Managerial Finance

Determinants of bank margins in a dual banking system

Siew Peng Lee, Mansor Isa,
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To cite this document:
Siew Peng Lee, Mansor Isa, (2017) "Determinants of bank margins in a dual banking system", Managerial Finance, Vol. 43
Issue: 6, doi: 10.1108/MF-07-2016-0189
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http://dx.doi.org/10.1108/MF-07-2016-0189
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 Determinants of bank margins in a dual banking system

Abstract
Purpose – This paper studies determinants of bank margins for conventional and Islamic
banks in the dual banking system in Malaysia.
Design/methodology/approach – The study uses unbalanced panel data for 20 conventional
banks and 16 Islamic banks over the period 2008 to 2014. The dynamic two-step GMM
estimator technique introduced by Arellano and Bond (1991) is applied.
Findings – The results suggest that there are significant similarities with minor differences in
terms of factors determining bank margins between conventional and Islamic banks in
Malaysia. The margins for conventional banks are influenced by operating costs, efficiency,
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credit risk, degree of risk aversion, market share, size of operation, implicit interest payments
and funding costs. For Islamic banks, the margin determinants are found to be operating
costs, efficiency, credit risk, market share and implicit interest payments. This means that
more factors influence the margins in conventional banks compared to Islamic banks.
Although bank diversification activities have increased in recent years, their impact on bank
margins is minimal.
Practical implications – The results suggest that improving operational costs, operational
efficiency and credit risk management, and minimising implicit interest payments would be
the best strategy to enhance the bank margins for both conventional and Islamic banks. The
results also have important policy implications on the necessity to expand the size of Islamic
banking in Malaysia.
Originality/value – There are relatively few studies concerning determinants of bank
margins in emerging markets. The present study adds to the literature by presenting evidence
from Malaysia, an emerging market with a dual banking system. This allows us to explore the
similarities and differences between conventional and Islamic banks in Malaysia in respect of
determinants of the margins.

Keywords bank margins, dual banking system, conventional banks, Islamic banks, Malaysia
Paper type Research paper

1
 1. Introduction
While determinants of bank interest margin in developed markets are quite well documented,
studies on emerging markets are scarce. For example, the pioneering work of Ho and
Saunders (1981) proposes the dealership model to examine determinants of the bank interest
margins of the US and European banking sectors. They find that the degree of risk aversion,
interest rate risk, size of transaction, and bank market structure are associated with bank
interest margins. Angbazo (1997) finds that both credit risk and interest rate risk are two
basic factors that affect the margins in the US banking sector. In another study, Maudos and
Fernández de Guevara (2004) examine bank margins in the European Union; they find that
the market structure and operating costs have an impact on bank margins. This study brings
evidence on bank interest margin in Malaysia, an emerging market that has a dual banking
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system. The dual banking system allows us to make a comparative study on determinants of
bank margins for conventional and for Islamic banks. Since Islamic banks operate in a non-
interest banking system, it would be interesting to see if their profits are driven by similar
determinants that drive conventional bank margin.

The main focus of this paper is to provide evidence on factors influencing profit
margins of Islamic banks as compared to conventional banks. Islamic banking in Malaysia
may be considered to have achieved maturity stage in view of its rapid development since its
establishment in the early 1980s due to strong support from the authorities and from the
consumers. Although Islamic banking in Malaysia represents less than a quarter of total
banking activities, it is important to know the drivers of their profits so that managers and
policy makers will be able to develop proper strategies for development. There have been a
few studies on Malaysian Islamic banks, such as Sufian (2007), Bader et al. (2008) and
Chong and Liu (2009) but none of them study profit margin. This paper aims to fill the gap
by analysing the determinants of profit margins of conventional and Islamic banks in
Malaysia. Studying this topic is important for many reasons including assessing trends in
bank efficiency over time and evaluating whether bank margins are providing effective price
signal to market (Hawtrey and Liang, 2008).

The study contributes to the literature in the following manner. First, this study brings
new evidence on determinants of bank margin from an emerging market and also comparing
margin determinants for Islamic and conventional banks. Second, Islamic banks in Malaysia
have gone through a fairly long history of development, thus providing reliable data for

2
 analysis. Further, focusing on Islamic banks in one country also removes the difficulty in
dealing with variations in shariah laws that govern bank operations in different countries.
Third, this study uses the GMM estimator to identify determinants of bank margin in a dual
banking system. This is different from Hutapea and Kasri (2010) who employ the
cointegration technique to investigate the long-run relationship between bank margins and
their determinants in the Indonesian dual banking system. In another study, Beck et al. (2013)
make an extensive comparative study of efficiency and stability between conventional banks
and Islamic banks across 22 countries with a dual banking system. However, Beck et al.
(2013) do not analyse bank margins between the two banking systems.

The paper is organised as follows. The next section provides brief background
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information on the Malaysian banking industry. Section 3 discusses the literature leading to
the hypotheses development. Section 4 describes the methodology and research data, and
Section 5 discusses the results. Finally, Section 6 concludes the paper.

2. An Overview of Islamic Banking in Malaysia

Malaysia practices a dual banking system in which non-interest based Islamic banks operate
alongside the interest based conventional banks. The growth of the Islamic banking sector has
been very rapid. Table I shows an overview of bank assets in Malaysia for the period 2008 to
2014. Currently, the entire banking assets are valued at about RM2.2 trillion (about USD0.5
trillion), about 22% of which belongs to Islamic banks. The table shows that total bank assets
grew at an average rate of 6.5% per year. The growth rate for Islamic bank assets over the
period is about 12.6%, which is far greater than that for conventional banks, at about 5.7%.

