Humanomics

A comparative study of the returns on Mudhārabah deposit and on equity in Islamic

banks
Abdou Diaw Abdoulaye Mbow
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Abdou Diaw Abdoulaye Mbow, (2011),"A comparative study of the returns on Mudh#rabah deposit and on
equity in Islamic banks", Humanomics, Vol. 27 Iss 4 pp. 229 - 242
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Saiful Azhar Rosly, Mohammad Ashadi Mohd. Zaini, (2008),"Risk-return analysis of Islamic banks'
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dx.doi.org/10.1108/03074350810891010
Saiful Anwar, Dadang Romansyah, Sigit Pramono, Kenji Watanabe, (2010),"Treating return of mudharabah
time deposit as investment instrument: A utilization of artificial neural networks (ANNs)", Humanomics, Vol.
26 Iss 4 pp. 296-309 http://dx.doi.org/10.1108/08288661011090893
Hichem Hamza, Zied Saadaoui, (2013),"Investment deposits, risk-taking and capital decisions in Islamic
banks", Studies in Economics and Finance, Vol. 30 Iss 3 pp. 244-265 http://dx.doi.org/10.1108/SEF-
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Mudhārabah
A comparative study of the deposit
returns on Mudhārabah deposit and equity
and on equity in Islamic banks
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229
Abdou Diaw and Abdoulaye Mbow
International Centre for Education in Islamic Finance (INCEIF),
Kuala Lumpur, Malaysia

Abstract
Purpose – The paper aims to compare the return on Mudhārabah deposits (ROMD) to the return on
equity (ROE) in Islamic banks.
Design/methodology/approach – The summary statistics of the ROMD and the ROE is used to
make a comparison between them with a sample of nine Islamic banks, from seven countries, over the
last five years. Regression analysis is also undertaken to unveil the variables affecting the behaviour
of ROMD and ROE at Kuwait Finance House.
Findings – The results show that the ROE tend to be at least two times higher than the ROMD. In
most of the investigated cases the ROMD are more correlated to the corresponding conventional
interest rate than to ROE. The regression analysis suggests that the return on assets affects more
significantly the ROE than the ROMD.
Originality/value – The originality of the paper resides in the size of the sample and in the design
and the findings.
Keywords Islam, Banks, Risk, Return, Mudhārabah deposits, Equity
Paper type Research paper

Introduction
Islamic finance has nowadays gained recognizance in the global financial system as well
as in the academia. Thanks to its relative resilience during the recent global financial
crisis, an increasing number of people look now at it as a credible alternative. In theory,
Islamic banking and finance is based on the principles of Sharı̄’ah which promotes
equity, fairness and transparency in all transactions. However, the practice may diverge
from the above principles. Many theoretical and empirical studies have investigated
Islamic finance operations, and raised few issues which need to be addressed. The
present paper is intended to be a contribution to that existing literature.
The paper examines the returns on Mudhārabah deposits (ROMD) and equity in
Islamic banks. It attempts to find out whether the similarities between the Mudhārabah
contract and equity in terms of risk profile warrant a similitude of the returns on them,
and what would be the factors of differences if any. The paper further tries to discover to
what extent the adoption of the Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI) accounting treatment for Mudhārabah deposit affects
the return on these accounts.
Humanomics
Vol. 27 No. 4, 2011
The raw data for the banks and the interest rates for this paper were taken, respectively, from the pp. 229-242
q Emerald Group Publishing Limited
annual reports of the banks and the annual reports of the central banks, downloaded from the 0828-8666
internet. DOI 10.1108/08288661111181288
 HUM To address these issues we employ risk-return framework and regression analysis
27,4 methods on a set of data from selected Islamic banks. The summary statistics of the
ROMD and the return on equity (ROE) is used to make a comparison between them
with a sample of nine Islamic banks, from seven countries, over the last five years. In
addition to this, regression analysis is undertaken to unveil the variables affecting the
behavior of ROMD and ROE at Kuwait Finance House (KFH) which is one of the oldest
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230 and leading Islamic bank.

