Islamic vs. Conventional Banks in The GCC Countries: A Comparative Study Using Classification Techniques

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Islamic vs. conventional banks in

the GCC countries: A comparative
study using classification
techniques
ARTICLE in RESEARCH IN INTERNATIONAL BUSINESS AND FINANCE AUGUST 2014
DOI: 10.1016/j.ribaf.2014.07.002
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Karim Ben Khediri
Universit Paris Ouest Nanterr
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Lanouar Charfeddine
Qatar University
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Retrieved on: 23 October 2015
Research in International Business and Finance 33 (2015) 7598
Contents lists available at ScienceDirect
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
classication techniques
Karim Ben Khediri a,b,c,1, Lanouar Charfeddine d,e,f,,
Slah Ben Youssef g
a
CEROS, Universit Paris Ouest Nanterre La Dfense, France

College of Administrative Sciences, Najran University, KSA
c
FSEGN, Universit de Carthage, Tunisia
d
Department of Finance and Economics, College of Business and Economics, P.O. Box 2713, Doha, Qatar
e
Institut de prparation ladministration et la gestion, 184 Boulevard Saint-Germain, 75006 Paris,
France
f
Institut Suprieur de Gestion de Gabs (ISGG), University of Gabs, Tunisia
g
Facult des Sciences Economiques et de Gestion de Sfax, route Aroport km 4, BP N 1088, 3018 Sfax,
Tunisie
b
a r t i c l e
i n f o
Article history:
Received 10 December 2013
Received in revised form 13 May 2014
Accepted 23 July 2014
Available online 1 August 2014
JEL classication:
C44
C45
C25
G21
G28
Keywords:
Islamic nance
GCC banking
Classication techniques
a b s t r a c t
This paper contributes to the empirical literature on Islamic
nance by investigating the feature of Islamic and conventional
banks in Gulf Cooperation Council (GCC) countries over the period
20032010. We use parametric and non-parametric classication
models (Linear discriminant analysis, Logistic regression, Tree of
classication and Neural network) to examine whether nancial
ratios can be used to distinguish between Islamic and conventional banks. Univariate results show that Islamic banks are, on
average, more protable, more liquid, better capitalized, and have
lower credit risk than conventional banks. We also nd that Islamic
banks are, on average, less involved in off-balance sheet activities
and have more operating leverage than their conventional peers.
Results from classication models 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
Corresponding author. Tel.: +216 22998570.

E-mail addresses: benkhedirikarim@yahoo.com (K.B. Khediri), lanouar charf@yahoo.fr (L. Charfeddine),
benyoussef slah@yahoo.fr (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) 7598
of protability and liquidity. More interestingly, we nd that the

