Bank Parikrama

Volume XXXIX, Nos. 1 & 2, March & June 2014 (pp. 136-149)

Determinants of Profitability of Banks: Evidence

from Islamic Banks of Bangladesh

- Nusrat Jahan*

Abstract
This empirical study is conducted on randomly selected six Islamic banks of Bangladesh.
This study utilizes widely used Measures of banks’ profitability which are Return on Asset
(ROA), Return on Equity (ROE) and Return on Deposit (ROD) and these are also commonly
suggested tools by Bangladesh Bank to evaluate banks’ performance. In addition, this study
examined the relationship of ROA with Asset Utilization (AU), Operational Efficiency (OE)
and ROD. The result reveals that EXIM Bank Limited is performing very good in terms of all
profitability measures ROA, ROE and ROD even though average asset size of Islami Bank
Bangladesh Limited is found to be largest among all six Islamic Banks. The result of
regression found the explanatory variable ROD is significantly associated with ROA but failed
to establish any significant association with operational efficiency and asset utilization.
Keywords: Profitability, Determinants, Bank, DuPont Analysis
JEL Classification:G30, G21

1. Introduction
The dominating industry in the financial sector of Bangladesh is banking
industry. Bangladesh Bank (BB) continues to focus on strengthening the
financial system of Bangladesh and improving functioning of its various
scheduled banks and financial institutions. The importance of bank’s financial
performance and profitability is appraised both at micro and macro level of
economy, since it is one of the important source of finance for enterprises in
Bangladesh. The significance of bank’s financial performance in the financial
sector of Bangladesh led to the undertaking of this research. Since the
establishment of Islamic banking system during 1983 in Bangladesh, Islamic
banks have gained a footing in the banking industry. Islamic banks not only
provide profit-sharing banking facilities, but they also undertake business and
trade activities on the basis of fair and legitimate profits. In such banks,

*
The author is Assistant Professor, School of Business, Independent University Bangladesh,
Chittagong. Views expressed in this article are the author’s own.

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ensuring fair practices in dealings with customers and shareholders takes
centre stage, more so than in conventional banking where much fair practice
needs to be imposed by external regulation (Haron, 1996).
The basic aim of any bank is generating profit, which is essential
requirement for conducting any business (Bobáková, 2003). To measures
profitability of the banks’, the common criteria used by BB are Return on
Asset (ROA) and Return on Equity (ROE) (Bangladesh Bank, Annual Report,
2011). In addition to this, another important profitability measure is Return on
Deposit (ROD) (Shrivastava, 1979). The profitability of any bank depends to a
great extent on the asset utilization and operational efficiency. The level of
bank’s resources invested in earning asset contributes to the increased income
and profitability of that bank. Besides, the amount of assets that constitute
credits and investments is an important asset management decision.
Furthermore, income or profit of a bank is the result of revenue function and
cost function. The revenue function shows that the total income of a bank
deriving from the service rendered by the bank and the cost function shows
total expenses incurred in producing any service rendered by the bank (Khan
2008). Hence, efficient management of these functions or operations would
lead to increase profitability for the bank. The aforesaid discussion led to the
assumption that there is a measurable linkage of profitability of a bank with its
asset management and operational efficiency. Henceforth, this study proposes
to evaluate the profitability of sample Islamic banks based on common
profitability indicators. Furthermore, this paper also investigates the
relationship of one of the profitability measure, i.e. ROA with operational
efficiency, asset utilization and ROD.

2. Banking Industry of Bangladesh

The financial system of Bangladesh is dominated by banks. The banking
sector of Bangladesh comprises of Bangladesh Bank as central Bank and four
categories of scheduled banks. There are four State-owned Commercial Banks
(SCBs), four State-owned Development Financial Institutions (DFIs), thirty
Private Commercial Banks (PCBs) and nine Foreign Commercial Banks
(FCBs).The total number of banks is 47 as of 2011. These banks had a total
number of 7961 branches during 2011. The maximum number of branches is
held by SCBs followed by PCBs, DFIs and FCBs. Structure of the banking
sector with breakdown for each category is shown in Table-1.