Due to the prohibition of interest in Islam, Islamic banking is therefore interest-free

while conventional banking is interest-based. The basis of conventional banking is that
interest is fixed or predetermined on deposits and loans, while for Islamic banks, returns to
banks and customers are based on profit-and-loss sharing (PLS), and mark-up financing
(Kabir et al., 2015). Due to the practical difficulties in monitoring loans, the PLS practices of
Islamic banks have been very limited, and Islamic banks currently rely on sales-type and
fixed-rate products that are permissible under Islamic law (Chong and Liu, 2009; and Lee et
al., 2016).

3
 In respect of the liabilities of Islamic banks, deposits are structured under savings with
guaranteed (al-wadiah), term deposits, and investment deposits (PLS). Banks may provide
returns or gifts (hibah) to the depositors periodically as a token of appreciation. The Islamic
term deposits are structured based on the commodity mark-up or cost-plus profit in which
deposits are held for a fixed term, whereas investment deposit accounts are equity-like from a
residual claimant perspective. Although investment deposits are supposed to be based on
PLS, banks may pay their investment account holders a competitive “market” return,
irrespective of their actual performance and profitability (Chong and Liu, 2009). As such,
Islamic banks rarely use PLS in the strict sense of the term in respect of liabilities (sharing
losses with depositors).
--- Insert Table I here ---
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3. Related Literature and Hypotheses Development

The dealership model proposed by Ho and Saunders (1981) provides a theoretical model to
analyse determinants of bank margins. This model considers banks as intermediaries between
lenders and borrowers in the financial market. Ho and Saunders (1981) empirically estimate
the dealership model for the US and European banks for the period 1976-1979. To analyse
determinants of bank margins, the model proposed by Ho-Saunders has been extended by
other researchers, such as Williams (2007), Maudos and Solis (2009), Fungacova and
Poghosyan (2011), and Islam and Nishiyama (2016), by incorporating a host of other factors.

3.1 Operating Costs and Operational Efficiency

The criticism of the Ho-Saunders model is that it fails to consider banks as a corporation with
certain production functions associated with intermediation services, such as the
administrative costs to maintain loan or deposit contracts. Maudos and Fernández de Guevara
(2004) respond to this criticism and extend the Ho-Saunders model by adding the operating
costs to capture the bank production function associated with bank services. They consider
bank operating costs to be a determinant of the net interest income. They argue that,
essentially, even in the absence of market power and any kind of risk, banks need to cover
their operating costs, which are a function of the deposits taken and loans granted. Therefore,
banks operating at a higher cost level will have to charge higher margins. Maudos and
Fernández de Guevara find a positive relationship between bank margins and operating costs
in the European banking sector. The positive impact of operating costs on the net interest
margin is supported by other studies. In the context of Mexico, Maudos and Solis (2009)

4
 conclude that operating costs have the most impact on bank margins. They find that banks
with high operating costs pass them on to their customers by setting higher interest rates for
lending and lower rates for deposits; therefore, resulting in higher bank margins.

In another study, Entrop et al. (2015) extend the Ho-Saunders model to investigate the
factors that influence the intermediation fees when a bank’s balance sheet shows a maturity
mismatch. They find that bank margins are positively related to operating costs in the
German case. Similarly, Islamic banks also incur operating costs in carrying out their lending
and borrowing activities. It is therefore expected that operating costs also have a positive
impact on bank margins for Islamic banks. However, Sun et al. (2016) failed to find support
for operating costs having a significant effect on the net profit margins of the banks in the
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OIC (Organisation of Islamic Cooperation) countries. Based on these discussions, we propose

the following hypothesis:

Hypothesis H1a: Bank margins are positively related to operating costs.

Other studies consider operational or managerial efficiency in their bank margin model.
Efficiency is measured by the ratio of operating costs to gross income or the amount of
expenditure incurred to generate one unit of gross income. A low ratio means a bank is more
efficient while a high ratio means it is less efficient. Vander Vennet (2002), and Claeys and
Vander Vennet (2008) find that higher efficiency reduces bank interest margins significantly
in European banks. They point out that banks with high operational efficiency may pass on
the benefits to their customers in the form of lower borrowing rates and/or higher deposit
rates, thereby reducing the margins. However, Maudos and Fernández de Guevara (2004),
Maudos and Solis (2009), and Sun et al. (2016) find that inefficient banks are associated with
low interest margins because they operate on less profitable assets and high-cost liabilities. It
is expected that Islamic banks behave in a similar fashion. The evidence for this is provided
by Sun et al. (2016) who report a negative association between the efficiency measure and
Islamic bank margins. Based on these arguments, we propose the following hypothesis:

Hypothesis H1b: Bank margins are negatively related to operating efficiency.

5
 3.2 Risks
3.2.1 Credit Risk
Angbazo (1997) extends the Ho-Saunders model by incorporating the risk of loan default in
the model. Banks will adjust the loan interest based on the credit risk of the borrower; the
higher the risk, the higher the interest charged, thereby creating a bigger interest spread.
Angbazo (1997) finds a positive relationship between default risk and the interest margins of
US banks. Drakos (2002) adopts the Angbazo model to investigate Greek banks. The results
are consistent with the findings of Angbazo (1997). In another study, Maudos and Fernández
de Guevara (2004) also find a similar relationship between bank margins and credit risk. The
authors document that banks with a higher loan loss provision face higher credit risk and are
likely to charge higher margins. However, there are also some contradictory results. For
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example, Williams (2007) finds that credit risk has a negative impact on bank margins in
Australia, while Carbó and Rodríguez (2007) find that risks are unrelated to bank margins.
Beck et al. (2013) find that there is no significant difference in loan loss provisions between
conventional and Islamic banks. However, they do not analyse the impact of loan loss
provisions on bank margins.

