Introduction

Differences between
the financial
characteristics of
interest-free banks and
conventional banks

Many countries, all over the world, currently

experience what became known as dual
banking, where interest-free banks operate
side by side with conventional banks. The
first country which enjoyed a dual banking
system is the United Arab Emirates where
the Dubai Islamic Bank was established in
1973 with a paid-up capital of US$14 million. This bank conducts normal business
like any conventional bank but does not pay
or receive interest. It operates on profit/loss
sharing principles following the Islamic laws
(known as Shariah) which prohibit interest
on any type of transaction. The creation of
the Dubai Islamic Bank was followed by the
establishment of a large number of banks
operating, in various parts of the world, on
the same principles. Currently, there are
more than 100 interest-free banks operating
in 45 different countries including the UK,
Denmark, Luxembourg, Switzerland, the
Bahamas and Cyprus. Also, the entire banking system in Iran, Pakistan and the Sudan is
interest-free.
The aim of this paper is to find out if the
application of the profit/loss sharing principle
results in any structural difference between
interest-free banks and conventional (interestbased) banks. This study is considered pioneer and innovative in three ways. First, it
uses high-powered statistical techniques in
deriving empirical evidence related to interest-free banks. Second, it has a much wider
scope than previous work. Third, the analysis
extends to a number of financial characteristics which were not subject to previous empirical research. (Previous work on the subject
has been descriptive in nature with a narrow
scope and a focus on few financial characteristics. See, for example, Abdel-Gader, 1990;
Brown, 1994; Choudhury, 1992; Moore,
1990; and Ray, 1995.)
The paper is divided into four sections.
The first gives a brief outline of the basis for
interest-free banks and their tools. The second
discusses the methodology and the data. The
statistical results of the logit model, the profit
model and the discriminant analysis are given
in the third section. Finally, the fourth section
summarizes the main findings of the study.

M.M. Metwally

The author
M.M. Metwally is a Professor in the Department of
Economics, University of Wollongong, Wollongong,
Australia.
Abstract
Uses logit, probit and discriminant analysis to test for
structural differences between the financial characteristics
of interest-free banks and conventional banks. The
analysis extends to various financial dimensions which
evaluate performance, namely: liquidity, leverage, credit
risk, profitability and efficiency. Covers 15 interest-free
banks and 15 conventional banks. The statistical evidence
suggests that the two groups of banks may be differentiated in terms of liquidity, leverage and credit risk, but not in
terms of profitability and efficiency.

European Business Review

Volume 97 Number 2 1997 pp. 9298
MCB University Press ISSN 0955-534X

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M.M. Metwally

Volume 97 Number 2 1997 9298

The basis for interest-free banks

some understanding of interest-free banking

methods, even if the exporter is not involved
directly with an interest-free bank and the
contact is through a Muslim importer, so that
the Western exporter can appreciate the
principles of operation involved.
Interest-free banks use tools which are
quite different from those used by traditional
banks. The most important of these tools are
(for more details see Metwally, 1993):
Partnership (Musharaka). This is a joint
venture between the bank and a client
designed for a certain project and ending
within an agreed period of time. The two
parties share any realized profit or incurred
loss according to an agreed ratio (AbdelGader and Al-Ghahtani, 1990).
Investment with no participation in management (Mudarabah or Quiradh). This may be
defined as a contract between two parties
in which the Modareb (the money provider)
pays a certain amount of money to a business man for the purpose of investing in a
specific profit-making project. The bank
and its client share profits but the client
does not share in losses as long as he is not
negligent (Moore, 1990).
Resale Contract (Murabaha). Murabaha is a
form of financing where the bank purchases for a client certain commodities based
on his request. The client promises to buy
the goods from the bank on a pre-agreed
profit basis. The bank justifies the profit on
the grounds that it takes some risks
because the client has no legal obligation to
fulfil his initial promise. Many have criticized this method of finance on the
grounds that it does not strictly conform to
Islamic teachings and introduces interest
through the back-door (Metwally, 1994).
However, Murabaha is the most commonly
used method of finance by interest-free
banks (Kuran, 1995). It is based on the use
of a mark-up or profit margin which does
not seem to differ much (in its calculation
or application) from interest charges used
by conventional banks (Brown, 1994).
This has subjected the interest-free banks
to severe criticisms.