recent global nancial crisis has a negative impact on the protability for both Islamic and conventional banks, but time shifted.
Finally, results show that Logit regression obtained slightly higher
classication accuracies than other models.
2014 Elsevier B.V. All rights reserved.
1. Introduction
In recent years, many conventional banks have encountered nancial difculties and failure due to
the global nancial crisis of 20072008. In contrast, Islamic banks have successfully withstood this crisis. In empirical literature, most studies have attributed this success of Islamic banks to their nancial
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 nancial institutions worldwide including
banks, mutual funds and insurance rms. In addition, most Western international banks such as Citigroup, HSBC and others have opened Islamic windows. Several factors can explain this rapid growth
of interest-free nance, including strong demand for Sharia-compliant products, improvement in the
legal and regulatory framework for Islamic nance, growing demand from conventional investors for
diversication purposes, and the capacity of the industry to innovate and develop a number of nancial
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 contracts, where the prots 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 xed return). Islamic banks
have developed free nancing products based on prot 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 nancing contracts rather than PLS based nancing contracts. Chong
and Liu (2009) and Khan (2010) nd that only a small portion of Islamic banks nancing 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 nance, 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 efciency
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 protability 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 nancial stability of Islamic banks during the
global nancial crisis (Cihak and Hesse, 2010; Hasan and Dridi, 2010; Beck et al., 2013; Caby and
Boumediene, 2013; Bourkhis and Nabi, 2013).
77
The rapid increase of interest on Islamic banking and their resistance to the global nancial crisis
make it important to examine whether Islamic and Conventional Banks behave similarly or differently
before, during and after the crisis period. Specically, we test whether nancial ratios can be used to
discriminate between the two types of banks. This paper adds to the empirical literature on Islamic
nance 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 worlds largest Islamic banking markets2 ; and the nancial sector in the GCC is
relatively developed compared to other countries in the Middle East.3 Second, in contrast to previous
studies on Islamic nance, 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 classication models. Finally, our sample
period allows us to examine the consequence effects of the global nancial crisis of 20072008 to
both Islamic and conventional banks in term of protability, liquidity and risk ratios.
We perform a comparison between the two types of banks, using the t-test of equality of means,
and some classication techniques. We nd that Islamic banks are, on average, more protable 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 signicantly different from that of conventional banks. Islamic banks have higher operating
leverage and are less involved in off-balance sheet activities. More interestingly, we nd that the
nancial crisis has a negative impact on the protability for both Islamic and conventional banks, but
time shifted. Finally, results from classication models show that some nancial 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 classication
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 nance 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
ofces that offer separate Islamic or Sharia-compliant products within an otherwise conventional
banking structure.
There are ve principles of Islamic nance. These principles are determined by the Sharia or Islamic
law which provides guidelines and legal framework for all aspects of life. (1) The prot and loss
sharing (PLS) principle is one of the most important features of Islamic nance. The provider of capital
funds (lenders) and the entrepreneur (borrowers) share business risk in return of sharing prots
and losses. This PLS principle contradicts those of conventional nance where the rate of return of
nancial assets is xed 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 dened as interest or excessive interest) is the most prominent features of Islamic nance.
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 nancial intermediation, controlling on average 24% of the regions banking
system assets (Al-Hassan et al., 2010).
3
The last 30 years have been characterized by a signicant structural change in the GCC nancial system by implementing
several policies that stimulate nancial liberalization and nancial 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
of gharar (excessive uncertainty) and maysar (excessive risk or gambling).4 (5) The prohibition on
nancing for illicit sectors. Islamic nance 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 nancing. Some of them are based on PLS
such as mudharaba (trustee nance or prot sharing) and musharaka (equity participation or joint
venture) and some other nancial instruments are based on mark-up such as murabaha (cost-plus
nancing), 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 qualication and knowledge on Islamic jurisprudence (Usul al-Fiqh) and/or
Islamic transaction law (Fiqh al-Muamalat). 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
protability and efciency. The majority of studies examine the internal and external factors that affect
the performance of Islamic and conventional banks using nancial 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 nancial characteristics
of 15 interest-free banks and 15 conventional banks over the period 19921994. He nds that the
two groups of banks may be differentiated in terms of liquidity, leverage and credit risk, but not in
terms of protability and efciency. Using data from 24 banks including 12 Islamic banks for the
period 19901998, Iqbal (2001) nd that Islamic banks are better capitalized and more protable
than conventional banks. Olson and Zoubi (2008) examine whether nancial ratios can be used to
distinguish between conventional and Islamic banks in the GCC region over the period 20002005.
They nd 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
protable but less efcient 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
19952009. They nd few signicant differences in business models. However, they nd that Islamic
banks are less efcient, but have higher intermediation ratios, have higher asset quality, and are better
capitalized than conventional banks. They also nd 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 nd that Islamic banks
are, on average, more capitalized and protable than conventional banks. They also nd 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 sh in the sea, birds in the sky, an unborn calf in its mothers womb, un-ripened fruits on the tree, etc., are
forbidden in Islam. An important example of gharar is insurance contract. The interdiction of thats types of contract follows
from the non respectability of the PLS because only the insurance company acquire all the prots 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 dened as all activities involving betting for money or property or
undue speculation.
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 prot efciency levels of 71 commercial banks in GCC countries over the period 19992007. He
nds that in terms of both cost and prot efciency levels, the conventional banks are more efcient
than Islamic banks. Abdull-Majid et al. (2010) investigate the efciency of a sample of Islamic and
conventional banks in 10 countries for the period 19962002, using an output distance function, and
nd that Islamic banks have moderately higher return to scale than conventional banks. Belanes and
Hassiki (2012) examine the efciency of 32 Islamic and conventional banks from the MENA countries
over the period 20062009 and nd no signicant difference in the efciency 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 nancial
characteristics. Our rst hypothesis is about bank protability. Hassoune (2002) shows that Islamic
banks are more protable 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-prot bearing deposits,
or non-remunerated current accounts. He considers these lower costs of funding as a market imperfection, 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 protable. Abedifar et al. (2013) point out that the PLS arrangement provides pro-cyclical protection 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 banks protability is less volatile than
that of the conventional one. Moreover, Abedifar et al. (2013) argue that the religiosity can also inuence the banks performance by encouraging borrowers to fulll their obligations under Islamic loan
contracts. Indeed, clients with religious beliefs are more likely to prefer Islamic to conventional banking and to be prepared to pay rents for receiving nancial 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 protability and bank capital has been reported in previous empirical 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 protability for the former. Therefore,
bank protability 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 protability. 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 protable 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 prot rates. Deposits
are received by Islamic banks in the form of Qard Al-Hasan or Amanaa.
80
Table 1
Existing literature.
Sample
Methodology
Variables
Main results
Metwally (1997)
15 Isl. banks
15 conv. banks
19921994
Logit model
Probit model
Descriminant
analysis
The two groups of banks may be differentiated in

terms of liquidity, leverage and credit risk, but not
in terms of protability and efciency
Iqbal (2001)
12 conv. banks
12 Isl. banks
19901998
T-test for
equality of
means
Olson and Zoubi

