How profitable is Islamic banking?

The record profitability of the Islamic banking sector is, by now, a well-known fact and, besides raising accusations of hypocrisy and taking advantage of people’s religious faith, it has also provoked a policy response from the State Bank of Pakistan. But exactly where does the profitability of this sector come from, and how structural is it? Specifically, are the record profits at Islamic banks – which are undeniable – the result of rent-seeking behaviour on the part of the Islamic banking sector, or are they simply a cyclical rise in profitability that can come from a time of high interest rates?

In this story, we will attempt to answer these questions by comparing the profitability of Islamic banks to the industry as a whole, the bulk of which is still conventional, and examine the determinants of that profitability. What we will not do is comment on the religious foundations of Islamic finance. We are not religious scholars and will not pretend otherwise, nor insert ourselves in a debate in which we cannot offer informed comment.

As always, we will dispense with the suspense up front: Profit’s analysis of the data from the banking sector suggests that while there appear to have been some regulatory advantages available to Islamic banks until recent changes, the industry’s profitability has less to do with that regulatory arbitrage and more to do with the fact that it is dominated by what is clearly one of Pakistan’s best run banks: Meezan Bank.

Here is the summary of our evidence for the above statement: remove Meezan Bank from the Islamic banking industry’s statistics, and then calculate their profitability and you will find that the Islamic banking sector, ex-Meezan, has underperformed the conventional banking sector in terms of return on equity for every single year for the past 15 years for which we can gather consistent data.