Interest-free banks were established to conform with Islamic law which prohibits interest
on all types of loans (personal, commercial,
agricultural, industrial, etc.) whether these
loans are made to friends, private or public
companies, government or any identity.
Those opposed to interest have recognized
that modern banks perform a useful function
which cannot simply be ignored. The supporters of interest-free banking believe that
the best solution is to permit banks to function but to specify a code under which they
should avoid the payment and receipt of
interest. Such a code already exists and is
being refined and modified constantly to meet
the rapidly changing needs of ever more
sophisticated businesses. The essential principle of interest-free banking is profit/loss sharing. By this, it means both the supplier for the
capital and the borrower share the risks; both
prosper when returns are favourable and
suffer together when returns are poor. This is
the basis for what became known as interestfree banks.
Currently, there are more than 100 interest-free banks active in 45 different countries.
The Al Baraka group, which began at the start
of the 1980s, is the fastest growing interestfree banking group with branches in the
Middle East, Africa and Europe. The Al Rajhi
group, which was developed by a group of
Saudi money changers in 1978, is also
expanding into the UK. It, together with Al
Baraka group and the Kuwait Financial
House, established the Islamic Banking System International which has founded a separate Islamic bank in Denmark (IBID) the
first such European-based bank designed to
encourage trade and development participation between Scandinavia and the Middle
East.
Very few Western business people deal with
interest-free banks, however, as they are
regarded as a strange kind of institution which
functions in unusual ways which few can
understand, although this is now beginning to
change as such institutions penetrate European financial services and set up branches
there (Wilson, 1985). Normally, however, the
first indirect contact most Western business
people have with these banks is when
importers in the Islamic world arrange their
own credit through Islamic banks. It is clearly
important for the Western exporter to have

Methodology and data

The methodology
To test for differences in financial characteristics between the two types of banks, three
models have been used. The probit model,
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Volume 97 Number 2 1997 9298

the logit model and the linear discriminant

function.
In the probit case, the normal distribution
is used so the probability of occurrence of the
dependant variable, P (Y = 1) can be
described as:
Pt = F ( I t ) =

It

1
2

D = discriminant score
bs = discriminant coefficients or weights
Xs= prediction or independent variables.
The coefficients b are calculated to maximize
, by solving:
b Bb
max =
b Wb

exp (t 2 / 2)dt

At maximum, we have:
( B W ) b = 0

where It is an unobservable utility index which

is determined by the explanatory variables, in
such a way that the larger the value of Ij the
greater the probability of a bank being of a
particular kind (for example, interest-free)
and F( ) represents the cumulative normal
density function. The index I is a linear function of X or:

To solve for b, we solve the following characteristic equation:

(W B I ) b = 0.
The maximum value of is the largest eigenvalue of the matrix W-1B and b is the associated eigenvalue. The elements of b are the
discriminant coefficients or weights associated
with the discriminant function (Hair et al.,
1992; Johnson and Wichern, 1982).

I j = 0 + 1 X ij + 2 X2 j + + n X nj
where Xij is the value of the ith independent
variable related to the jth bank. We let Y = 1,
if the bank is interest-free and Y = 0 if it is a
traditional bank. It is assumed that, for each
bank, there is a critical or threshold level of
the index, say I*j, such that if Ij exceeds I*j the
bank will become interest-free; otherwise it
will not.
In the logit model, an equivalent index can
be defined but the logistic function is used to
model the dependent variable (see Judge
et al., 1988; Kramer, 1991; Maddala,
1983):
1
Pt = F ( I t ) = F ( X t ) =
(1 + exp ( X t ))

The data
Almost every Middle East country and a
number of African and Asian countries run
what becomes known as a dual banking
system, where interest-free banks operate
side-by-side with conventional banks. However, the banks of some Muslim countries,
namely Iran, Pakistan and the Sudan, have all
converted to interest-free financial organizations. It was possible to collect data on the
financial characteristics of 30 banks, half of
which are interest-free. Forty-two conventional banks and 19 Islamic banks operating in
various parts of the world, where a dual banking system (or a sole interest-free banking
system) operates, were requested to provide
information on their total assets, equity,
deposits, loans, gross income before tax,
operating expenses, return on deposit and
cash reserves for the three years 1992, 1993
and 1994. Replies were received from 21
conventional banks and 18 interest-free financial institutions. However, only 15 banks of
each group provided enough details for the
purpose of this study.
The data provided by the sample banks
were used to test for structural differences
between the two groups of banks in terms of
the five financial dimensions suggested by
Wood and Porter (1979), namely: liquidity,
leverage, credit risk, profitability and efficiency. Liquidity refers to the bank ability to meet
deposit withdrawals, maturing liabilities and
loan requests without delay. There are several
financial ratios which reflect a bank liquidity