(2008)
28 conv. banks
16 Isl. banks GCC
region
20002005
T-test for
equality of
means
Logistic
regression
Neural networks
k-means nearest
neighbors
Srairi (2010)
48 conv. banks
23 Isl. banks GCC
region
19992007
Belanes and Hassiki

(2012)
19 conv. banks
13 Isl. banks MENA
region
20062009
Beck et al. (2013)
Sample of 510 banks

across 22 countries
19952009
stochastic
frontier analysis
T-test for
equality of
means
Data
envelopment
analysis
Wilcoxon
rank-sum test
T-test for
equality of
means,
regression
Liquidity: cash to deposits

Leverage: deposits to assets; equity to assets
Credit risk: funds channeled to direct investments to loanable funds; loans
used to nance durable to total loans; personal loans to total loans
Protability: gross income to assets; average return on deposits
Efciency ratios: operating expenses to assets
Protability: return on asset (ROA); return on equity (ROE)
Bank capital: capital to assets
Liquidity: cash and accounts with banks to total deposits
Deployment ratio: total investment to total equity and total deposits
Efciency: cost to income ratio
Protability: ROA; ROE; prot margin; return on deposits; return on
shareholders capital; net operating margin
Efciency: interest income to expenses; operating expense to asset; operating
income to assets; operating expenses to revenue; asset turnover; net interest
margin; net-non interest margin
Asset quality: provision to earning assets; adequacy of provisions for loans;
write off ratio; loan to assets; loans to deposits
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
Protability: net prot to average total assets
Capital adequacy: equity to total assets
Credit risk: loans to total assets
Operation cost: cost to income
Size: natural logarithm of total assets
Protability: ROA; ROE; net Interest margin
Liquidity: short-term assets to short-term loans
Risk: total debts to assets; reserves for losses on credits to total credits
There are few signicant differences in business

models. Islamic banks are less efcient, but have
higher intermediation ratios, have higher asset
quality, and are better capitalized than
conventional banks
Abedifar et al. (2013)
553 banks from 24

countries
19992009
Business model: Fee income to operational income; nondeposit funding to

total funding; loans to deposit
Efciency: cost to income ratio; overheads to assets
Asset quality: loss reserves to gross loans; loan loss provisions to gross loans;
nonperforming loans to gross loans;
Stability: z-score; ROA; equity to assets; liquid assets to deposit
Credit risk: loan loss reserves to gross loans; impaired loans to gross loans;
loan loss provision to average gross loans
Insolvency risk: z-score
Bank interest rate: net interest margin; interest income rate; interest expense
rate; loan rate; deposit rate
Financial ratio: equity capital to asset ratio; ROA; ROE; net loans to total
earning assets; cost to income ratio; total assets
T-test for
equality of
means, random
effect regression
Islamic banks are better capitalized and more

protable than conventional banks
Accounting ratios are good discriminators between

Islamic and conventional banks. Islamic banks are
more protable but less efcient than conventional
banks
Conventional banks are more efcient than Islamic

banks
There is no signicant difference in the efciency

scores between these two types of banks
Islamic banks are more capitalized and protable

than conventional banks. Islamic banks have lower
credit risk than conventional banks, specically
small, leveraged, or those operating in countries
with more than 90% Muslim populations. In terms
of insolvency risk small Islamic banks are more
stable than small conventional banks
Authors
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 protable 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 signicantly exceed new
deposits over a short period, then banks get into liquidity trouble. Cash ratios measure the banks
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 prot 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 difcult 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 nancial 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 nancial 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 nance
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 difcult access to liquidity put pressures on Islamic banks to be
more conservative (resulting in less moral hazard and risk taking).
82
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. Specically, 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 rst
bank dates back to no earlier than the 1950s. The GCC region has one of the worlds 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 reects entry barriers and licensing
restrictions on foreign banks, including GCC banks. The GCC Banking sector is well capitalized and
protable. 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 protability 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 countrys banking system defaults is measured by the z-score. The indicator compares the systems
buffers (returns and capitalization) with the systems riskiness (volatility of returns). A higher z-score implies a lower probability of insolvency, indicating that the banking sector is more stable. The z-score (or distance to default) is a ratio, dened 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.
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 20032010 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 nal sample includes 44 conventional
and 18 Islamic banks operating in ve 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 nancial ratios have been considered. In Table 4, we classify these ratios into
ve groups: protability 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 xed 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 nancial 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 rst 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 signicantly different from conventional banks
at 5% level with respect to the most variables used in this study. The protability, 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 signicantly larger at the 5% level. This nding is in line with the rst
hypothesis (H1). However, when we use the ROE as proxy of protability, we do not nd any signicant
difference between Islamic and conventional banks.
Regarding the second hypothesis, when the differences in liquidity between Islamic and conventional banks are signicant, Islamic banks are more liquid. We nd 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 signicant 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 signicant 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 nancing economic activity via lending compared to conventional banks,
The mean value of z-score for the world is 15.5 as reported in the global nancial development report (2014).
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 20032006, 20072008, and 20092010 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 rst wave of the world nancial crisis and its economic wave starting from 2009.
8
84
Kuwait
Bahrain
Domestic credit to private sector (% GDP)