Like conventional banks, Islamic banks also face risks in their operations. When a
customer’s credit risk is high, a bank may assign a higher risk premium to the customer,
which leads to a higher financing cost and an increase in bank margins.

Based on this discussion, we test the following hypothesis:

Hypothesis H2a: Bank margins are positively related to credit risk.

3.2.2 Liquidity Risk

In addition to credit risk, liquidity risk could also affect bank margins. The liquidity risk
refers to banks having insufficient cash or borrowing capacity to meet either the deposit
withdrawals or the new financing demands, thereby forcing banks to borrow emergency
funds at possibly excessive costs (Drakos, 2002). This seems to suggest that an increased
liquidity risk is accompanied by increased bank margins to cover the excessive cost of
funding. However, the evidence is inconsistent. Drakos (2002) examines the link between
bank margins and liquidity risks, and concludes that the liquidity risk is negatively related to
the margins. Similar evidence is reported in Fungacova and Poghosyan (2011). In contrast,

6
 Carbó and Rodríguez (2007), and Lin et al. (2012) find a positive relationship between bank
margins and liquidity risk.

For Islamic banks, How et al. (2005) find that Islamic financing is significantly related
to the credit risk and liquidity risk in Malaysian banks. Hutapea and Kasri (2010) use
cointegration analysis to study bank margin determinants in Indonesia. The authors suggest
that long-run relationships exist between Islamic bank margins in Indonesia and their
determinants, which include bank reserves, capital ratio, default risk, implicit return, interest
rate volatility, liquidity risk, and management quality. The authors also mention that there is a
negative relationship between Islamic bank margins and interest rate volatility.
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Based on the above discussion, the following hypothesis will be tested:

Hypothesis H2b: Bank margins are positively related to liquidity risk.

3.2.3 Degree of Risk Aversion

As a measure to protect banks and the interests of depositors, banks are required to comply
with the mandatory capital requirement, which is measured by the ratio of their capital to the
total risk-weighted assets. Banks with a high degree of risk aversion would maintain their
capital ratio well above the required level. Generally, equity capital is considered to be the
most costly funding source compared to depositor funds. Therefore, the higher the risk
aversion, the greater the margin expected to cover the higher cost of equity financing
(Maudos and Fernández de Guevara, 2004). In respect of the degree of risk aversion, Maudos
and Fernández de Guevara (2004), Maudos and Solís (2009), and Entrop et al. (2015) find
that bank margins are positively related to risk aversion. Based on the above discussion, our
testable hypothesis is formulated as follows:

Hypothesis H2c: Bank margins are positively related to degree of risk aversion.

3.3 Market Share

According to the market power paradigm, an increase in market power leads to monopoly
profits, which translate into an increase in bank margins. In this study, the market power of a
bank is represented by its market share, which is measured by the ratio of the bank’s assets
over total banking assets. This measure has been used in the study of Claeys and Vander
Vennet (2008), who test the market power hypothesis in Central and Eastern Europe banks.

7
 They argue that banks with large market shares are able to exercise market power to set
prices autonomously, and, hence, earn higher margins. Hawtrey and Liang (2008) corroborate
the findings, and conclude that banks with greater market power have the freedom to set loan
margins accordingly. This evidence suggests that bank margins are positively related to
market share – the larger the market share, the larger the margins. Similar behaviour is also
expected for Islamic banks. Based on the above discussion, the hypothesis related to market
share is as follows:

Hypothesis H3: Bank margins are positively related to market share.

3.4 Bank-specific Factors

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Several studies examine the association among bank-specific factors as determinants of bank
margins. Such factors include bank size, implicit interest payments, opportunity costs of
reserves and funding costs.

3.4.1 Size
As far as size is concerned, it is expected to have a negative relationship with bank margins,
which means that larger banks should have a smaller spread, and smaller banks should have a
larger spread. Larger banks have better resources and can afford the latest technology in their
operations, which should lead to improved efficiency and lower cost of operations. Hence,
they can afford to pay more to depositors and charge less to borrowers. Larger banks can also
take larger transactions leading to economies of scale, which reduces the unit cost of
transactions. Empirically, Hawtrey and Liang (2008), and Islam and Nishiyama (2016) find a
negative relationship between the interest margins and the size. They argue that an increase in
the volume of loans should result in a reduction of the unit costs. For Islamic banks, it is also
expected that size and margins are similarly related. Based on this argument, the hypothesis
related to the size of operations is as follows:

Hypothesis H4a: Bank margins are negatively related to size.

3.4.2 Implicit Interest Payments

Implicit interest payments are another bank-specific variable that are likely to impact on bank
margins. An implicit interest rate is an interest rate that is not specifically stated in a business
transaction. Implicit interest payments refer to the cost of the additional services for which

8
 bank customers have not been explicitly charged (Maudos and Solis, 2009). According to
Hawtrey and Liang (2008), banks impose extra interest margins to cover the cost of the
banking services. Previous studies find a positive relation between bank margins and implicit
interest payments (e.g. Maudos and Fernández de Guevara, 2004; and Maudos and Solis,
2009). Although we could not find any related study for Islamic banks, it is expected that the
behaviour of implicit interest payments in respect to bank margins is similar to that of
conventional banks. The estimated coefficient for this variable is expected to have a positive
sign. The hypothesis may be written as follows:

Hypothesis H4b: Bank margins are positively related to implicit interest payments.
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3.4.3 Opportunity Cost of Holding Reserves

In the banking environment, banks have to comply with the reserve requirement regulation.
Banks are required to maintain reserves at the central bank. These reserves bear zero return,
and at the same time, reduce a bank’s opportunity to provide financing. The opportunity cost
of this reserve is the return on the earning assets foregone by holding deposits in cash. This
cost is considered to be an additional expense for banks. Thus, the greater the reserve amount,
the higher the opportunity costs, and banks will raise their margins to cover these costs.
However, the studies of Maudos and Solis (2009), and Entrop et al. (2015) do not find a
significant impact on bank margins. Similar to conventional banks, Islamic banks have to
satisfy the reserve requirement regulation, and hence have similar opportunity costs. Based
on the discussion, the hypothesis is formulated as follows:

Hypothesis H4c: Bank margins are positively related to opportunity costs of holding
reserves.

One variable that could have a considerable influence on bank margins, but has not
been incorporated in prior studies is the funding costs. The funding costs are represented by
the ratio of the interest (or financing costs in Islamic banks) expenses to total deposits.
Generally, the deposits of customers are a bank’s major source of funds, for which they have
to pay interest or provide a return. Banks with higher funding costs are expected to recover
these costs by setting a higher lending or financing rate. The testable hypothesis is as follows:

Hypothesis H4d: Bank margins are positively related to funding costs.

9
 3.5 Bank Diversification
Due to the increased competition in the banking industry, banks are finding themselves
looking for non-traditional banking activities to compensate for a decline in profitability
(Mercieca et al., 2007; and Entrop et al., 2015). Banks need to diversify their sources of
income by performing new activities, such as financial advice, fee and commission-based
services and other non-interest income activities (Nguyen, 2012). Carbó and Rodríguez
(2007) extend the Ho-Saunders model by including the importance for banks to diversify
their activities. They propose a multi-output model to examine the relationship between bank
margins and non-traditional activities in European banking. They find that banks with a
higher degree of diversification tend to have lower interest margins. Similarly, Maudos and
Solis (2009), and Entrop et al. (2015) find that banks with a greater reliance on non-interest
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income activities are able to charge lower lending rates. They argue that a diversified bank is
expected to offer traditional banking products with a small margin or even a negative margin,
with the objective of keeping and/or attracting customers. Based on this evidence, the
coefficient for the net non-interest income is expected to be negative. The diversification of
income in Islamic banks is expected to have a similar impact on bank margins. The
hypothesis is formulated as follows:

Hypothesis H5a: Bank margins are negatively related to net non-interest income.

Bank total earning assets include loans, securities, and investments. If a bank only
provides loans, it will be classified as having zero asset diversity. Lin et al. (2012) extend
Angbazo’s (1997) model by incorporating bank diversification activities to explore their
influence on commercial bank margins in nine Asian countries (China, India, Indonesia,
Japan, the Philippines, Singapore, South Korea, Taiwan, and Thailand). They find that asset
diversity has a significant positive impact on bank margins, and conclude that asset
diversification contributes to better bank performance. The hypothesis is formulated as
follows:

Hypothesis H5b: Bank margins are negatively related to asset diversity.

10
 4. Empirical Models and Data
4.1 Empirical Models
To analyse determinants of bank margins, we use the following regression equation, which is
a dynamic model that includes a lag dependent variable in the explanatory variables:

 


 =  +

 +    +  
 +  +  (1)
 

where BMit is bank margins, SVit denotes the spread variables, BSit denotes the bank-specific
factors, i is the unobservable bank-specific effect and ε denotes the remaining disturbance
term; the subscript i denotes individual banks, i = 1, 2,…36, and t is the time period, t =
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2008,…2014.

Previous studies suggest that diversification into non-traditional banking activities by

banks would also have an impact on bank margins (Lin et al., 2012; and Entrop et al., 2015).
We, therefore, augment the base model (equation 1) by including the diversification
variables. The augmented model is as follows:

  


 =  +

 +    +  
 +    +  +  (2)
  

where DV refers to the diversification variables.

For ease of reference the definitions and expected signs of all independent variables are
presented in Table II. Table III presents the Pearson’s pair-wise correlation between the
independent variables. As Table III shows, the correlations among the independent variables
are relatively low, which indicates the absence of the multicollinearity problem in our
regression. As pointed out by Kennedy (2008), multicollinearity becomes a problem when the
correlation coefficient is above 0.80.

--- Insert Table II here ---

--- Insert Table III here ---

11
 4.2 Estimation Methods
This study uses the two-step difference generalized method of moments (Difference GMM)
introduced by Arellano and Bond (1991). This methodology addresses the presence of
unobserved bank-specific effects, which are eliminated by taking the first differences of all
variables. The likelihood of endogeneity problems in terms of the explanatory variables
associated with dynamic models is dealt with in this paper using the GMM procedure. The
GMM estimator is presented as an instrumental variable estimator in which the lags of the
endogenous regressor, and the current values of the exogenous variables are used as
instruments. The authors demonstrate that additional instruments can be obtained in a
dynamic panel data model if one utilizes the orthogonality conditions that exist between the
lagged values of the dependent variable and the disturbances i. Using these moment
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conditions, they propose a two-step difference GMM estimator. In this study, we estimate the
model using a two-step estimator that is efficient and robust to heteroscedasticity (Roodman,
2009).