The log of likelihood function (L()) for

either the profit or logit regression is given in
both cases by:
L( ) =

{Yt 1n[ F ( X t )]

t =1

+ (1 Yt )1n[1 F ( X t )]}.
The estimates of the parameters from the two
methods (the probit and the logit) are not
directly comparable. Amemiya (1981) suggests that, if we multiply the logit estimates by
0.625, we will obtain a close approximation
between the logistic distribution and the
distribution function of the standard normal.
The discriminant analysis model involves
linear combinations of the following form
(Lachenbrach, 1975):
D = b0 + b1X1 + b2 X 2 + + bk X k
where:
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Volume 97 Number 2 1997 9298

status. Disagreement exists, however, on what

ratio or ratios are the best liquidity indicators.
The most frequently used indices are the cash
to total assets ratio and cash to total deposits
ratio. This study uses the case-to-deposit ratio
(CD), as an indicator of liquidity. Leverage or
capital adequacy refers to the banks ability to
absorb losses. If these losses are large enough
to wipe out reserves and profit, then the bank
is in danger of becoming insolvent. This study
uses the equity capital plus reserves to total
assets ratio (EA) as an indicator of leverage.
Credit risk analysis ratios were also used to
assess the level of risk in the bank credit policies. Three ratios were used: the ratio of funds
channelled to direct investment to total loanable funds (RL); the ratio of loans used to
finance durables to total loans (DL); and the
ratio of personal loans to total loans (PL). The
study tests the hypothesis that the profit/loss
sharing principle has an important impact on
the loan structure of interest-free banks.
Banks profitability is measured by the ratio of
gross income (before tax) to total assets (YA).
Efficiency is measured by the ratio of total
operating expenses to total assets (XA). Since
Islamic banks are a new experience in the
world of finance, the study also tests the
hypothesis that many savers may approach
these banks with caution. Therefore two more
ratios were considered: the ratio of total
deposits to total assets (DA) and the average
return to deposits (PD). The study tests the
hypothesis that interest-free Islamic banks
face difficulties in attracting deposits. The
study also tests the hypothesis that profit/loss
sharing results in a higher return on deposits
than income from interest.
Thus nine explanatory variables were used
in the regression and discriminant analysis.
The dependent variable is the type of bank
(Y ) where:
Y = 1 if the bank is interest-free,
Y = 0 if the bank is conventional.

the higher the equity/assets, cash/deposits and

the ratio of direct investment to total loans,
the higher the probability that the bank is
operating on a profit/loss share principle, i.e.
is an interest-free bank. The regression results
of both the logit and probit models also reveal
that the coefficients of the variables DA and
PL are negative and statistically significant.
This suggests that the lower the ratios of
deposits to assets and personal loans to total
loans the more likelihood that the bank is an
interest-free bank. On the other hand, the
coefficients of the variables XA, YA, PD and
DL are not statistically significant, suggesting
no real difference between the two types of
banks with respect to the financial characteristics represented by the ratios of operating
expenses to total assets, the ratio of gross
income to total assets, returns on deposits and
the ratio of loans for durables to total loans.
The results of the two-group discriminant
analysis are given in Tables II to VII. The
dependent variable was the two groups of
banks (interest-free banks and conventional
banks) and the independent variables were
the values of the nine financial characteristics
of the two types of banks. The pooled withingroups correlation matrix indicates low correlations between the predictors. Hence, there is
no severe problem of multi-collinearity. The
significance of the univariate F ratio indicates
that, when the indicators are considered
individually, the deposit/assets, personal
loans/total loans, cash/deposits and direct
investment/total loan ratios differentiate
significantly between interest-free banks and
conventional banks.
The eigenvalue associated with the discriminant function is 2.6411 and it accounts
for 100 per cent of the explained variance.
The canonical correlation associated with this
function is 0.8517. The square of this correlation (0.7254), indicates that over 72 per cent
of the variance in the dependent variable is
explained by the model. Also, the Wilkes
lambda () associated with the discriminant
function is 0.275 which transforms to a significant chi-square at the 0.0004 level.
The standardized discriminant function
suggests that the ratio of personal loans to
total loans (PL) is the most important prediction in discriminating between the two types
of banks followed by the cash/deposit ratio
(CD), the ratio of deposits to assets (DA), the
ratio of direct investment to total loans (RL)
and the ratio of equity to assets (EA). The

