7% for the Saudi Arabia.
Finally, the z-score,6 measuring the banking sector soundness, is relatively high compared to average

6
The probability that a country’s banking system defaults is measured by the z-score. The indicator compares the system’s
buffers (returns and capitalization) with the system’s riskiness (volatility of returns). A higher z-score implies a lower proba-
bility of insolvency, indicating that the banking sector is more stable. The z-score (or distance to default) is a ratio, defined as
((ROA + (equity)/assets))/sd(ROA), where ROA is average annual return on end-year assets and sd(ROA) is the standard deviation
of ROA.
 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98 83

of the word,7 indicating that the GCC banking sector is stable. All these indicators for the banking
sector in the GCC countries for the years 2003 and 2010 are reported in Table 2.

4.2. Data and variables

We use banks from the GCC region over the period 2003–2010 covering the 2007/2008 subprime
crisis. We use a sample that comprises only countries with both conventional and Islamic banks.
Bank-level data is retrieved from the Bankscope database provided by Fitch-IBCA.8 We only include
banks with at least seven consecutive yearly observations. The final sample includes 44 conventional
and 18 Islamic banks operating in five different countries9 (Bahrain, Kuwait, Qatar, Saudi Arabia,
and the United Arab Emirates), consisting of 466 bank-year observations. Table 3 lists the number of
conventional and Islamic banks and observations in each country.
In this paper, fourteen financial ratios have been considered. In Table 4, we classify these ratios into
five groups: profitability ratios (ROA, and ROE), liquidity ratios (CTA, and CTD), credit risk (LLR, NPL,
LTA, LTD), insolvency risk (ETA, DA, DTA, and DTE), and asset structure ratios (FAA, OBSIA). Regarding
the later ratios, we use fixed assets to assets ratio, and off-balance sheet items to assets ratio to account
for the operating leverage, and off-balance sheet activities, respectively. These ratios are used in the
previous empirical banking literature (for instance, Pasiouras, 2008; Srairi, 2013).

4.3. Univariate analysis

Table 5 reports the mean of financial ratios for Islamic and conventional banks, and the p-value for
the t-test of differences in means between the two groups of banks. The sample period is split into
three groups. The first one covers the pre-crisis period from 2003 to 2007, the second one covers the
crisis period from 2007 to 2008 and the third one covers the post-crisis period from 2009 to 2010.10

4.3.1. Overall period

The univariate analysis shows that Islamic banks are significantly different from conventional banks
at 5% level with respect to the most variables used in this study. The profitability, as measured by the
ROA, is higher for Islamic banks than for conventional peers. The ROA of 2.82% for Islamic banks versus
2.16% for conventional banks is significantly larger at the 5% level. This finding is in line with the first
hypothesis (H1). However, when we use the ROE as proxy of profitability, we do not find any significant
difference between Islamic and conventional banks.
Regarding the second hypothesis, when the differences in liquidity between Islamic and conven-
tional banks are significant, Islamic banks are more liquid. We find that Islamic banks hold more cash
relative to assets. CTA averages 24.61% for Islamic banks versus 20.71% for conventional banks. The
difference is statistically significant at the 1% level. This result corroborates the second hypothesis
(H2). But, in terms of cash to deposits, it does not seem that the two types of banks are different. CTD
averages 31.19% for Islamic banks versus 31.68% for conventional banks.
Regarding the credit risk exposure, the average loans to assets ratio of Islamic banks stands at
54.16% versus 55.87% for conventional banks and the average loans to deposits ratio for the two
bank types are 91.51 and 71.76%, respectively. The difference is statistically significant only for the
LTD ratio at 10% level. These results show that Islamic banks intermediate more of the deposits they
receive and engage more in financing economic activity via lending compared to conventional banks,

7
The mean value of z-score for the world is 15.5 as reported in the global financial development report (2014).
8
We use unconsolidated data when available and consolidated if unconsolidated data are not available, in order not to double
count subsidiaries of international banks.
9
Oman is excluded from our sample since it does not have Islamic banks over our sample period. In Oman the regulator
approved Islamic banking from January, 1, 2013.
10
Bank for International Settlements (2010) identify the pre-crisis period from January 2003 to June 2007 and the acute-crisis
as July 2007 to March 2009. Since quarterly data are not available, we consider 2003–2006, 2007–2008, and 2009–2010 as
the pre-crisis, the crisis and the post-crisis periods, respectively. These three periods are also considered by Bourkhis and Nabi
(2013) to distinguish between the first wave of the world financial crisis and its economic wave starting from 2009.
 84
K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98
Table 2
Banking sector indicators 2003–2010.

Bahrain Kuwait Qatar Saudi UAE

2003 2010 2003 2010 2003 2010 2003 2010 2003 2010

Domestic credit to private sector (% GDP) 47.86 67.69 67.73 76.26 29.96 44.69 28.39 39.26 36.17 75.03
Concentration (%) 82.58 80.68 67.42 89.58 93.13 83.09 56.36 51.80 49.24 59.58
Minimum regulatory capital ratio 12 12 12 12 10 10 8 8 10 12
Bank capital ratio 21 20 23 19 - 21 20 17 20 21
ROA (%) 1.30 0.90 2.03 1.65 2.30 2.60 2.27 1.75 2.18 1.44
ROE (%) 12.10 7.42 18.52 12.32 16.67 18.48 21.31 13.35 14.50 10.76
NPLs to total loans (%) 10.3 4.5 6.1 8.9 8.1 1.7 5.4 3 14.3 5.6
Provisions to NPLs (%) 67.7 65.9 77.7 33.9 85.4 86.3 128.2 115.7 88.5 68
Z-score 17.43 18.39 15.59 18.87 25.31 25.46 12.17 14.24 24.41 21.27

Sources: World Bank World Development Indicators and National authorities.