4.3 Data
In 2014, 43 banks were operating in Malaysia, of which 27 were conventional banks and 16
were Islamic banks (see Table I). However, 7 of the conventional banks are excluded due to
missing data for three consecutive years. The data set contains 20 conventional and 16
Islamic banks for the period 2008 to 2014. This is an unbalanced panel because the number
of banks in each year is not the same. The annual bank balance sheets and income statements
were obtained from the Bank Scope database. All the ratios are calculated based on the
standardised accounting format provided by Bank Scope to ensure comparability across
banks.

Table IV reports the mean of the variables used in this study for the entire sample as
well as for the subsample of conventional and Islamic banks. The table also shows the t-
statistics of the test for differences between the means of the conventional banks and the
Islamic banks. Table IV reveals some interesting observations. First, the margin for
conventional banks is marginally higher than that for Islamic banks. This is somewhat
unexpected given the relatively large size of operation of conventional banks, which should
lead to a smaller spread compared to that of Islamic banks. However, it seems that Islamic
banks have to operate with a smaller net interest margin in order to compete with the more
well-established conventional banks. Second, on average, the size of conventional banks
12
 (total loans) is almost three and a half times the size of Islamic banks and so is the market
share of the conventional banks.

Third, conventional banks are more efficient than Islamic banks. This is shown by the
lower operating costs and lower efficiency ratio of conventional banks compared to Islamic
banks. This observation is consistent with the findings of Beck et al. (2013) who find that, in
general, Islamic banks are less efficient than conventional banks. Fourth, as far as risks are
concerned, credit risks are lower for conventional banks, but liquidity risks and the degree of
risk aversion are higher compared to Islamic banks. Finally, the net non-interest income
diversification variable in conventional banks is higher compared to that of Islamic banks.
This might imply that conventional banks place greater emphasis on diversifying their
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income sources.
--- Insert Table IV here ---

5. Regression Results
Our analysis is conducted using regression equations in a two-step difference GMM
approach. This model is deemed suitable as the autoregressive parameter is below 0.8
(Moshirian and Wu, 2012). To determine the consistency of the estimators, this study uses
the Hansen over-identifying test, which tests the overall validity of the instruments and
autocorrelation (Arellano and Bond, 1991). Tables V and VI both show that the Hansen test
value is insignificant. This indicates that the model is correctly specified and that the
instruments are valid. The second test examines the assumption of no serial correlation in the
errors in the levels. The evidence shows insignificant second-order autocorrelation. Hence,
the Hansen’s null hypothesis and the autocorrelation tests are not rejected; this suggests that
the dynamic model is validated. Tables V and VI show that the coefficients on the lagged
dependent variable on the right-hand side are positive and significant at the 5% level in all
regressions, which suggests that the lag bank margin has an impact on the current bank
margin. This result confirms the appropriateness of our choice of a dynamic specification for
the model.

13
 5.1 Full Sample
5.1.1 Spread variables
The first column in Table V reports the regression (equation 1) results for the full sample.
The results show that the coefficients are generally in agreement with the predicted signs.
With regard to the operating costs, the coefficient is positive and significant at the 1% level,
and the most sizable in economic terms compared to other determinants. This suggests that
the high operational costs incurred by the banks are passed on to their customers by way of
higher margins. This result is in line with the findings of Maudos and Fernández de Guevara
(2004) for European banks; and Maudos and Solis (2009) for Mexican banks. The ratio of
operating costs to gross income, as a proxy for operational efficiency, has a negative
coefficient, as predicted, and is significant at the 1% level. This means that the ratio and the
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margins move in opposite directions. This is consistent with the explanation that a lack of
efficiency (high operating cost ratio) leads to banks having to operate with smaller margins.

Our model contains three risk variables: credit risk, liquidity risk and the degree of risk
aversion. As expected, the coefficient for credit risk is positive and significant at the 1%
level, which means that the higher the credit risk, the higher the margin. This result is
consistent with previous studies (e.g. Maudos and Fernández de Guevara, 2004; and Maudos
and Solis, 2009). The next variable is the liquidity risk, which shows an insignificant
coefficient. Our results suggest that this ratio is not important in explaining bank margins.
This result is inconsistent with that of Carbó and Rodríguez (2007). In the banking
environment, the liquidity risk arises from the inability of a bank to accommodate decreases
in liabilities or to fund increases in assets. It is possible that the insignificance of the liquidity
risk is due to the fact that banks are less relying on liquid assets because of greater
accessibility to the interbank market. Regarding a bank’s risk aversion, which is measured by
the ratio of equity to total assets, the coefficient has the expected positive sign, and is
significant at the 5% level. A potential explanation for this is that holding high equity is
relatively costly for banks and reduces their profitability; therefore, banks have to maintain a
higher spread. This finding is consistent with those of previous studies, such as Carbó and
Rodríguez (2007), and Maudos and Solis (2009).

The market power of banks, as proxied by market share, is positive and significant at
the 1% level. This suggests that banks with a greater market share would be able to charge
higher financing rates in order to have a higher bank margin. This is also consistent with the

14
 argument that banks with a large market share act as if they have a monopoly power and can,
therefore, set higher prices for their services. The result is consistent with Maudos and
Fernández de Guevara (2004), and Maudos and Solis (2009).

5.1.2 Bank-specific Variables

In this study, we include four bank-specific variables: size (total loans), implicit interest
payments, opportunity cost of holding reserves, and funding costs. The results for the bank-
specific variables in Table V show that three of the four variables are significant in
explaining bank margins. The log of total loans as a proxy for bank size has a negative sign
and is significant at the 5% level, thereby showing that large operation size results in lower
margins. This is consistent with our expectation, and suggests that large banks are associated
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with low margins. As previously discussed, large banks can afford sophisticated technology
and can benefit from economies of scale of operation, which will translate into lower
margins. The result of this study is consistent with Maudos and Fernández de Guevara
(2004), and Fungacova and Poghosyan (2011).