Statistical results
The results of both the logit and the probit
models are given in Table I. The logit coefficients are reported in their original form. The
figures in parentheses under each coefficient
represent the t values. The logit model gives
marginally better results (in terms of R2 and t
values) than the probit model. The variables
EA, CD and RL are statistically significant
and carry a positive sign. This suggests that
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Table I Results of logit and probit analysis

Independent variables
Constant term
Equity capital plus reserves/total assets (EA)
Total deposits/total assets (DA)
Operating expenses/total assets (XA)
Cash/total deposits (CD)
Gross income/total assets (YA)
Average return on deposits (PD)
Loans for durables/total loans (DL)
Direct investment/total loans (RL)
Personal loans/total loans (PL)
Log of likelihood function
R-squared
Per cent correct predictions

Logit

Probit

157.4
(0.884)
234.5*
(2.098)
250.2**
(2.359)
3885.1
(0.979)
267.0**
(2.482)
4280.2
(0.932)
439.7
(0.776)
371.8
(0.789)
148.0**
(2.288)
138.9**
(2.951)
5.012
0.830
0.967

83.1
(0.774)
142.2*
(2.059)
164.6**
(2.355)
2504.3
(0.875)
168.8**
(2.249)
2643.0
(0.881)
287.6
(0.764)
234.6
(1.042)
91.3**
(2.2601)
84.8**
(2.662)
4.338
0.827
0.967

Notes:
**Significant at the 0.05 level
*Significant at the 0.10 level

Table II Results of the discriminant analysis: pooled within-groups correlation matrix

DA
DA
EA
DL
PD
PL
CD
RL
XA
YA

EA

DLPD

PL

CD

RL

XA

1.00000
0.19975 1.00000
0.16359 0.06276 1.00000
0.29806 0.37231 0.01544 1.00000
0.36000 0.19168 0.11277 0.22286 1.00000
0.25852 0.40088 0.20039 0.22510 0.42794 1.00000
0.16217 0.04096 0.28644 0.09292 0.16643 0.243543 1.00000
0.09890 0.02356 0.26717 0.00439 0.37311 0.09712 0.17623
0.26147 0.12156 0.20841 0.17650 0.17532 0.10049 0.12075

standardized discriminant scores also suggest

that both types of banks do not seem to differ
much in terms of the ratios of operating
expenses to assets (XA), the ratio of gross
income to assets (YA) and the return on
deposits (PD) and the ratio of loans for
durables to total loans (DL).
The discriminant function was successful
in classifying 93.3 per cent of the cases. Both
the regression and discriminant analysis
suggest that interest-free banks do not differ
much from conventional banks in terms of

YA

1.00000
0.20212

1.00000

efficiency. The average ratio of operating

expenses to total assets is very similar in both
cases. The same conclusion can be made
about the banks profitability. The ratio of
total gross income to total assets and the
average return on deposits are only marginally
higher in the case of interest-free banks than
in the trading banks covered by the sample.
The statistical results, however, suggest
that interest-free banks would seem to differ
from conventional banks in terms of the three
other criteria of performance. The ratio of
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Volume 97 Number 2 1997 9298

Table III Results of the discriminant analysis: Wilks lambda *U-statistic) and univariate F-ratio with 1 and 28 degrees of
freedom

Variable

DA
EA
DL
PD
PL
CD
RL
XA
YA

Wilks lambda

Significance

0.62961
0.69692
0.92938
0.93395
0.41917
0.48682
0.66593
0.99884
0.94330

16.4721
12.2605
2.1276
1.9803
38.7986
29.5156
14.0467
0.0324
1.6831

0.0004
0.0011
0.1558
0.1704
0.0000
0.0000
0.008
0.8585
0.2051

Table IV Results of the discriminant analysis: canonical discriminant functions

Percentage
of
Cumulative Canonical
Function Eigenvalue variance percentage correlation