Concentration (%)
Minimum regulatory capital ratio
Bank capital ratio
ROA (%)
ROE (%)
NPLs to total loans (%)
Provisions to NPLs (%)
Z-score
Qatar
Saudi
UAE
2003
2010
2003
2010
2003
2010
2003
2010
2003
2010
47.86
82.58
12
21
1.30
12.10
10.3
67.7
17.43
67.69
80.68
12
20
0.90
7.42
4.5
65.9
18.39
67.73
67.42
12
23
2.03
18.52
6.1
77.7
15.59
76.26
89.58
12
19
1.65
12.32
8.9
33.9
18.87
29.96
93.13
10
2.30
16.67
8.1
85.4
25.31
44.69
83.09
10
21
2.60
18.48
1.7
86.3
25.46
28.39
56.36
8
20
2.27
21.31
5.4
128.2
12.17
39.26
51.80
8
17
1.75
13.35
3
115.7
14.24
36.17
49.24
10
20
2.18
14.50
14.3
88.5
24.41
75.03
59.58
12
21
1.44
10.76
5.6
68
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.
Table 2
Banking sector indicators 20032010.
85
Table 3
Sample description.
Islamic banks
Conventional banks
Bahrain
Kuwait
Qatar
Saudi Arabia
UAE
Total
Islamic banks (%)
No bank
No obs
No bank
No obs
8
4
5
11
15
43
55
32
40
88
120
335
7
2
2
2
5
18
51
14
16
14
36
131
46.66
33.33
28.57
15.38
25.00
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 signicantly lower levels of credit risk compared
to conventional banks. However, we do not nd any signicant 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 gures 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 signicant 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 signicantly better capitalized compared
to their conventional peers. Overall our ndings 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: xed assets to assets
Table 4
Denition of variables.
Ratios
Denitions
Protability
ROA
ROE
Return on assets = Net income/Total assets

Return on equity = Net income/Stockholders equity
Liquidity
CTA
CTD
Cash to assets = Cash/Total assets

Cash to deposits = Cash/Total customer deposits
Credit risk
LLR
NPL
LTA
LTD
Loans loss reserves to gross loans

Non-performing loans to gross loans
Loans to assets = Loans/Total assets
Loans to deposits = Loans/Total customer deposits
Insolvency risk
DA
ETA
DTA
DTE
Debt to assets = Total debt/Total assets

Equity to assets = Total equity/Total assets
Deposits to assets = Deposits/Total assets
Deposits to equity = Deposits/Stockholders equity
Asset structure
FAA
OBSIA
Fixed assets to assets = Fixed assets/Total assets

Off-balance sheet items to assets = Off-balance sheet items/Total assets
86
Overall period 20032010

CV
ROA
ROE
CTA
CTD
LLR
NPL
LTA
LTD
LTE
DA
ETA
DTA
DTE
FAA
OBSIA
2.16
15.40
20.71
31.68
5.19
5.20
55.87
71.76
400.3
89.74
14.26
78.73
628.00
1.05
44.25
IB
2.82
13.10
24.61
31.19
3.08
5.78
54.16
91.51
347.6
79.52
20.32
68.86
441.73
1.59
18.2
Pre-crisis period 20032006

P-value
**
0.022
0.181
0.006***
0.850
0.000***
0.673
0.367
0.005***
0.000***
0.020**
0.000***
0.000***
0.000***
0.001***
0.000***
CV
2.57
17.89
22.63
36.24
5.82
5.11
52.97
68.00
401.8
93.52
14.98
78.80
614.03
0.979
43.70
IB
3.59
16.99
28.11
35.37
3.46
4.81
52.87
89.81
333.2
77.60
22.08
68.58
447.74
1.473
22.32
Crisis period 20072008

P-value
**
0.012
0.518
0.021**
0.855
0.001***
0.842
0.974
0.021**
0.040**
0.069*
0.000***
0.000***
0.000***
0.027**
0.007***
CV
1.92
14.38
20.05
27.48
3.41
3.41
58.47
74.52
484.8
85.94
13.12
79.16
664.23
1.02
50.78
IB
3.64
17.74
21.54
28.82
2.66
3.50
54.73
99.19
344.6
80.25
19.74
67.82
417.79
1.86
16.46
Post-crisis period 20092010