The second bank-specific variable is the implicit interest payment. Of the four bank-
specific variables, this variable has the strongest impact on bank margins. Implicit interest
payments are charges that, although not specifically stated in a business transaction, are
nevertheless charged to customers. The positive coefficient reflects the fact that implicit
interest payments are being transferred to consumers in the form of greater bank margins.
Our results show that the third variable, the opportunity costs for the holding of reserves, are
insignificant. This means that the proportion of cash and reserves with the central bank does
not affect bank margins (Maudos and Fernández de Guevara, 2004). According to McCarthy
et al. (2010), customer deposits are the primary source of bank loans, but the authors do not
examine their relationship with bank margins. The results in Table V show that the
coefficient of funding costs is positive and significant. This means that banks with high
funding costs have to pass on these costs to borrowers, which leads to higher margins.

--- Insert Table V here ---

15
 5.2 Conventional versus Islamic Banks
5.2.1 Spread Variables
To date, the possibility that determinants of bank margins might be different for conventional
and Islamic banks has not been properly investigated in the literature. For this purpose, this
study subdivide the sample into conventional and Islamic banks. Columns 2 and 3 in Table V
show the regression results for the conventional and Islamic banks, respectively.

Column 2 shows that the results for conventional banks are very similar to the results
for the full sample. However, there is a slight difference for Islamic banks. Column 3 shows
that there are fewer significant variables for Islamic banks. The results indicate that the bank
margins for both conventional and Islamic banks respond in the same manner to changes in
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operating costs, operational efficiency, credit risk, market share and implicit interest
payments. The variables that are significant for conventional banks but insignificant for
Islamic banks are the degree of risk aversion, size of operation and the funding costs.

In terms of the operating costs, although both banks show a positive relation, the impact
is greater for conventional banks than it is for Islamic banks; an increase of 100 basis points
in operating costs translates into an increase of 266 basis points in conventional bank margins
but only 99 basis points in the Islamic bank margins. In terms of bank efficiency, as measured
by the ratio of operating costs to gross income, as predicted, both banks show a negative
relationship. A high ratio means less efficient, which leads to the bank having to operate with
lower margins; this is true for both conventional and Islamic banks. These results support
Hypotheses 1a and 1b for both banks.

As for the risk variables, only credit risk shows a clear positive relationship with the
bank margins for both banks, with Islamic banks having a greater sensitivity. The liquidity
risk, as measured by the ratio of liquid assets to short-term funding, seems to be unrelated to
the bank margins for conventional as well as Islamic banks. As for the degree of risk
aversion, which is measured by the equity ratio, there is a positive relationship with the bank
margins for conventional banks, while it is insignificant for Islamic banks. Therefore,
Hypothesis 2a is supported by both banks, Hypothesis 2b is not supported by either bank,
while Hypothesis 2c is supported by conventional banks but not by Islamic banks. The
market power variable, as proxied by market share, shows a positive relation with the bank
margins for both banks; hence, supporting Hypothesis 3.

16
 5.2.2 Bank-specific Variables
With respect to the bank-specific variables, only the implicit interest payment shows a
significant relationship with the bank margins for both banks (Hypothesis 4b). Size, as
measured by total loans, is only significant for conventional banks, but not for Islamic banks
(Hypothesis 4a). The opportunity costs for bank reserves are insignificant for both banks
(Hypothesis 4c), while the funding costs are only significant for conventional banks
(Hypothesis 4d). In summary, we find that Hypothesis 4a is only supported by conventional
banks, Hypothesis 4b is supported by both banks, Hypothesis 4c is not supported by either
bank, and Hypothesis 4d is only supported by conventional banks.

One possible explanation for the insignificance of the loan size and funding costs for
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Islamic banks is that Islamic banks are relatively small in size compared to conventional
banks, hence having limited competitive advantage in price setting in a dual banking
environment. Their pricing policy is therefore more market driven than firms’ characteristic
driven.

5.3 Results for the Diversification Variables

Diversification is a strategy that is normally used by investors to eliminate asset unique risks
to provide a more stable portfolio returns. Likewise, banks may adopt a diversification
strategy to achieve a stable income by engaging in non-traditional banking activities, such as
non-interest income services and products, transaction fees and commissions (Lin et al.,
2012). However, the existing literature concerning determinants of bank margins does not
adequately account for the effects of diversification (Lin et al., 2012). To assess how
diversification activities may impact on bank margins, we re-estimate our regression equation
to include two diversification variables (Equation 2). The two new variables are non-interest
income and asset diversity.

Table VI reports regression results for Equation (2). Overall, the results for the spread
variables and the bank-specific variables are qualitatively similar to the results presented in
Table V. Therefore, this section only discusses the diversification results. Table VI shows
that the coefficient of net non-interest income is negative for the whole sample as well as for
the conventional bank subsample; it is insignificant for Islamic banks. The negative sign
means that diversification leads to lower margins for conventional banks. One possible
explanation is that when banks are diversified, they can afford to charge lower spreads to

17
 attract customers; because, whatever the shortfall from the lower spread incurred, it is
compensated by income from other sources. The different sources of income act as a
substitute for each other (Carbó-and Rodríguez, 2007). The coefficient for the asset diversity
is found to be insignificant for both banks. This indicates that asset diversity has no impact on
bank margins. Therefore, our results in this section, partially support Hypothesis 5a, but do
not support Hypothesis 5b.