After
function

Wilks
lambda

Chisquare

df Significance

0.274645

30.368

:
1*

2.6411

100.00

100.00

0.8517

Note:
*Marks the 1 canonical discriminant functions remaining in the analysis

equity capital plus reserves to total assets is

much higher in interest-free banks than in
conventional banks. The opposite seems to be
true about the ratio of total deposits to total
assets. This suggests that interest-free banks
depend much more on their equity in loans
financing than traditional banks. Also, the
statistical results suggest that interest-free
banks tend to hold much higher cash ratios to
total deposits than conventional banks.
As far as credit risk is concerned, the data
in Tables II to VII suggest that there is no
significant difference between the ratio of
loans directed to financing durables by interest-free banks and traditional banks. This may
be surprising since interest-free banks are
expected to direct most of their funds towards
profit/loss sharing projects. The statistical
results suggest that these banks rely heavily on
the principle of Murabaha than on other
principles of finance (i.e. Musharaka and
Mudaraba). Interest-free banks simply find it
more convenient and less risky to finance
durables on a mark-up (or profit-margin)
basis. Whether this mode of finance is Islamic
and whether the mark-up method of finance
differs from the interest-based mode of
finance is an open question. However, interest-free banks also tend to avoid the financing
of personal loans and channel more funds

Table V Results of the discriminant analysis: standardized

canonical discriminant function coefficients

Function 1

DA
EA
DL
PD
PL
CD
RL
XA
YA

0.50808
0.40649
0.17292
0.04512
0.66647
0.58971
0.14099
0.19225
0.03965

towards direct investment. There are two

explanations for this. First, interest-free banks
have not as yet found a perfect alternative to
interest which they can use in financing personal loans. The profit/loss sharing principle
is not applicable in this case and the use of
mark-up (or profit margin) will be a clear
violation of the principles on which these
banks were created. Second, the methods of
Musharaka and Mudaraba imply direct investment by interest-free banks. This mode of
finance is seldom followed by conventional
banks. This may explain why interest-free
banks are sometimes called investment
companies.
97

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Differences between the financial characteristics of banks

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Volume 97 Number 2 1997 9298

(7) Both interest-free banks and conventional

banks channel the largest proportion of
their funds towards the financing of
durables.
(8) Interest-free banks rely heavily on the
Murabaha method of finance which is
based on the use of a mark-up which does
not differ much from the interest charge.
This may explain the conclusions reached
in (5) and (6) above.

Table VI Results of the discriminant analysis: canonical

discriminant functions evaluated at group means (group
centroids)

Group

Function 1

0
1

1.57003
1.57003

Table VII Results of the discriminant analysis: classification results

Actual
group
Group 0
Group 1

No. of
cases
15
15

Predicted group membership

0
1
14
1
6.7%

References

1
14
93.3%

Abdul-Gader, A. and Al-Ghahtani, S. (1990), Islamic and

commercial banking role in economic development:
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East Business and Economic Review, Vol. 2 No. 2,
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Note:
Per cent of grouped cases correctly classified: 93.33%

Amemiya, T. (1981), Quantitative response model: a

survey, Journal of Economic Literature, Vol. 19,
pp. 481-536.

Conclusions

Brown, K. (1994), Islamic banking: faith and creativity,

Los Angeles Times, 8 April.

This paper used logit, probit and discriminant

analysis to find out if there are structural differences between the performance of conventional or interest-based banks and interest-free
banks which operate on the profit/loss sharing
principles. The statistical results suggest that:
(1) Interest-free banks rely more heavily on
their equity in loan financing than conventional banks.
(2) Interest-free banks face more difficulties
in attracting deposits than interest-based
banks.
(3) Interest-free banks tend to be relatively
more conservative in using their loanable
funds and/or lack lending opportunities.
As a result, these banks hold a higher
cash/deposit ratio than the conventional
banks.
(4) The profit/loss sharing principle has
made it difficult for interest-free banks to
finance personal loans (where current,
interest-free tools of finance are not suitable). The same principle has pushed
interest-free banks to channel a greater
proportion of their funds to direct investment (using Musharaka and Mudaraba
tools of finance).
(5) The statistical evidence suggests that
profitability and efficiency do not discriminate between interest-free banks and
conventional banks.
(6) Both interest-free banks and traditional
banks offer their depositors similar
returns.

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