P-value
***
0.001
0.091*
0.538
0.717
0.333
0.931
0.254
0.162
0.001***
0.000***
0.000***
0.000***
0.000***
0.019**
0.000***
CV
IB
P-value
1.57
11.47
17.98
26.81
5.72
7.14
59.05
76.48
462.6
86.02
13.97
78.16
619.54
1.21
38.90
0.56
1.20
20.72
26.05
2.85
9.12
55.85
86.27
376.6
82.21
17.78
70.50
461.68
1.50
13.96
0.035**
0.002***
0.181
0.790
0.001***
0.600
0.384
0.356
0.020**
0.004***
0.004***
0.020**
0.002***
0.421
0.000***
Notes: This table reports the mean of nancial 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.
*
Signicance at 10% level.
**
***
Table 5
Univariate analysis.
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 xed 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
signicant 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 (20032006), the
crisis period (20072008) and the post-crisis period (20092010). Evidence shows that our ndings
over the pre-crisis period do not differ from those over the overall period (20032010). Therefore,
we focus in our analysis on the next two periods to gauge the impact of the rst wave of the world
nancial crisis (20072008) and its economic wave starting from 2009. Concerning the protability, the mean values of ROA and ROE of Islamic banks are 3.64 and 17.74%, respectively, while the
corresponding gures for conventional banks are 1.92 and 14.38%, respectively during the crisis. The
differences between the two groups of banks are statistically signicant. In terms of evolution, there
is no variation in protability for Islamic banks but a slight decrease for conventional banks. However
after the crisis, we observe a substantial decrease in protability for Islamic banks. Therefore, based
on the evolution of the ROA and ROE, we conclude that the Islamic banks outperform the conventional banks before and during the nancial 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
nancial crisis has a negative impact on the protability 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 protability in 2008, while weaknesses in risk-management practices in some
Islamic banks led to larger declines in protability 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 nancial 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, regarding the asset quality, as measured by loans to assets ratio, loans to deposits ratio, and non-performing
loans to loans ratio, we do not nd any signicant differences between Islamic and conventional
banks during and after the nancial crisis. However, in respect to the loans loss reserves to loans ratio,
the difference between Islamic and conventional banks remains negative and statistically signicant,
indicating that Islamic banks have lower credit risk during and after the crisis. Regarding the insolvency 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 xed assets to assets ratio even during and after the nancial
crisis.
5. Parametric and non-parametric methods
Parametric methods (Linear discriminant analysis and Logit model) and non-parametric methods
(neural network and tree of classication) 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 classication, on the other. Whereas the rst two parametric methods use all (statistically signicant) predictor variables simultaneously in the model, the second two
88
non-parametric methods use the predictor variables in a hierarchical and recursive manner. Furthermore, to get a high rate of classication, parametric methods suppose the normality of observations,
no outliers, large size of sample, and homogeneity of the variancecovariance matrix (Rubin, 1990;
Robert, 2002). On the other hand, when these hypotheses are not satised non-parametric methods
become more efcient than parametric methods.
5.1. Parametric methods
Linear discriminant analysis (LDA) and logistic regression are widely used multivariate statistical methods for analysis of data with categorical outcome variables. Both of them are appropriate
for the development of linear classication models. The goal of logistic regression is to nd the best
tting 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 discriminates between two or more classes (Islamic or conventional banks in our study), and to derive a
classication 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 variancescovariances 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 fullled, but in all other situations logistic regression should be more
appropriate. Specically, logistic regression outperforms LDA where one of the assumptions of the
LDA is not satised. Hence, logistic regression is more exible 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 observations based on a set of variables known as predictors or input variables (nancial ratios in our
analysis). The application of this method requires some assumptions: normal distribution of data,
homogeneity of the variancescovariances 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 sometimes 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 = + 1 x1 + 2 x2 + + n xn + i
where i for i [0, 1, 2, ..., n] are discriminant coefcients, x are the input variables or predictors, is
a constant, and i is the error term. These discriminant functions are used to predict the class of a new
observation with an unknown class.
Among the fourteen nancial ratios considered in this study, the LDA method selects the most
signicant 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
classication. Results reported in Table 7 shows that, for the whole period (20032010), ve ratios can
signicantly discriminate between Islamic and conventional banks: ETA, DTA, FAA, OBSIA, and LTD.