Notes: This table reports the domestic credit to private sector as a percentage of GDP, the concentration, measured as the percentage share of the three largest banks in terms of assets,
the minimum regulatory capital ratio, the bank capital, measured as the percentage of bank capital to risk-weighted assets, the return on assets (ROA), the return on equity (ROE), the
percentage of nonperforming loans (NPLs) to total loans, the percentage of provisions to nonperforming loans, and the z-score.
 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98 85

Table 3
Sample description.

Conventional banks Islamic banks Islamic banks (%)

No bank No obs No bank No obs

Bahrain 8 55 7 51 46.66
Kuwait 4 32 2 14 33.33
Qatar 5 40 2 16 28.57
Saudi Arabia 11 88 2 14 15.38
UAE 15 120 5 36 25.00
Total 43 335 18 131 29.50

indicating higher exposure to credit risk. In fact, Islamic banks face higher restrictions on investing in
non-real sector related securities (such as bonds) since they are not authorized to invest in interest
bearing instruments. For the credit loans quality measures, the average loans loss reserves to loans of
Islamic banks stands at 3.08% versus 5.19% for conventional banks and the average non-performing
loans to loans ratio for the two bank types are 5.78% and 5.20%, respectively. The mean test for the
loans loss reserves show that Islamic banks have significantly lower levels of credit risk compared
to conventional banks. However, we do not find any significant difference between the Islamic and
conventional banks in respect to the ratio of non-performing loans to loans. In terms of solvency
measures, the average ratios of debt to assets, and equity to assets of Islamic banks are 79.52% and
20.32%, respectively, while the corresponding figures for conventional banks are 89.74 and 14.26%,
respectively. Furthermore, the average deposits to assets ratio of Islamic banks stands at 68.86% versus
78.73% for conventional banks and the average deposits to equity ratio for the two bank types are
441.73% and 628.0%, respectively. The differences are statistically significant at 1% level. The mean
test results show that Islamic banks employ more capital than their conventional peers in funding
their assets. These results suggest that Islamic banks are significantly better capitalized compared
to their conventional peers. Overall our findings indicate that Islamic banks have lower credit and
insolvency risks than conventional peers. These results are in line with our third hypothesis suggesting
that Islamic banks are less risky than conventional banks.
In this study, we also investigate whether some asset structure ratios behave differently across
Islamic and conventional banks. The asset structure ratios investigated are: fixed assets to assets

Table 4
Definition of variables.

Ratios Definitions

Profitability
ROA Return on assets = Net income/Total assets
ROE Return on equity = Net income/Stockholders’ equity

Liquidity
CTA Cash to assets = Cash/Total assets
CTD Cash to deposits = Cash/Total customer deposits

Credit risk
LLR Loans loss reserves to gross loans
NPL Non-performing loans to gross loans
LTA Loans to assets = Loans/Total assets
LTD Loans to deposits = Loans/Total customer deposits

Insolvency risk
DA Debt to assets = Total debt/Total assets
ETA Equity to assets = Total equity/Total assets
DTA Deposits to assets = Deposits/Total assets
DTE Deposits to equity = Deposits/Stockholder’s equity

Asset structure
FAA Fixed assets to assets = Fixed assets/Total assets
OBSIA Off-balance sheet items to assets = Off-balance sheet items/Total assets
 86
K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98
Table 5
Univariate analysis.

Overall period 2003–2010 Pre-crisis period 2003–2006 Crisis period 2007–2008 Post-crisis period 2009–2010

CV IB P-value CV IB P-value CV IB P-value CV IB P-value

** ** ***
ROA 2.16 2.82 0.022 2.57 3.59 0.012 1.92 3.64 0.001 1.57 0.56 0.035**
ROE 15.40 13.10 0.181 17.89 16.99 0.518 14.38 17.74 0.091* 11.47 1.20 0.002***
CTA 20.71 24.61 0.006*** 22.63 28.11 0.021** 20.05 21.54 0.538 17.98 20.72 0.181
CTD 31.68 31.19 0.850 36.24 35.37 0.855 27.48 28.82 0.717 26.81 26.05 0.790
LLR 5.19 3.08 0.000*** 5.82 3.46 0.001*** 3.41 2.66 0.333 5.72 2.85 0.001***
NPL 5.20 5.78 0.673 5.11 4.81 0.842 3.41 3.50 0.931 7.14 9.12 0.600
LTA 55.87 54.16 0.367 52.97 52.87 0.974 58.47 54.73 0.254 59.05 55.85 0.384
LTD 71.76 91.51 0.005*** 68.00 89.81 0.021** 74.52 99.19 0.162 76.48 86.27 0.356
LTE 400.3 347.6 0.000*** 401.8 333.2 0.040** 484.8 344.6 0.001*** 462.6 376.6 0.020**
DA 89.74 79.52 0.020** 93.52 77.60 0.069* 85.94 80.25 0.000*** 86.02 82.21 0.004***
ETA 14.26 20.32 0.000*** 14.98 22.08 0.000*** 13.12 19.74 0.000*** 13.97 17.78 0.004***
DTA 78.73 68.86 0.000*** 78.80 68.58 0.000*** 79.16 67.82 0.000*** 78.16 70.50 0.020**
DTE 628.00 441.73 0.000*** 614.03 447.74 0.000*** 664.23 417.79 0.000*** 619.54 461.68 0.002***
FAA 1.05 1.59 0.001*** 0.979 1.473 0.027** 1.02 1.86 0.019** 1.21 1.50 0.421
OBSIA 44.25 18.2 0.000*** 43.70 22.32 0.007*** 50.78 16.46 0.000*** 38.90 13.96 0.000***