--- Insert Table VI here ---

6. Conclusion
This study compares the determinants of bank margins of conventional and Islamic banks in a
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dual banking system in Malaysia. The determinants are classified into three groups: spread
variables, bank-specific variables and diversification variables. We employ a two-step
dynamic panel estimation using the GMM estimator developed by Arellano and Bond (1991)
on a panel data set consisting of 20 conventional banks and 16 Islamic banks from 2008 to
2014.

Our results suggest that there are significant similarities in terms of determinants of
bank margins between conventional and Islamic banks. It is found that margins for both
banks are driven by operating costs, operational efficiency, credit risk, market share, and
implicit interest payments. However, differences also exist. Our results indicate that
conventional banks’ margins are additionally influenced by degree of risk aversion, size of
operation and funding costs. We propose that the reason why these three variables are
insignificant for Islamic banks is due to the small size of the banks. Because of their small
size, their pricing policy is more driven by the market than by bank’s specific characteristics.

The results show that operational costs are by far the most important determinant of
bank margins, followed by operational efficiency. The third important variable is credit risk,
which has a direct relationship with the margins. The bank’s market share, which is a proxy
for market power, is found to have a positive influence on bank margins. Implicit interest
payment turns out to be another important determinant of bank margins, which provides
evidence of additional operating costs. However, it should be cautioned that these results are
derived from a rather limited sample size of only 36 banks over a seven-year study period
using annual data.

18
 Our study reveals some interesting findings that may have important policy
implications to banks as well as to authorities. Looking at the spread variables, we find that
conventional banks are more efficiently managed than Islamic banks in terms of operational
costs and efficiency and also in terms of managing credit and liquidity risks. The difference
in the operational efficiency of these banks may have contributed to the smaller margin of
Islamic banks compared to conventional banks. It is therefore important for banks to improve
their operational efficiency and risk management and to control their implicit interest
payments as these variables have direct impact on their interest margin, more so for Islamic
banks. It should also be noted that conventional banks, with large market share command
considerable market power in determining the prices of their products and hence influencing
their interest margins. Due to their substantially smaller size, Islamic banks have to operate
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with relatively lower efficiency and may not be benefitting from the economies of operation.
Hence, it is important for Islamic bankers and authorities to increase efforts to expand the
size of Islamic banking.

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21
 Tables:

Table I
Number of banks and total bank assets for the years 2008-2014
Conventional bank Islamic bank Total bank
Number of Total assets Number of Total assets Total assets
Year banks RM mil. banks RM mil. RM mil.
2008 22 1,063,447 17 181,360 1,302,113
2009 22 1,111,386 17 219,848 1,391,510
2010 23 1,197,711 17 253,516 1,513,524
2011 25 1,356,862 16 320,519 1,744,398
2012 27 1,453,332 16 367,686 1,882,332
2013 27 1,561,229 16 426,469 2,043,367
2014 27 1,687,949 16 469,024 2,165,005
Source: Bank Negara Malaysia Annual Reports, Monthly Statistical Bulletin.
Notes: The total bank assets include also investment banks and finance companies.
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Table II
Definition of the variables and the expected sign
Variable
Dependent variable: Bank margin (BM)
Bank margin*
Independent variables
Spread variables
Operating costs (OC)
Operational efficiency (EFF)
Credit risk (CR)
Liquidity risk (LR)
Degree of risk aversion (DRA)
Market share(MS)
Bank-specific variable
Size
Implicit interest payments
(IIP)
Opportunity cost of holding
reserves (OCR)
Funding costs (FC)
Diversification variables
Net non-interest income (NII)
Asset diversity(AD)
Notes: *Bank margin refers to Net Interest Margin (NIM) for conventional banks and Net Profit Margin (NPM) for
Islamic banks
Definition Expected sign
Difference between interest income and interest expenses divided
by total assets for conventional banks and difference between
earnings on financing activities and payments on deposits divided
by total assets for Islamic banks.
The ratio of operational costs to total assets. +
The ratio of operating costs to gross income. -
The ratio of loan loss provision to total gross loan. +
The ratio of liquid assets to short term funding. +
The ratio of equity to total assets. +
The ratio of banki’s loans at time t to total loans within the +
banking sector as a proxy of market power.
Log of total loans. -
Difference between non-interest expenses and non-interest +
income divided by total interest-bearing assets.
Non-interest bearing reserves to total interest-bearing assets. +
The ratio of interest/return on deposit to total deposits. +
Difference between non-interest income and non-interest -
expenses divided by total assets.
Diversity = 1 - |2x - 1|, where x is the loans-to-assets ratio, take -
values between 0 and 1 and are increasing in the degree of
diversification.

1
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Table III
Correlation matrix of the independent variables
OC EFF CR LR DRA MS Size IIP OCR FC NII
EFF 0.248**
CR 0.164** 0.066
LR -0.298** 0.044 0.095
DRA -0.062 0.045 -0.044 0.276**
MS -0.095 -0.189* -0.087 -0.343 -0.202
Size 0.114 -0.148** -0.026 -0.435** -0.514** 0.609**
IIP 0.598** 0.314** 0.118 -0.165** -0.068 -0.121 -0.027
OCR -0.043 0.085 0.019 -0.151* 0.218* 0.199* 0.041 -0.037
FC 0.058 0.120 -0.022 -0.039 0.115 -0.074 -0.118 0.078 -0.011
NII -0.195** -0.363** 0.009 0.419* 0.330* 0.111 -0.191** -0.439** -0.003 -0.012
AD 0.307** 0.036 -0.022 -0.590* -0.274* 0.264* 0.649** 0.213* 0.138** -0.018 -0.577*

Notes: Variables definitions are in Table II. **and * denote significance at the 5% and 10% levels, respectively.