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 Table 1: Banking System Structure, 2011
(in Billion Tk.)
Bank Types Number Number of Total % of Deposits % of
of Branches Assets Industry Industry
Banks Assets Deposits
SCBs 4 3437 1629.2 27.8 1235.6 27.4
DFIs 4 1406 328.8 5.6 214.4 4.8
PCBs 30 3055 3524.2 60.0 2787.5 61.8
FCBs 9 63 385.4 6.6 272.2 6.0
Total 47 7961 5867.6 100.0 4509.7 100.0

Source: Bangladesh Bank, Annual Report 2012

In 2011, PCBs held 60 percent of the total industry assets whereas SCBs
held 27.8 percent. The least amount of share of industry assets is held by FCBs
and DFIs which are 6.6 percent and 5.6 percent respectively. The PCBs share
of total industry deposits is 61.8 percent during 2011 which was 27.4 for
SCBs, 6 percent for FCBs and only 4.8 percent for DFIs. These data indicates
that the performance of PCBs in terms of deposit mobilization and investment
in assets is superior compared SCBs, FCBs and DFIs. However, it should be
noted that maximum number of scheduled banks fall under the PCBs category,
therefore, PCBs holding of maximum share of deposits and assets in the
banking industry is justified.

2.1 Islamic Banking

Bangladesh entered into Islamic banking system alongside the
conventional interest based banking system in 1983. Table 2 reports the
number of Islamic banks and Islamic banking branches operating during 2011
and also the market share of the Islamic banking sector in terms of financing,
deposits and liquidity of the total banking system. During 2011, out of 47
banks in Bangladesh, 7 PCBs are operating as full-fledged Islamic banks and
16 conventional banks including 3 FCBs are involved in Islamic banking
through Islamic banking branches. The full-fledged Islamic banks are Islami
Bank Bangladesh Limited, Shahjalal Islami Bank Limited, Al-Arafah Islami
Bank Limited, First Security Islami Bank Limited, ICB Islamic Bank Limited,
Export Import Bank of Bangladesh Limited and Social Islami Bank Limited.

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 Table 2: Comparative Position of the Islamic Banking, 2011
(in Billion Tk.)
Islamic All
Islamic Dual
Particulars Banking Banking
Banks Banking
Sector Sector
Number of Banks 7.0 16.0 23.0 47.0
Deposits 751.2 56.2 818.9 4484.4
Investments (Credit) 693.0 45.8 738.8 3642.6
Credit Deposit Ratio 90.9 81.4 90.2 79.7
Liquidity: Excess (+) Shortfall (-) 31.0 0.5 31.5 358.5

Source: Bangladesh Bank, Annual Report 2012

Total deposits of the Islamic banks and Islamic banking branches of the
conventional banks stood at Tk. 818.9 billion at the end of December, 2011
and this was 18.3 percent of deposits of the total banking system. During 2011
total financing by the Islamic banks and the Islamic banking branches of the
conventional banks stood at Tk. 738.8 billion which was 20.3 percent of the
credit of the total banking system of the country. Excess liquidity maintained
by Islamic banking sector was Tk. 31.5 billion during 2011 and this was 8.8
percent of the excess liquidity maintained by the total banking system. During
2011 credit to deposit ratio of Islamic banking sector stood at 90.2 percent
which is higher compared to the ratio of 79.7 percent maintained by the total
banking system. Therefore, this data indicates, Islamic banking sector has
ample contribution in the total growth of the banking industry of Bangladesh.
3. Literature Review
Profitability is an important measure of financial performance for any
bank. Analysis of profitability of a bank provides an insight into the effective
utilization of assets. Although, there are various measures of earnings and
profitability, the best and widely used indicator is ROA, which is
supplemented by ROE and ROD.
Loans and investment in securities are a bank's assets and are used to
provide most of a bank's income. The ROA is a financial ratio used to measure
the relationship of earnings to total assets. It is a ratio of net earnings divided
by total assets. According to DuPont Analysis, ROA indicates both income
management and cost management of banks by including both asset utilization
ratio and net profit margin ratio. Asset utilization ratio is measured by total
operating revenue to total assets and net profit margin ratio is measured by net
earnings to total operating revenue. Therefore, ROA assesses how efficiently
bank is managing its revenues and expenses and also reflects the bank