Notes: This table reports the mean of financial ratios for Islamic and conventional banks, and the p-value for the T-test of differences in means between the two groups of banks. The T-test
for equality of means is calculated assuming unequal sample variances.
*
Significance at 10% level.
**
Significance at 5% level.
***
Significance at 1% level.
 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98 87

(FAA), and off-balance sheet items to assets (OBSIA). Results indicate that Islamic banks have lower
off-balance sheet items to assets ratio, and higher fixed assets to assets ratio. FFA averages 1.59%
for Islamic banks versus 1.05% for conventional banks, while OBSIA averages 18.2% for Islamic banks
versus 44.25% for conventional banks. The differences between the two groups of banks are statistically
significant at 1% level for these two ratios, suggesting that Islamic banks have higher operating leverage
and are less involved in off-balance sheet activities.

4.3.2. Pre, during and post crisis periods

In order to investigate the evolving behavior of Islamic and conventional banks and to test the
sensitivity of our results, we repeat the univariate analysis over the pre-crisis period (2003–2006), the
crisis period (2007–2008) and the post-crisis period (2009–2010). Evidence shows that our findings
over the pre-crisis period do not differ from those over the overall period (2003–2010). Therefore,
we focus in our analysis on the next two periods to gauge the impact of the first wave of the world
financial crisis (2007–2008) and its economic wave starting from 2009. Concerning the profitabil-
ity, the mean values of ROA and ROE of Islamic banks are 3.64 and 17.74%, respectively, while the
corresponding figures for conventional banks are 1.92 and 14.38%, respectively during the crisis. The
differences between the two groups of banks are statistically significant. In terms of evolution, there
is no variation in profitability for Islamic banks but a slight decrease for conventional banks. However
after the crisis, we observe a substantial decrease in profitability for Islamic banks. Therefore, based
on the evolution of the ROA and ROE, we conclude that the Islamic banks outperform the conven-
tional banks before and during the financial crisis. However, this was reversed since 2009 as the crisis
hit the real economy and so conventional banks perform better. This is a clear indication that the
financial crisis has a negative impact on the profitability for both Islamic and conventional banks, but
time shifted. Hasan and Dridi (2010) point out that business model helped Islamic bank to contain
the adverse impact on profitability in 2008, while weaknesses in risk-management practices in some
Islamic banks led to larger declines in profitability compared to conventional banks in 2009. Second,
evidence shows that the liquidity of Islamic banks, measured by either cash to assets ratio or cash to
deposits ratio, is not statistically different from that of conventional banks during and after the finan-
cial crisis. These results are consistent with Beck et al. (2013) and may suggest that the two groups
of banks follow the same liquidity policy during and after the crisis. In terms of evolution, there is a
decrease in cash holdings for both Islamic and conventional during and after the crisis. Third, regard-
ing the asset quality, as measured by loans to assets ratio, loans to deposits ratio, and non-performing
loans to loans ratio, we do not find any significant differences between Islamic and conventional
banks during and after the financial crisis. However, in respect to the loans loss reserves to loans ratio,
the difference between Islamic and conventional banks remains negative and statistically significant,
indicating that Islamic banks have lower credit risk during and after the crisis. Regarding the insol-
vency risk, evidence shows that leverage, as measured by debt to assets ratio, deposit to assets ratio,
and deposit to equity ratio, continue to be higher for conventional banks than for Islamic banks over
all periods. Moreover, Islamic banks remain better capitalized that their conventional peers. Overall,
all these results may suggest that Islamic banks are less risky than their conventional peers. Finally,
regarding the asset structure, evidence shows that Islamic banks have, on average, lower off-balance
sheet items to assets ratio and higher fixed assets to assets ratio even during and after the financial
crisis.

5. Parametric and non-parametric methods

Parametric methods (Linear discriminant analysis and Logit model) and non-parametric methods
(neural network and tree of classification) are used in the current study to determine which ratios can
discriminate between Islamic and conventional banks. In all empirical investigations, the dependent
variable is a dummy variable which takes the value 1 for Islamic banks and zero for conventional banks.
All these methods can be used to assign objects to two groups, and can employ one or more predictor
variables. However, that there is a difference between LDA and logistic regression on the one hand, and
the neural network and the tree of classification, on the other. Whereas the first two parametric meth-
ods use all (statistically significant) predictor variables simultaneously in the model, the second two
88 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98

non-parametric methods use the predictor variables in a hierarchical and recursive manner. Further-
more, to get a high rate of classification, parametric methods suppose the normality of observations,
no outliers, large size of sample, and homogeneity of the variance–covariance matrix (Rubin, 1990;
Robert, 2002). On the other hand, when these hypotheses are not satisfied non-parametric methods
become more efficient than parametric methods.