2
 Table IV
Means of the variables
Variables Full Conventional Islamic t-value
sample banks banks
Bank margin (%) 2.869 2.896 2.836 2.169**
Operating costs 0.038 0.036 0.040 -3.315***
Operational efficiency 0.932 0.910 0.959 -6.254***
Credit risk 0.005 0.003 0.008 -2.858***
Liquidity risk 0.376 0.408 0.337 2.955***
Degree of Risk aversion 0.097 0.105 0.088 3.511***
Market share 0.028 0.041 0.012 6.300***
Size (Total loans) (RM million) 30.01 43.70 12.71 6.247***
Implicit interest payments 0.013 0.008 0.018 -9.489***
Opportunity costs of holding reserves 0.031 0.036 0.025 3.143***
Funding costs 0.031 0.030 0.031 -0.414
Net non-interest income 0.159 0.229 0.070 15.337***
Asset diversify 0.685 0.662 0.714 -2.059**
Observations 249 139 110
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No. of banks 36 20 16
Notes: T-values test the difference between conventional and Islamic means. ** and *** denote
significance at the 5% and 1% levels, respectively (two-tail test).

Table V
Two-step difference GMM regression results for the determinants of bank margins (Equation (1))
Expected Full Conventional Islamic
sign sample banks banks
(1) (2) (3)
Bank margin t-1 0.381** (2.037) 0.297*** (3.631) 0.403** (2.436)
Spread variables:
Operating costs + 0.219*** (2.935) 0.266*** (4.213) 0.099** (2.334)
Operational efficiency - -0.007*** (-4.662) -0.002*** (-4.441) -0.014** (-2.875)
Credit risk + 0.018*** (2.912) 0.023** (2.091) 0.247** (2.135)
Liquidity risk + -0.002 (-0.587) -0.003 (-1.170) -0.020 (-1.643)
Degree of risk aversion + 0.032** (2.207) 0.021** (3.937) 0.017 (1.131)
Market share + 0.104*** (3.403) 0.035*** (4.243) 0.385* (1.838)
Bank-specific variables:
Size (Total loans) - -0.002** (-2.178) -0.001*** (-3.020) 0.002 (1.121)
Implicit interest + 0.141*** (4.750) 0.183*** (5.276) 0.467** (2.544)
payments
Opportunity costs of + 0.002 (0.068) -0.005 (-0.625) 0.045 (0.324)
holding reserves
Funding costs + 0.031*** (2.844) 0.048*** (3.127) 0.007 (1.043)
Arellano-Bond order 1 [p-value] [0.122] [0.152] [0.049]
Arellano-Bond order 2 [p-value] [0.762] [0.481] [0.514]
Hansen test [p-value] [0.484] [0.686] [0.716]
F-statistic 13.03 34.05 8.94
Number of instruments 12 19 12
Number of banks 36 20 16
Number of pooled observations 249 139 110
Notes: The dependent variable is the bank margin. The Hansen test is the test for the over-identifying
restrictions in the GMM model estimation. Arellano-Bond order 1 (2) is test for first (second) order serial
correlation (H0: no autocorrelation). T-values are shown in parentheses. *, ** and *** denote significance at
the 10%, 5% and 1% levels, respectively.

3
 Table VI.
Two-step difference GMM regression results for the determinants of bank margins (Equation (2))
Expected Full Conventional Islamic
sign sample banks banks
(1) (2) (3)
Bank margint-1 0.444** (2.381) 0.441** (2.412) 0.555** (2.533)
Spread variables:
Operating costs + 0.224*** (2.793) 0.337*** (3.639) 0.146** (2.243)
Operational efficiency - -0.006*** (-3.795) -0.002*** (-3.410) -0.016***(-3.371)
Credit risk + 0.019*** (2.875) 0.013** (2.237) 0.248** (2.696)
Liquidity risk + -0.003 (-0.943) -0.001 (-0.455) -0.017 (-1.466)
Degree of risk aversion + 0.037** (2.338) 0.020** (2.451) 0.007 (0.740)
Market share + 0.097*** (3.321) 0.028*** (3.684) 0.673* (1.973)
Bank-specific variables:
Size (Total loans) - -0.001* (-1.899) -0.001** (-2.091) 0.001 (0.625)
Implicit interest payments + 0.126*** (5.265) 0.080** (2.237) 0.529** (2.845)
Opportunity costs of + 0.008 (0.350) -0.010 (-0.813) 0.089 (0.605)
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holding reserves
Funding costs + 0.028** (2.486) 0.046*** (2.962) 0.007 (0.854)
Diversification variables:
Net non-interest income - -0.032* (-1.795) -0.010** (-3.046) -0.038 (-0.327)
Asset diversify - 0.012 (1.333) 0.002 (0.392) 0.592 (1.093)
Arellano-Bond order 1 [p-value] [0.054] [0.227] [0.026]
Arellano-Bond order 2 [p-value] [0.877] [0.449] [0.388]
Hansen test [p-value] [0.446] [0.938] [0.542]
F-statistic 25.13 162.36 67.71
Number of instruments 14 14 14
Number of banks 36 20 16
Number of pooled observations 249 139 110
Notes: The dependent variable is the bank margin. The Hansen test is the test for the over-identifying
restrictions in the GMM model estimation. Arellano-Bond order 1 (2) is test for first (second) order serial
correlation (H0: no autocorrelation). T-values are shown in parentheses. *, ** and *** denote significance at
the 10%, 5% and 1% levels, respectively.