4
managements’ ability to generate profits by using the available financial and
real assets (Clark et al. 2007 and Lopez 1999). Numerous studies have been
found to use ROA as a criterion for measuring profitability (Peters et al. 2004
and Tarawneh, 2006).
To extend credit or loan and to invest in securities, a bank must have
money, which comes primarily from the bank's owners in the form of equity
capital, from depositors, and from money that it borrows from other banks or
by selling debt securities. Credits and investments are important sources of
both interest income and non-interest income of the firm. Hence, this study
employs ROE as a measure of profitability, which is a ratio of net earnings to
shareholders’ equity. This ratio indicates to what extent bank is using equity
fund to produce earnings. The growth in ROE depends on how actively and
efficiently the bank is managing its equity capital. Peters et al. (2004) and
Tarawneh (2006) have used the ratio as an indicator of profitability. According
to DuPont Analysis, ROE equals ROA multiplied by Equity Multiplier (EM),
which indicates the usage of leverage and effect of leverage on ROE of a bank
(Clark et al. 2007 and Lopez 1999).
ROD is considered to be better index of profitability in the same way as
return on sales for non-banking companies. It is a ratio of net earnings to total
deposits (Shrivastava, 1979). This ratio shows percentage return on each dollar
of customers’ deposit. In another words, it indicates the effectiveness of bank
in converting deposits into net earnings (Rosly and Bakar 2003 and Tanaweh,
2006).
Furthermore, profitability is considered as an index of operational
efficiency of banks (Shrivastava1979). Efficiency ratio is a popular tool used
by bank financial analyst to evaluate the ability of bank to manage its costs.
Operational efficiency of a bank is calculated by the ratio of non-interest
expense to total operating income. It measures the level of non-interest
expense needed to support one dollar of operating income, consisting of both
interest income and non-interest fee income (Hays et al., 2009).
Investigating the financial performance and determinants of bank
profitability has been one of the popular topics among researchers in banking
studies. Till date, researchers have managed to examine and identify various
factors that have a significant influence on banks performance and
profitability. The literature divides the determinants of bank profitability into
two categories, namely internal and external. Internal determinants of

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profitability, which are within the control of bank management, are basically
financial statement variables. External variables are those factors that are
considered to be beyond the control of management of a bank. Among the
widely discussed external variables are competition, regulation, concentration,
market share, ownership, scarcity of capital, money supply, inflation and size
(Haron, 2004).However, current study focuses on only internal factors or
financial statement variables.
Begrer (1995) examined the relationship between ROE and the capital
asset ratio of US banks and found them to be positively related. Positive
correlation between ROE and capital has been evident in many past studies
(Keeley and Furlong, 1990; Naceur, 2003; and Kwan and Eisenbeis, 2005).
Empirical evidence form Naceur and Goained (2001) indicate that the best
performing banks are those who have maintained a high level of deposit
accounts relative to their assets and this lead to higher return on assets.
Guru et al. (2002) found efficient expenses management as one of the
significant factor in explaining Malaysian banks’ profitability. Bashir (2003)
found Islamic bank’s profitability measures respond positively to the increases
in capital and negatively to loan ratios. Haron and Azmi (2004) reported in
their study that liquidity, deposit items and asset structure, inflation and money
supply has statistically significant impact on profitability of Islamic banks.
Tarawneh (2006) found that financial performance of the Omani banks was
strongly and positively influenced by the operational efficiency and asset
management, in addition to the bank size. Naceur and Goaied (2008) examine
the impact of bank characteristics, financial structure, and macroeconomic
conditions on Tunisian banks' net-interest margin and profitability during the
period of 1980 to 2000.The study suggest that banks that hold a relatively high
amount of capital and higher overhead expenses tend to exhibit higher net-
interest margin and profitability levels, while size is negatively related to bank
profitability.
Kosmidou (2008) examined the determinants of performance of Greek
commercial banks during the period 1990-2002. This study found that
profitability is positively associated with well capitalized banks and lower cost
to income ratios. This study also suggests that the growth of Gross Domestic
Product (GDP) is positively related to bank profitability, while inflation rate is
negatively related to bank profitability during the period under study. More
recently, Sufian and Habibullah (2009) reported in their study that bank
specific characteristics in particular loan intensity credit risk and cost have