5.1. Parametric methods

Linear discriminant analysis (LDA) and logistic regression are widely used multivariate statisti-
cal methods for analysis of data with categorical outcome variables. Both of them are appropriate
for the development of linear classification models. The goal of logistic regression is to find the best
fitting and most parsimonious model to describe the relationship between the outcome and a set
of independent variables. Linear discriminant analysis can be used to determine which variable dis-
criminates between two or more classes (Islamic or conventional banks in our study), and to derive a
classification model for predicting the group membership of new observations. Nevertheless, the two
methods differ in their basic idea. In logistic regression, unlike in the case of LDA, no assumptions are
made regarding the underlying data (normal distribution and large size of sample, homogeneity of
the variances–covariances matrix, and no outliers). LDA has been developed for normally distributed
explanatory variables with equal covariance matrices. LDA gives better results in the case when the
normality assumptions are fulfilled, but in all other situations logistic regression should be more
appropriate. Specifically, logistic regression outperforms LDA where one of the assumptions of the
LDA is not satisfied. Hence, logistic regression is more flexible and robust method in case of violations
of these assumptions.

5.1.1. Linear discriminant analysis

The Linear discriminant analysis (LDA) approach is widely used for classifying samples of unknown
classes, based on training samples with known classes (Fisher, 1936). The purpose is to classify obser-
vations based on a set of variables known as predictors or input variables (financial ratios in our
analysis). The application of this method requires some assumptions: normal distribution of data,
homogeneity of the variances–covariances matrix, large size of sample and no outliers. The model is
built based on a set of observations for which the classes are known. This set of observations is some-
times referred as the training set. Based on the training set, the technique constructs a set of linear
functions of the predictors, known as discriminant functions, such that:

Z = ˛ + ˇ1 x1 + ˇ2 x2 + · · · + ˇn xn + εi

where ˇi for i ∈ [0, 1, 2, ..., n] are discriminant coefficients, x are the input variables or predictors, ˛ is
a constant, and εi is the error term. These discriminant functions are used to predict the class of a new
observation with an unknown class.
Among the fourteen financial ratios considered in this study, the LDA method selects the most
significant and important variables that discriminate between the two types of banks. Moreover, it
provides the Wilks’ Lambda, the canonical correlation, the Chi2 , and the hit rate (or accuracy rate) of
classification. Results reported in Table 7 shows that, for the whole period (2003–2010), five ratios can
significantly discriminate between Islamic and conventional banks: ETA, DTA, FAA, OBSIA, and LTD.
The positive and significant coefficient on the equity to assets ratio (ETA) variable confirms that Islamic
banks are better capitalized than their conventional peers, suggesting that Islamic banks are less risky
than conventional banks because of their reliance on equity. The negative coefficient on deposit to
assets ratio (DTA) indicates that Islamic banks rely less on deposits than conventional banks. The
credit risk ratio retained by the estimated LDA model is the loans to deposits ratio (LTD). This ratio has
a positive and significant coefficient at 1% level, indicating that Islamic banks are characterized by a
higher level of loans relative to deposits compared to conventional banks. This positive and significant
coefficient on the LTD indicates that Islamic banks extend more loans than conventional banks. In fact,
unlike conventional banks, Islamic banks cannot allocate a part of their funds to investments in interest
bearing instruments (such bonds). The higher level of loans indicates a higher exposure to credit risk
 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98
Table 6
Pearson correlation coefficients.

ROA ROE CTA CTD LLR NPL LTA LTD DA ETA DTA DTE FAA OBSIA

ROA 1
ROE 0.756*** 1
CTA −0.016 −0.009 1
CTD 0.077* −0.005 0.858*** 1
LLR −0.150*** −0.168*** 0.332*** 0.324*** 1
NPL −0.204*** −0.299*** 0.253*** 0.220*** 0.824*** 1
LTA −0.032 0.073 −0.506*** −0.480*** −0.340*** −0.409*** 1
LTD 0.094** 0.017 −0.389*** −0.176*** −0.201*** 0.287*** 0.534*** 1
DA −0.103** −0.046 0.102** 0.018 0.184*** 0.074 −0.061 −0.070 1
ETA 0.506*** −0.023 0.020 0.213*** 0.112** 0.172*** −0.119*** 0.189*** −0.172*** 1
DTA −0.302*** 0.051 0.162*** −0.174*** 0.002 −0.043 0.049 −0.622*** 0.128*** −0.636*** 1
DTE 0.342*** −0.025 0.200*** 0.179*** −0.036 −0.091* −0.133*** −0.123*** 0.459*** 0.680*** −0.174*** 1
FAA 0.112** −0.010 −0.016 0.032 −0.003 −0.042 0.012 −0.030 −0.048 0.250*** −0.120** 0.229*** 1
OBSIA 0.055 0.069 0.104** 0.133*** 0.016 −0.005 0.065 0.060 0.036 0.062 −0.011 0.049 −0.049 1
*
Significance at 10% level.
**
Significance at 5% level.
***
Significance at 1% level.