The positive and signicant coefcient on the equity to assets ratio (ETA) variable conrms 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 coefcient 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 signicant coefcient 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 signicant
coefcient 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
ROA
ROE
CTA
CTD
LLR
NPL
LTA
LTD
DA
ETA
DTA
DTE
FAA
OBSIA
*
ROA
ROE
CTA
CTD
LLR
NPL
LTA
LTD
DA
ETA
DTA
DTE
FAA
OBSIA
1
0.756***
0.016
0.077*
0.150***
0.204***
0.032
0.094**
0.103**
0.506***
0.302***
0.342***
0.112**
0.055
1
0.009
0.005
0.168***
0.299***
0.073
0.017
0.046
0.023
0.051
0.025
0.010
0.069
1
0.858***
0.332***
0.253***
0.506***
0.389***
0.102**
0.020
0.162***
0.200***
0.016
0.104**
1
0.324***
0.220***
0.480***
0.176***
0.018
0.213***
0.174***
0.179***
0.032
0.133***
1
0.824***
0.340***
0.201***
0.184***
0.112**
0.002
0.036
0.003
0.016
1
0.409***
0.287***
0.074
0.172***
0.043
0.091*
0.042
0.005
1
0.534***
0.061
0.119***
0.049
0.133***
0.012
0.065
1
0.070
0.189***
0.622***
0.123***
0.030
0.060
1
0.172***
0.128***
0.459***
0.048
0.036
1
0.636***
0.680***
0.250***
0.062
1
0.174***
0.120**
0.011
1
0.229***
0.049
1
0.049
**
***
Table 6
Pearson correlation coefcients.
89
90
Table 7
The linear discriminant analysis results.
LTD
ETA
DTA
FAA
OBSIA
Canonical correlation
Wilks Lambda
Chi2
P-value
Hit rate (%)
No obs.
Overall period
20032010
Pre-crisis period
20032006
0.279***
(0.000)
0.477***
(0.000)
0.296***
(0.000)
0.260***
(0.000)
0.649***
(0.000)
0.481***
(0.000)
0.770***
(0.000)
0.514***
(0.000)
0.269***
(0.000)
0.591***
(0.000)
0.532
0.717
144.037
0.000
81.20
432
0.556
0.691
76.731
0.000
80.20
208
Crisis period
20072008
Post-crisis period
20092010
0.844***
(0.000)
0.418***
(0.000)
0.443***
(0.000)
0.528***
(0.000)
0.754***
(0.000)
0.543
0.705
19.211
0.000
82.80
114
0.519
0.730
51.373
0.000
78.40
113
Notes: This table reports the results from linear discriminant analysis model. P-values are reported in parentheses.
***
for Islamic banks. This result is not consistent with our third hypothesis. The positive coefcient on
xed assets to assets ratio (FAA) and the negative coefcient on off-balance sheet items to assets
ratio (OBSIA) indicate that Islamic banks have higher operating leverage and less involved in offbalance sheet activities, respectively. Finally, Results indicate that the protability and liquidity ratios
cannot discriminate between the two groups of banks. Hence, the rst two hypotheses, pertaining to
protability and liquidity, are not supported by the LDA results.
We also repeat the LDA over the sub-periods. Results over the pre-crisis period (20032006) 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 (20072008), the LDA retain only two variablesequity to assets ratio (ETA) and off-balance sheet items to assets ratio (OBSIA)-with the same sign on
the coefcients. Results over the post-crisis period (20092010) 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 classication 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:
log
p
1p
= + 1 x1 + 2 x2 + + n xn + i
where p is the probability of the outcome of interest, is the intercept term, i for i (0, 1, . . ., n)
represents the coefcient associated with the corresponding explanatory variable xi for i (0, 1, . . ., n),
and i 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 coefcients of corresponding parameters when the logistic
regression models are used.
The classication results of logistic regression are sensitive to high correlation between the explanatory variables. Hence, we excluded some of the explanatory variables because of the problem of
91
Table 8
Logit model result.
LLR
LTA
ETA
DTA
OBSIA
FAA
Constant
LR Chi2
P-value
R squared
Hit rate (%)
No obs.
Overall period
20032010
Pre-crisis period
20032006
Crisis period
20072008
Post-crisis period
20092010
14.48***
(0.001)
2.282***
(0.063)
14.37***
(0.000)
4.923***
(0.009)
8.127***
(0.000)
26.47**
(0.040)
14.89***
(0.003)
15.734*
(0.019)
5.598*
(0.093)
28.97***
(0.000)
4.905**
(0.050)
13.08**
(0.014)
9.986***
(0.000)
11.26***
(0.000)
1.394
(0.481)
183.15
0.000
0.389
87.27
432
2.720
(0.239)
72.89
0.000
0.348
87.98
208
4.781
(0.019)
62.06
0.000
0.458
88.60
114
3.400*
(0.079)
46.15
0.000
0.352
82.30
113
13.72***
(0.001)
5.320**
(0.033)
6.154
(0.000)
Notes: This table reports the results from stepwise logit model. P-values are reported in parentheses.
*
**
***
multicolinearity. The Pearson correlation coefcients are reported in Table 6. The nal selected specication is obtained using backward stepwise method.
Results from logistic regressions are reported in Table 8. For the whole period (20032010), only
six predictor variables out of fourteen are statistically signicant 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), xed assets to
assets ratio (FAA), and off-balance sheet items to assets ratio (OBSIA). The positive coefcient on the
equity to assets ratio (ETA) conrms that Islamic banks are more capitalized. The deposit to assets ratio
(DTA) shows a signicant and negative coefcient, which indicate that Islamic banks are characterized
by a lower level of deposit to assets ratio compared to conventional banks. The coefcient on loans
to assets ratio (LTA) is positive and signicant 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 coefcient on loans loss reserves to loans ratio indicate that Islamic
banks have lower credit risk than conventional banks. Overall, these ndings suggest that Islamic
banks are less risky compared to conventional banks, supporting our second hypothesis. Finally, the
negative coefcient 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 coefcient on