6
positive and significant impacts on profitability of Bangladeshi banks, while
non-interest income exhibits negative relationship with bank profitability. This
study found that size has a negative impact on Return on Average Equity
(ROAE) while it has positive impact on Return on Average Assets (ROAA)
and Net Interest Margin (NIM)
The aforesaid discussion indicates that there is abundance of literature on
banks’ performance studies and on determinants of profitability, but these
studies are mostly confined to conventional banks. Up to this date, there has
been little research in Bangladesh on the profitability of Islamic banks. The
present research is conducted considering the importance of Islamic banks’
role in both micro and macro level economy of Bangladesh. Henceforth, this
research contributes to the existing literature on banking studies written in the
context of Bangladesh.
4. Objectives of the Study
The objectives of this study are as follows:
i. To evaluate the profitability position of selected banks with profitability
ratios- ROA, ROE and ROD.
ii. To examine ROA and ROE of selected banks through DuPont
Analysis.
iii. To examine the relationship of one of the profitability measures, i.e.,
ROA with operational efficiency, asset utilization and ROD.
5. Methodology of the Study
The sample consists of six Islamic banks, which are randomly selected for
this study and constitutes about 86% of the seven full-fledged Islamic banks of
Bangladesh. These banks are Islami Bank Bangladesh Limited (IBBL),
Shahjalal Islamic Bank Limited (SJIBL), Al-ArafahIslami Bank Limited
(AAIBL), First Security Islami Bank Limited (FSIBL), ICB Islamic Bank
Limited (ICBIBL) and Export Import Bank of Bangladesh Limited
(EXIMBL). This study also aims to examine the relationship of ROA with
operational efficiency, asset utilization, and ROD. This research primarily
focuses on secondary data collected from the annual reports of selected Islamic
banks. The present study covers the relevant data for the period 2008-2012
only.

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 The profitability measures used in this study are ROD, ROA and ROE. In
addition, ROA and ROE are also decomposed with the help of DuPont
Analysis. Five years average is calculated for all the selected profitability
measures for analyzing profitability and examining the statistical association
between dependent and independent variables. In examining empirical
relationship between ROA and three independent or explanatory variables,
named operational efficiency, asset utilization and ROD, correlation and
regression have been used Simple correlation coefficient is used to test the
linear relationship among all the dependent and independent variables.
Furthermore, to determine the significance of a correlation coefficient, a t-test
is performed, which hypothesizes that linear relationship between two
variables is zero. The result of correlation and t-test is reported through a
correlation matrix table. Multiples regression analysis is used to see how far
the explanatory variables are related with ROA. To test the significance of beta
coefficients t-test is utilised. In addition to this, ANOVA is used to examine
the significance of coefficient of determination that is R-square and to report
the fitting of regression equation with the help of ‘F’ value.
6. Findings and Analysis
6.1. Comparison of the Bank’s Profitability Measures- ROA, ROE, and ROD
According to DuPont Analysis, ROE is decomposed into the profitability
of assets indicated by ROA and the leverage of the bank measured by EM. By
decreasing equity and increasing leverage, i.e. EM, a bank can increase ROE
based on any given level of ROA.
Table 3: ROE: DuPont Analysis (ROE= ROA × EM)