89
90 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98

Table 7
The linear discriminant analysis results.

Overall period Pre-crisis period Crisis period Post-crisis period

2003–2010 2003–2006 2007–2008 2009–2010

LTD 0.279*** 0.481***

(0.000) (0.000)
ETA 0.477*** 0.770*** 0.844*** 0.418***
(0.000) (0.000) (0.000) (0.000)
DTA −0.296*** −0.514*** −0.443***
(0.000) (0.000) (0.000)
FAA 0.260*** 0.269***
(0.000) (0.000)
OBSIA −0.649*** −0.591*** −0.528*** −0.754***
(0.000) (0.000) (0.000) (0.000)

Canonical correlation 0.532 0.556 0.543 0.519

Wilks’ Lambda 0.717 0.691 0.705 0.730
Chi2 144.037 76.731 19.211 51.373
P-value 0.000 0.000 0.000 0.000
Hit rate (%) 81.20 80.20 82.80 78.40
No obs. 432 208 114 113

Notes: This table reports the results from linear discriminant analysis model. P-values are reported in parentheses.
***
Significance at 1% level.

for Islamic banks. This result is not consistent with our third hypothesis. The positive coefficient on
fixed assets to assets ratio (FAA) and the negative coefficient on off-balance sheet items to assets
ratio (OBSIA) indicate that Islamic banks have higher operating leverage and less involved in off-
balance sheet activities, respectively. Finally, Results indicate that the profitability and liquidity ratios
cannot discriminate between the two groups of banks. Hence, the first two hypotheses, pertaining to
profitability and liquidity, are not supported by the LDA results.
We also repeat the LDA over the sub-periods. Results over the pre-crisis period (2003–2006) are
similar to those over the overall period, except that the ratio of loans to assets (LTD) is replaced by the
ratio of loans to equity (LTE). During the crisis period (2007–2008), the LDA retain only two variables-
equity to assets ratio (ETA) and off-balance sheet items to assets ratio (OBSIA)-with the same sign on
the coefficients. Results over the post-crisis period (2009–2010) show that equity to assets ratio (ETA),
deposits to assets ratio (DTA), and off-balance sheet items to assets ratio (OBSIA) discriminate between
the two groups of banks. The success rate, or classification accuracy, for these four LDA models ranges
from 78.4% for the post crisis period to 82.8% for the crisis period.

5.1.2. Logistic regression models

The second parametric method is the logistic regression. This method supposes that the probability
of a dichotomous outcome is related to a set of potential predictor variables in the form:
 p 
log = ˛ + ˇ1 x1 + ˇ2 x2 + · · · + ˇn xn + εi
1−p

where p is the probability of the outcome of interest, ˛is the intercept term, ˇi for i ∈ (0, 1, . . ., n)
represents the coefficient associated with the corresponding explanatory variable xi for i ∈ (0, 1, . . ., n),
and εi is the error term. The dependent variable is the logarithm of two probabilities of the outcome of
interest. These variables are usually selected for inclusion by using some form of backward or forward
stepwise regression technique (Neter et al., 1996; Pampel, 2000) though these selection techniques
may be subject to problems. In addition, the maximization of the likelihood function is usually applied
as the convergent criterion to estimate the coefficients of corresponding parameters when the logistic
regression models are used.
The classification results of logistic regression are sensitive to high correlation between the explana-
tory variables. Hence, we excluded some of the explanatory variables because of the problem of
 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98 91

Table 8
Logit model result.

Overall period Pre-crisis period Crisis period Post-crisis period

2003–2010 2003–2006 2007–2008 2009–2010

LLR −14.48*** −14.89*** −15.734*

(0.001) (0.003) (0.019)
LTA 2.282*** 5.598* 4.905**
(0.063) (0.093) (0.050)
ETA 14.37*** 13.72*** 28.97*** 13.08**
(0.000) (0.001) (0.000) (0.014)
DTA −4.923*** −5.320**
(0.009) (0.033)
OBSIA −8.127*** −6.154 −9.986*** −11.26***
(0.000) (0.000) (0.000) (0.000)
FAA 26.47**
(0.040)

Constant 1.394 2.720 −4.781 −3.400*

(0.481) (0.239) (0.019) (0.079)
LR Chi2 183.15 72.89 62.06 46.15
P-value 0.000 0.000 0.000 0.000
R squared 0.389 0.348 0.458 0.352
Hit rate (%) 87.27 87.98 88.60 82.30
No obs. 432 208 114 113

Notes: This table reports the results from stepwise logit model. P-values are reported in parentheses.
*
Significance at 10% level.
**
Significance at 5% level.
***
Significance at 1% level.