xed assets to assets ratio (FAA) indicates that Islamic banks hold more xed 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 coefcients on these ratios remain
unchanged. The success rate, or classication accuracy, for these four logistic models ranges from
82.3% for the post-crisis period to 88.6% for the crisis period.
92
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 outputs 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 nd 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
specied 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 network 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 nal layer providing 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 classication rule of the neural network is as follows: If the output unit 0.5, then the observation 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 classication 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
nancial ratios. Table 9 shows the importance and the normalized importance of all variables in the
neural network classication model. The importance of an independent variable measures how much
the networks 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 (20032010), 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 xed assets to assets ratio (FAA). OBSIA scored 15.9%, which indicates that
OBSIA strongly inuence the predicted value of the model. On the other hand, ROE has the lowest
importance level of 1.2% which suggests that the protability has no inuence on the predicted value.
For the pre-crisis period (20032006), 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), xed assets to assets ratio (FAA), etc. For the crisis period (20072008), equity to assets
Overall period 20032010
Pre-crisis period 20032006
Importance
Normolized
importance
(%)
Importance
Normolized
importance
(%)
Importance
Normolized
importance
(%)
Importance
Normolized
importance
(%)
ROA
ROE
CTA
CTD
LLR
NPL
LTA
LTD
DA
ETA
DTA
DTE
FAA
OBSIA
0.039
0.022
0.057
0.089
0.113
0.076
0.089
0.075
0.074
0.068
0.044
0.062
0.052
0.192
20.60
11.20
29.90
46.60
58.80
39.80
46.60
39.30
38.60
35.70
22.80
32.30
27.10
100.00
0.031
0.032
0.057
0.064
0.039
0.054
0.076
0.092
0.083
0.063
0.089
0.047
0.115
0.158
19.50
20.20
36.10
40.30
24.60
34.50
48.40
58.60
52.90
39.90
56.20
29.70
73.00
100.00
0.049
0.029
0.060
0.013
0.082
0.103
0.070
0.077
0.112
0.088
0.074
0.101
0.085
0.055
43.60
25.50
53.80
11.90
73.00
92.30
62.80
69.00
100.00
78.70
65.60
90.00
76.20
49.30
0.035
0.063
0.083
0.046
0.043
0.097
0.074
0.147
0.062
0.037
0.030
0.024
0.097
0.163
21.40
38.40
51.10
28.40
26.10
59.80
45.60
90.30
38.00
22.60
18.30
14.60
59.40
100.00
Hit rate (%)
87.4%
81.9%
Crisis period 20072008
81.8%
Notes: This table reports the neural network results, specically the importance and normalized importance for independent variables.
Post-crisis period 20092010
79.7%
Table 9
Neural network results.
93
94
Fig. 2. Classication tree.
ratio (ETA) is ranked rst with the highest importance value, followed by loans to deposits (LTD), xed
assets to assets ratio (FAA), deposits to equity (DTE), off-balance sheet items to assets ratio (OBSIA),
etc. Finally for the post-crisis period (20092010), 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 classication accuracy, for these
four neural network classication models ranges from 58.3% for the crisis period to 86.3% for the
overall period.
5.2.2. The Classication tree
Classication trees are among the classication 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).
Classication 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 classication 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 classication tree model. The importance of an independent variable measures how much the classications
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 (20032010), 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 inuence the predicted value of the model. On the other hand, ROE has the lowest importance level of 0.6%
which suggests that the protability has weak or no inuence on the predicted value. For the pre-crisis
period, the best discriminant variables are, in order of importance, equity to assets ratio (ETA), deposits
Overallperiod 20032010
Pre-crisisperiod 20032006
Crisisperiod 20072008
Post-crisisperiod 20092010
Importance
Normalized
importance
Importance
Normalized
importance
Importance
Normalized
importance
Importance
Normalized
importance
ROA
ROE
CTA
CTD
LLR
NPL
LTA
LTD
DA
ETA
DTA
DTE
FAA
OBSIA
0.009
0.006
0.015
0.011
0.060
0.051
0.046
0.033
0.069
0.061
0.087
0.094
0.014
0.134
6.40
4.80
11.40
8.60
44.70
38.30
34.60
24.90
51.70
45.70
64.50
70.40
10.50
100.00
0.040
0.026
0.036
0.018
0.003
0.009
0.010
0.015
0.086
0.032
0.050
0.012
0.001
0.234
22.20
14.90
20.00
9.80
1.60
4.90
5.60
8.40
48.31
17.90
28.20
6.74
8.00
100
0.112
0.002
0.000
0.000
0.025
0.006
0.000
0.002
0.198
0.214
0.114
0.214
0.047
0.186
46.67
0.83
00.00
00.00
11.68
2.80
00.00
0.83
82.50
100.00
47.50
100.00
19.58
77.50
0.016
0.057
0.018
0.018
0.049
0.000
0.016
0.020
0.066
0.109
0.053
0.048
0.018
0.129
12.40
41.19
13.95
13.95
37.98
0.07
12.40
15.50
51.16
84.49
41.08
37.21
13.95
100.00
Hit rate (%)
75.3%
80.2%
72.7%
Notes: This table reports the classication tree results, specically the importance and normalized importance for independent variables.
75.0%
Table 10
Classication tree Results.
95
96
Table 11
Classication accuracies and error analysis.
Correctly
predict IB (%)
Predict CB but
IB (type I error)
(%)
Correctly
predict CB (%)
Predict IB but
CB (type error
II) (%)
Overall
classication
accuracy (%)
Overall period (20032010)

