While costs have not changed much for the top 25 Islamic standalone banks between 2006 and 2012, returns have dropped significantly. The Banker takes an overview of the key factors determining their operational efficiency.

The Banker’s operational efficiency tableof the top 25 standalone Islamic banks between 2006 and 2012 reveals that while average cost-to-income ratios did not change much in the six-year period, average return on assets dropped significantly. 

The average cost-to-income ratio for the top 25 Islamic banks rose from 44% in 2006 to 44.8% in 2012, while average return on assets fell from 2.58% to 1.41%. 

The decline in operational efficiency is particularly noticeable among Iranian banks, which comprise 12 of the banks in the top 25 table and six of the top 10. The international sanctions that Iran’s Islamic banks have been subjected to over the past couple of years have compounded their decline in profits, but the drop in return on assets across the industry is clearly a reflection of a multitude of factors rather than one overarching cause.

Our survey of Top Islamic Financial Institutions this year shows that while assets have continued to grow (from $1166bn to $1267bn), this 8.67% expansion marks a slowdown compared with the 20.7% achieved in last year’s survey.

This overall slowdown in asset growth is making it harder to generate profits, while growing levels of competition in the industry are also eroding profit margins. Another factor contributing to the slowdown is the added cost associated with sharia compliance.

Islamic banks have also posted higher investment losses in recent years due to their relatively high exposure to real estate. Sharia principles favour the development and sharing of risk in physical assets that contribute to the economic growth of society, making real estate a preferred investment. The reduced performance of the property market, most notably in Dubai where prices fell by as much as 50%, hit many Gulf Islamic banks hard.

Islamic banks are also still grappling with an endemic asset/liability mismatch. The lack of a healthy Islamic interbank market means that Islamic banks struggle to access low-cost funding.

Impaired revenue growth

In a report published by Standard & Poor’s in October, the rating agency noted that while Gulf Islamic banks continue to grow faster than their conventional peers, they are experiencing impaired revenue growth. “Profitability rates for the two banking models are converging as Islamic banks are taking a more pronounced hit from lower interest rates and non-core banking revenues than their conventional peers because they traditionally operate with larger bases of non-interest bearing liabilities,” says the report.

While the Islamic finance industry is still in growth mode, a broader question is emerging as to how to maintain its profitability and clearly finding alternative revenue sources is part of the answer.

Going forward, new profits may be captured through growth opportunities in market segments or products currently underpenetrated by Islamic banks. Those segments include affluent banking, wholesale finance and emerging regions, while further product development and innovation will also provide a boost.

Top 25 Full Sharia Banks Operational Efficiency 2006 to 2012

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