multicolinearity. The Pearson correlation coefficients are reported in Table 6. The final selected spec-
ification is obtained using backward stepwise method.
Results from logistic regressions are reported in Table 8. For the whole period (2003–2010), only
six predictor variables out of fourteen are statistically significant and so can be used to discriminate
between Islamic and conventional banks. These variables are: loans loss reserves to loans ratio (LLR),
loans to assets ratio (LTA), equity to assets ratio (ETA), deposits to assets ratio (DTA), fixed assets to
assets ratio (FAA), and off-balance sheet items to assets ratio (OBSIA). The positive coefficient on the
equity to assets ratio (ETA) confirms that Islamic banks are more capitalized. The deposit to assets ratio
(DTA) shows a significant and negative coefficient, which indicate that Islamic banks are characterized
by a lower level of deposit to assets ratio compared to conventional banks. The coefficient on loans
to assets ratio (LTA) is positive and significant at 5% level. This result suggests that Islamic banks
extend more loans than conventional banks, suggesting higher exposure to credit risk for Islamic
banks. However, the negative coefficient on loans loss reserves to loans ratio indicate that Islamic
banks have lower credit risk than conventional banks. Overall, these findings suggest that Islamic
banks are less risky compared to conventional banks, supporting our second hypothesis. Finally, the
negative coefficient on off-balance sheet items to assets ratio (OBSIA) indicates that Islamic banks
are less involved in off-balance sheet activities than conventional banks. The positive coefficient on
fixed assets to assets ratio (FAA) indicates that Islamic banks hold more fixed assets than conventional
banks, suggesting higher operating leverage for the former.
We also re-estimate the logistic regressions over the sub-periods. Results indicate that three or
four variables can be used to discriminate between Islamic and conventional banks. These variables
are loans loss reserves to loans ratio (LLR), loans to assets ratio (LTA), equity to assets ratio (ETA), and
off-balance sheet items to assets ratio (OBSIA). The sings of the coefficients on these ratios remain
unchanged. The success rate, or classification accuracy, for these four logistic models ranges from
82.3% for the post-crisis period to 88.6% for the crisis period.
92 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98

Fig. 1. Neural network with one hidden layer.

5.2. Non parametric methods

5.2.1. The neural network method

The neural network method is an algorithmic procedure for transforming inputs into desired out-
puts using highly inter-connected networks of relatively simple processing elements. The essential
features of a neural network are the nodes, the network architecture describing the connections
between the nodes, and the training algorithm used to find values of the weights for a particular
network. The nodes are connected to one another in the sense that the output from one node can
be served as the inputs to other nodes. Each node transforms an input into an output using some
specified function that is typically monotone, but otherwise arbitrary. This function depends on
parameters whose values should be determined with a training set of inputs and outputs. The net-
work architecture is the organization of nodes and the types of connections allowed. The nodes are
arranged in a series of layers with connections between nodes in different layers, but not between
nodes in the same layer. The layer receiving the inputs is called the input layer. The final layer pro-
viding the target output signal is the output layer. Any layers between the input and output layers are
hidden layers. A simple representation of a neural network with one hidden layer can be shown in the
Fig. 1.
The classification rule of the neural network is as follows: If the output unit ≥0.5, then the obser-
vation belongs to the group 1 (G1). In contrast, if the output unit ≤0.5, then the observation belongs
to the group 2 (G2).
The neural network classification model is used in many areas of research. In this paper, we use
this technique in order to classify Islamic and conventional banks in two groups according to their
financial ratios. Table 9 shows the importance and the normalized importance of all variables in the
neural network classification model. The importance of an independent variable measures how much
the network’s predicted value varies for different values of the independent variable. The normalized
importance is the importance values divided by highest importance value and displayed as a per-
centage. For the whole period (2003–2010), results show that off-balance sheet items to assets ratio
(OBSIA) scored the highest importance, followed by loans to equity (LTE), equity to assets ratio (ETA),
return on assets (ROA), and fixed assets to assets ratio (FAA). OBSIA scored 15.9%, which indicates that
OBSIA strongly influence the predicted value of the model. On the other hand, ROE has the lowest
importance level of 1.2% which suggests that the profitability has no influence on the predicted value.
For the pre-crisis period (2003–2006), the best discriminant variables are, in order of importance,
off-balance sheet items to assets ratio (OBSIA), debt to assets (DA), loans to deposits (LTD), loans to
equity (LTE), fixed assets to assets ratio (FAA), etc. For the crisis period (2007–2008), equity to assets
 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98
Table 9
Neural network results.

Overall period 2003–2010 Pre-crisis period 2003–2006 Crisis period 2007–2008 Post-crisis period 2009–2010

Importance Normolized Importance Normolized Importance Normolized Importance Normolized

importance importance importance importance
(%) (%) (%) (%)

ROA 0.039 20.60 0.031 19.50 0.049 43.60 0.035 21.40

ROE 0.022 11.20 0.032 20.20 0.029 25.50 0.063 38.40
CTA 0.057 29.90 0.057 36.10 0.060 53.80 0.083 51.10
CTD 0.089 46.60 0.064 40.30 0.013 11.90 0.046 28.40
LLR 0.113 58.80 0.039 24.60 0.082 73.00 0.043 26.10
NPL 0.076 39.80 0.054 34.50 0.103 92.30 0.097 59.80
LTA 0.089 46.60 0.076 48.40 0.070 62.80 0.074 45.60
LTD 0.075 39.30 0.092 58.60 0.077 69.00 0.147 90.30
DA 0.074 38.60 0.083 52.90 0.112 100.00 0.062 38.00
ETA 0.068 35.70 0.063 39.90 0.088 78.70 0.037 22.60
DTA 0.044 22.80 0.089 56.20 0.074 65.60 0.030 18.30
DTE 0.062 32.30 0.047 29.70 0.101 90.00 0.024 14.60
FAA 0.052 27.10 0.115 73.00 0.085 76.20 0.097 59.40
OBSIA 0.192 100.00 0.158 100.00 0.055 49.30 0.163 100.00

Hit rate (%) 87.4% 81.9% 81.8% 79.7%

Notes: This table reports the neural network results, specifically the importance and normalized importance for independent variables.