66.98
LDA
83.82
Logit
57.40
Neural Network
63.00
Tree classication
33.02
16.18
32.60
37.00
85.80
87.91
95.80
80.90
14.20
12.09
04.20
19.10
81.20
87.27
87.40
75.30
Pre-crisis period (20032006)

58.70
LDA
86.96
Logit
33.30
Neural Network
63.00
Tree classication
41.30
13.04
66.70
37.00
86.14
88.11
98.60
85.70
13.86
11.89
01.40
14.30
80.20
87.98
81.90
80.20
Crisis period (20072008)

76.47
LDA
85.19
Logit
68.80
Neural Network
87.50
Tree classication
23.53
14.81
31.20
12.50
85.36
89.66
87.20
68.00
14.64
10.34
12.80
32.00
82.80
88.60
81.80
72.70
Post-crisis period (20092010)

65.95
LDA
70.83
Logit
Neural Network
30.40
31.00
Tree classication
34.05
29.17
69.60
69.00
83.06
85.39
100.00
95.20
16.94
14.61
00.00
04.80
78.40
82.30
79.70
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 (20072008), equity to assets ratio (ETA) is ranked rst
with the highest importance value, followed by deposits to equity ratio (DTE), debt to assets (DA), offbalance sheet items to assets ratio (OBSIA), deposits to assets ratio (DTA), etc. Finally for the post-crisis
period (20092010), 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 classication accuracy, for these four classication 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 classication models
The classication 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, classication accuracy rate is the most common quantitative measure used in evaluating
the predictive accuracy of classication models. In addition, it represents the percentage of banks
that are classied correctly. For the whole period (20032010), the overall classication accuracy is
higher for the Logit regression and Neural network model, with a rate of 87% compared to the LDA
and classication tree models (81.2% and 75.3%, respectively). For the sub-periods, Logit regression
obtained slightly higher classication accuracies than other classication models. Overall, the different
models achieve high rate of classication accuracies, suggesting that nancial ratios can be used to
distinguish between Islamic and conventional banks.
6. Summary and implications
Islamic nance 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 nance have investigated and
explained the general Islamic principles and the instruments used in Islamic banking, recent
97
researches have investigated whether protability, efciency, and risks differ signicantly 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 nancial ratios and some
parametric methods (linear discriminant analysis and logistic regression) and non-parametric methods (neural network and the classication tree). Moreover, we contribute to Islamic nance empirical
literature by testing three hypotheses examining the protability, liquidity, and risk of Islamic and
conventional banks.
This study documents several interesting ndings. First, we show that Islamic and conventional
banks behave somewhat differently. Mean tests results show that Islamic banks are more protable,
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 nancial ratios.
Specically, classication 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 protability and liquidity. Finally, the current paper provides insights into the potential of using
classication 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, efciency, 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-dened regulatory and supervisory framework, and risk management tools for Islamic banking,
taking into account specic 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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Islamic vs. conventional banks in

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Islamic versus conventional banks in the GCC

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of protability and liquidity. More interestingly, we nd that the

The two groups of banks may be differentiated in

Olson and Zoubi

Belanes and Hassiki

Beck et al. (2013)

Sample of 510 banks

Liquidity: cash to deposits

There are few signicant differences in business

Abedifar et al. (2013)

553 banks from 24

Business model: Fee income to operational income; nondeposit funding to

Islamic banks are better capitalized and more

Accounting ratios are good discriminators between

Conventional banks are more efcient than Islamic

There is no signicant difference in the efciency

Islamic banks are more capitalized and protable

Islamic banks are more protable than conventional banks.

Islamic banks hold higher liquidity than conventional banks.

Islamic banks are less risky than conventional banks.

4. Data and variables

Domestic credit to private sector (% GDP)

Sources: World Bank World Development Indicators and National authorities.

Islamic banks (%)

Return on assets = Net income/Total assets

Cash to assets = Cash/Total assets

Loans loss reserves to gross loans

Debt to assets = Total debt/Total assets

Fixed assets to assets = Fixed assets/Total assets

Overall period 20032010

Pre-crisis period 20032006

Crisis period 20072008

Post-crisis period 20092010

Signicance at 10% level.

Fig. 1. Neural network with one hidden layer.

5.2. Non parametric methods

Overall period 20032010

Pre-crisis period 20032006

Hit rate (%)

Crisis period 20072008

Post-crisis period 20092010

Fig. 2. Classication tree.

Hit rate (%)

Overall period (20032010)

Pre-crisis period (20032006)

Crisis period (20072008)

Post-crisis period (20092010)

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