Ratios SJIBL FSIBL EXIMBL AAIBL IBBL ICBIBL

ROE 21.31% 11.70% 20.38% 20.15% 14.41% -26.42%
ROA 1.86% 1.46% 2.24% 1.92% 1.34% -7.83%
EM 11.46 7.65 9.57 10.49 10.75 3.37
Source: Author’s Calculation

As it is visible from the Table 3, ROE is highest for SJIBL, which is

recorded as21.31%. This result can be justified by the increased use of
leverage as reported by the higher EM of SJIBL. The lowest ROE is accounted
for ICBIBL, which is -26.42%. This poor performance of ICBIBL in terms of
ROE is contributed to the losses incurred from bank’s assets (ROA) and less
usage of leverage as reflected through the EM in Table-3.Ranking of these
banks based on ROE reveals SJIBL to be in first position, EXIMBL to be in
second position and the last position is held by ICBIBL.

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 The DuPont Analysis of ROA for sample Islamic banks is presented in
Table-4. DuPont analysis presented in this table suggests ROA evaluates both
efficiency of bank in utilizing assets and effectiveness in managing income
and expenses indicated by Net Profit Margin (NPM).
Table 4: ROA: DuPont Analysis (ROA= NPM × AU)

Ratios SJIBL FSIBL EXIMBL AAIBL IBBL ICBIBL

ROA 1.86% 1.46% 2.24% 1.92% 1.34% -7.83%
NPM 33.38% 22.15% 36.12% 34.73% 25.19% -289.87%
AU 0.0557 0.0659 0.0590 0.0546 0.0532 0.0911
Source: Author’s Calculation

Highest ROA reported for EXIMBL is 2.13%, which indicates the greater
ability of this bank in generating profit by using its available financial and real
assets and enhancing bank’s efficiency in saving costs and raising income. In
Table-4, highest NPM ratio of36.12% is also reported for EXIMBL which
indicates the bank’s efficiency in managing costs and income. Negative ROA
is reported for ICBIBL which is -26.42%. This negative ROA is a resultant
factor of negative NPM ratio of -289.87%. This is highest negative result
among all the six Islamic banks as reported in Table-4.Rankingof these banks
based on ROA ratio reveals, EXIMBL to be in first position. The second
position is held by AAIBL and the last position would be posted to ICBIBL.
Table 5: ROD Ratio of the Sample Islamic Banks

Ratio SJIBL FBSIL EXIMBL AAIBL IBBL ICBIBL

Return on Deposit 2.19% 0.71% 2.24% 2.49% 1.40% -10.92%
Source: Author’s Calculation

Many financial analysts consider ROD as one of the best measures of

bank profitability performance. This ratio reflects the bank’s management
ability to utilize the customers’ deposits to generate profits. In Table-5, highest
ROD ratio is reported for AAIBL. Higher ROD ratio is reported for both
SJIBL and EXIMBL which are also above 2%. Lowest and negative ROD
ratio is recorded for ICBIBL, which is -10.92%.

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6.2. Association of ROA with Asset Utilization, Operational Efficiency and
ROD
Table 6: Sample Islamic Bank’s Descriptive Statistics

Variable SJIBL FSIBL EXIMBL AAIBL IBBL ICBIBL

Y(ROA) 1.86% 1.46% 2.24% 1.92% 1.34% -7.83%
X1(OE) 30.17% 48.47% 32.43% 30.40% 36.70% 103.13%%
X2(AU) 0.0557 0.0659 0.0590 0.0546 0.0532 0.0911
X3(ROD) 2.19% 0.71% 2.24% 2.49% 1.40% -10.92%
Source: Author’s Calculation

Table-6 provides the descriptive statistics of dependent variable ROA and

independent variables-OE, AU and ROD for six Islami banks. It is evident
from the table that performance of EXIMBL is at peak in terms of profitability
measures ROA and ROD. However, FSIBL’s performance is soaring in terms
of OE and AU even though average asset size of IBBL found to be largest
among all six Islami Banks(Asset size of IBBL is Tk. 342,299.31 whereas that
of EXIMBL is only Tk. 99,401.31 million).
Table 7: Correlation Matrix of All Dependent and Independent Variables