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Fig. 2. Classification tree.

ratio (ETA) is ranked first with the highest importance value, followed by loans to deposits (LTD), fixed
assets to assets ratio (FAA), deposits to equity (DTE), off-balance sheet items to assets ratio (OBSIA),
etc. Finally for the post-crisis period (2009–2010), the ratio with the highest importance is off-balance
sheet items to assets ratio (OBSIA), followed by equity to assets ratio (ETA), loans to deposits (LTD),
loans to equity (LTE), cash to deposits (CTD), etc. The success rate, or classification accuracy, for these
four neural network classification models ranges from 58.3% for the crisis period to 86.3% for the
overall period.

5.2.2. The Classification tree

Classification trees are among the classification techniques of data mining. Once built, a tree is in
the form of an inverted tree where each terminal node (or sheet) contains a fraction of the original
sample in which individuals are almost all in a single class. Indeed, several types of decision trees are
available, but they differ mainly in how they choose and carry out the connections, and in how they
manage the nominal predictors. The main types of decision trees are: C&RT, CHAID and QUEST.
A new observation descends the tree from the root to a single sheet. Its trajectory in the tree is
determined by the values of its attributes (or predictors). It is then affected to the dominant class of
the sheet. Each sheet is a “segment” of the sample which is as homogeneous as possible compared to
the dependent variable (class).
Classification trees accept any kind of predictor: numerical, ordinal or nominal. They are fast and
can handle large volumes of data, and their decisions can be transcribed in the form of logical rules.
Several types of classification trees are commercially available. Their differences are mainly in how
they choose and make connections and how they deal with nominal predictors. Decision trees are
obtained by binary recursive partitioning. The parent nodes are always divided into two descendant
nodes (intermediary or terminal). This process is reiterated by regarding each intermediate node as a
parent node (see Fig. 2).
Thus, each branch of the tree represents a different combination of the explanatory variables, and
the ways leading a node to the sheets do not necessarily have the same number of branches.
Table 10 reports the importance and the normalized importance of all variables in the classifica-
tion tree model. The importance of an independent variable measures how much the classification’s
predicted value varies for different values of the independent variable. The normalized importance
is the importance values divided by highest importance value and displayed as a percentage. For the
whole period (2003–2010), results show that off-balance sheet items to assets ratio (OBSIA) scored
the highest importance, followed by debt to assets (DA), equity to assets ratio (ETA), deposits to assets
ratio (DTA), and return on assets (ROA). OBSIA scored 13.4%, which indicates that OBSIA strongly influ-
ence the predicted value of the model. On the other hand, ROE has the lowest importance level of 0.6%
which suggests that the profitability has weak or no influence on the predicted value. For the pre-crisis
period, the best discriminant variables are, in order of importance, equity to assets ratio (ETA), deposits
 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98
Table 10
Classification tree Results.

Overallperiod 2003–2010 Pre-crisisperiod 2003–2006 Crisisperiod 2007–2008 Post-crisisperiod 2009–2010

Importance Normalized Importance Normalized Importance Normalized Importance Normalized

importance importance importance importance

ROA 0.009 6.40 0.040 22.20 0.112 46.67 0.016 12.40

ROE 0.006 4.80 0.026 14.90 0.002 0.83 0.057 41.19
CTA 0.015 11.40 0.036 20.00 0.000 00.00 0.018 13.95
CTD 0.011 8.60 0.018 9.80 0.000 00.00 0.018 13.95
LLR 0.060 44.70 0.003 1.60 0.025 11.68 0.049 37.98
NPL 0.051 38.30 0.009 4.90 0.006 2.80 0.000 0.07
LTA 0.046 34.60 0.010 5.60 0.000 00.00 0.016 12.40
LTD 0.033 24.90 0.015 8.40 0.002 0.83 0.020 15.50
DA 0.069 51.70 0.086 48.31 0.198 82.50 0.066 51.16
ETA 0.061 45.70 0.032 17.90 0.214 100.00 0.109 84.49
DTA 0.087 64.50 0.050 28.20 0.114 47.50 0.053 41.08
DTE 0.094 70.40 0.012 6.74 0.214 100.00 0.048 37.21
FAA 0.014 10.50 0.001 8.00 0.047 19.58 0.018 13.95
OBSIA 0.134 100.00 0.234 100 0.186 77.50 0.129 100.00

Hit rate (%) 75.3% 80.2% 72.7% 75.0%

Notes: This table reports the classification tree results, specifically the importance and normalized importance for independent variables.

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Table 11
Classification accuracies and error analysis.

Correctly Predict CB but Correctly Predict IB but Overall

predict IB (%) IB (type I error) predict CB (%) CB (type error classification
(%) II) (%) accuracy (%)

Overall period (2003–2010)

LDA 66.98 33.02 85.80 14.20 81.20
Logit 83.82 16.18 87.91 12.09 87.27
Neural Network 57.40 32.60 95.80 04.20 87.40
Tree classification 63.00 37.00 80.90 19.10 75.30

Pre-crisis period (2003–2006)

LDA 58.70 41.30 86.14 13.86 80.20
Logit 86.96 13.04 88.11 11.89 87.98
Neural Network 33.30 66.70 98.60 01.40 81.90
Tree classification 63.00 37.00 85.70 14.30 80.20

Crisis period (2007–2008)

LDA 76.47 23.53 85.36 14.64 82.80
Logit 85.19 14.81 89.66 10.34 88.60
Neural Network 68.80 31.20 87.20 12.80 81.80
Tree classification 87.50 12.50 68.00 32.00 72.70

Post-crisis period (2009–2010)

LDA 65.95 34.05 83.06 16.94 78.40
Logit 70.83 29.17 85.39 14.61 82.30
Neural Network 30.40 69.60 100.00 00.00 79.70
Tree classification 31.00 69.00 95.20 04.80 75.00

to equity ratio (DTE), debt to assets (DA), off-balance sheet items to assets ratio (OBSIA), deposits to
assets ratio (DTA), etc. For the crisis period (2007–2008), equity to assets ratio (ETA) is ranked first
with the highest importance value, followed by deposits to equity ratio (DTE), debt to assets (DA), off-
balance sheet items to assets ratio (OBSIA), deposits to assets ratio (DTA), etc. Finally for the post-crisis
period (2009–2010), the ratio with the highest importance is off-balance sheet items to assets ratio
(OBSIA), followed by equity to assets ratio (ETA), loans to equity (LTE), debt to assets (DA), return on
equity (ROE), etc. The success rate, or classification accuracy, for these four classification tree models
ranges from 72.0% for the crisis period to 80.2% for the pre-crisis period.

5.3. Comparison of the performance of classification models

The classification accuracy rate, as well as Type I (Predict conventional bank but Islamic bank) and
Type II (Predict Islamic bank but conventional bank) errors for the four models are reported in Table 11.
In general, classification accuracy rate is the most common quantitative measure used in evaluating
the predictive accuracy of classification models. In addition, it represents the percentage of banks
that are classified correctly. For the whole period (2003–2010), the overall classification accuracy is
higher for the Logit regression and Neural network model, with a rate of 87% compared to the LDA
and classification tree models (81.2% and 75.3%, respectively). For the sub-periods, Logit regression
obtained slightly higher classification accuracies than other classification models. Overall, the different
models achieve high rate of classification accuracies, suggesting that financial ratios can be used to
distinguish between Islamic and conventional banks.

6. Summary and implications

Islamic finance has grown rapidly over the last three decades. This rapid growth of Islamic
or interest-free banking system has attracted the attention of many international policy makers
and academic researchers. While most previous studies on Islamic finance have investigated and
explained the general Islamic principles and the instruments used in Islamic banking, recent
 K.B. Khediri et al. / Research in International Business and Finance 33 (2015) 75–98 97

researches have investigated whether profitability, efficiency, and risks differ significantly across
Islamic and conventional banks.
Our paper is a novelty in several ways. First, using 61 Islamic and conventional banks, this paper
extends this line of research to shed light on the behavior of Islamic and conventional banks in the GCC
countries between 2003 and 2010. The aim of the current paper was to compare between the features
of Islamic banks and conventional banks in the GCC countries using selected financial ratios and some
parametric methods (linear discriminant analysis and logistic regression) and non-parametric meth-
ods (neural network and the classification tree). Moreover, we contribute to Islamic finance empirical
literature by testing three hypotheses examining the profitability, liquidity, and risk of Islamic and
conventional banks.
This study documents several interesting findings. First, we show that Islamic and conventional
banks behave somewhat differently. Mean tests results show that Islamic banks are more profitable,
liquid, and capitalized, and have less credit risk than their conventional peers. Islamic banks also are
less involved in off-balance sheet activities and have more operating leverage. Second, results also
indicate that it is possible to distinguish between these two types of banks based on financial ratios.
Specifically, classification models results show that the two types of banks may be differentiated in
terms of credit and insolvency risk, operating leverage and off-balance sheet activities, but not in terms
of profitability and liquidity. Finally, the current paper provides insights into the potential of using
classification models. Interestingly, results show that logistic regression model is more accurate and
interpretive than other models.
The current research may be extended by investigating other features of banks such as business
model, efficiency, and stability. Further, the question of whether Islamic and conventional banks have
or not the same behavior when operating on a small or large scale should be explored in future research.
As a related issue, it is also interesting to account for the differences in ownership structure.
As a matter of policy implications, we need to draw some proposals according to the results. It is
obvious that Islamic banking is different from conventional banking in terms of credit and insolvency
risks. These differences have implications for policymakers and regulators. As a result, a particular and
well-defined regulatory and supervisory framework, and risk management tools for Islamic banking,
taking into account specific features of Sharia-compliant contracts and Islamic banks, is needed for
their effective functioning.

Acknowledgments

We would like to thank an anonymous reviewer for valuable and insightful comments that helped
us improve an earlier version of the manuscript. Any remaining errors are, of course, our own.

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