ROA OE AU ROD
ROA Pearson Correlation 1
Sig. (2-tailed)
N 6
OE Pearson Correlation -0.980** 1
Sig. (2-tailed) 0.001
N 6 6
AU Pearson Correlation -0.949** 0.978** 1
Sig. (2-tailed) 0.004 0.001
N 6 6 6
ROD Pearson Correlation 0.997** -0.992** -0.966** 1
Sig. (2-tailed) 0.000 0.000 0.002
N 6 6 6 6
**Correlation is significant at the 0.01 level (2-tailed).
Source: Author’s Calculation

The values reported in Table-6are used to calculate correlation and

conduct regression analysis. The correlation results and results of t-test are
shown in Table-7. The correlation matrix table indicates that there exist
significant positive relationship between ROA and ROD. However, result

10
shows ROA has significant inverse relationship with OE and AU, which is not
expected.
Table 8: Multiple Regression Analysis Result

Particular Coefficient Standard Deviation T-statistic

Constant -0.037 0.013 -2.905
OE (X1) 0.064 0.026 2.490
AU(X2) 0.196 0.252 0.777
ROD (X3) 1.141 0.113 10.117
Standard Error 0.00165675
R2 99.9%
R2(Adjusted) 99.8%

Multiple regression analysis was conducted to examine what affect the

independent variables have on the dependent variable ROA. The multiple
regression result is shown in Table-8 and the critical value of ‘t’ found at 0.10
level of significance is 2.92. This table shows that beta coefficients of
operational efficiency, asset utilization and ROD are positive and the
association of ROA with ROD is a statistically significant. Hence this suggests
that ROD is significant explanatory variable on increasing ROA.
Table 9: Analysis of Variance

Source Degree of Sum of Mean of Squares F-Statistics

Freedom Squares
Regression 3 0.008 0.003 931.877
Error 2 0.000 0.000
Total 5 0.008

To examine whether the regression model as a whole is significant,

coefficient of determination, r-square is calculated. Table-8reports 99.8
percent of the variation in ROA is explained by the regression line. The
calculated value of F-ratio 931.877 as reported in Table-9 is higher than the
critical value of F-ratio 19.2 at 0.05 level of significance which suggest that
the regression model as a whole to be statistically significant.
7. Conclusion
This study utilizes widely used measures of banks’ profitability, which are
ROA, ROE, and ROD and these are also commonly suggested tools by
Bangladesh Bank to evaluate banks’ performance. In addition, this study
evaluates the OE ratio, AU ratio and ROD as a measure of Islamic banks’
profitability measured by ROA. The result reveals that performance of
EXIMBL is excellent, in terms of all profitability measures ROA, ROE and
ROD average asset size data is not reported in this report. The correlation

11
result shows that ROA has significant linear relationship with AU, OE and
ROD. The result of regression found the explanatory variable ROD is
significantly related with ROA but failed to establish any significant
association with OE and AU. The sample size for this study is too small,
constituting only six Islamic banks and this is considered as the major
shortcoming of present study since many commercial banks are operating
Islamic Banking branches. However, the total number of private commercial
banks operating as full-fledged Islamic banks in Bangladesh is only seven.
Furthermore, the data obtained from the sample banks were only for the period
2008-2012 and five years average for all measures of profitability are
calculated, which are also considered as major drawbacks of this study.
Therefore, this prompts further researches in future covering a longer time
period and using panel data model to investigate these stated measures.
Further, future researches can be extended by covering both internal and
external measures of bank’s profitability. The importance of this study may be
viewed as the addition with the existing body of literature on Islamic banking
studies. Furthermore, it can also serve as a starting point based on which future
related studies can be done in the context of Bangladesh.

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