In the next section we will carry out a brief review of the literature on the concept of
Mudhārabah, which is one of the contracts used by Islamic banks to collect deposits.
The third section, will be devoted to the comparison between the ROMD and ROE for
selected Islamic banks. In fourth section, we will carry out a regression analysis for the
two variables in the context of KFH. The conclusion will constitute the last section.

A review of selected literature

After more than three decades of existence Islamic banking has positioned itself as a
respectable component of the global financial system. The primary raison d’être of
Islamic banks is to meet the financial needs of Muslims, who are not allowed to deal
with interest, which is a form of Ribā severely prohibited in the Quran.
To Siddiqi (2000) the theoretical model of Islamic banks was based on the concept of
two-tier Mudhārabah or al-mudhārib yudhārib. Mudhārabah is a contract endorsed by
Sharı̄’ah, whereby one party, the Rabbul-māl or financier, provides the capital, while
the other party, the Mudhārib, provides the entrepreneurship and effort to run the
business. Profits derived from the business are shared by the two parties according to a
predetermined profit-sharing ratio. Losses are to be born by the financier if they are not
due to the Mudhārib negligence. Unlike the contract of sale, Mudhārabah is not
binding, that is any party may terminate the Mudhārabah agreement. The Mudhārib
has the entire responsibility for running the business; hence the financier is not allowed
to interfere.
Under the two-tier Mudhārabah Islamic banks act as Mudhārib for the depositors
and at the same time as Rabbul māl for the investors or businessmen. Any profit will be
shared between the three parties according to pre-agreed ratios, whereas loss will be
born by the capital.
However, the current practice of Islamic banking is far from this theoretical model,
in the sense that on the asset side the use of Mudhārabah financing is minimal and on
the liability side its use, though quite extensive, raises some issues (Table I).
Using finance theories Bacha (1997) argues that Mudhārabah financing has serious
agency problems, lacks the bonding effect of debt financing and can induce perverse
incentives. Furthermore, within a risk-return framework, he shows that for a
“borrower” faced with the alternative of using Mudhārabah, debt or equity financing,
Mudhārabah would be the best. On the other hand, for a financier faced with the same
three alternatives, Mudhārabah financing would be the worst. These factors could
explain the decline of Mudhārabah as financing vehicle by Islamic banks.
However, other writers, while acknowledging the agency problem in Mudhārabah,
invoke additional factors which are related to attitudes and structures. Thus, for the
development of Mudhārabah financing, the current negative attitude of the Islamic
bankers towards risk and long-term investment needs to be adjusted.
Similarly, the structure of the institutions that are called upon to undertake
 Mudhārabah
2009 2008 2007 2006 2005 Average
deposit
Albaraka and equity
Mud. deposits/TAa (%) 62.57 61.65 61.59 61.60 63.66 62.21
Mud. financing/TA (%) 5.63 5.85 5.22 2.03 2.66 4.28
BIB
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Mud. deposits/TA (%) 74.60 71.41 61.19 69.68 61.70 67.72 231
Mud. financing/TA (%) 5.85 6.34 6.62 5.08 9.19 6.62
BIMB
Mud. deposits/TA (%) 35.05 29.19 35.47 46.64 52.85 39.84
Mud. financing/TA (%) 0.03 0.04 0.10 0.15 0.14 0.09
BMMB
Mud. deposits/TA (%) 61.65 52.55 44.06 51.58 50.11 51.99
Mud. financing/TA (%) 0.00 0.00 0.00 0.00 0.01 0.00
DIB
Mud. deposits/TA (%) 47.47 47.91 49.70 49.77 47.45 48.46
Mud. financing/TA (%) 6.47 8.51 6.58 4.74 5.10 6.28 Table I.
QIB The share of
Mud. deposits/TA (%) 34.74 34.27 36.64 42.78 48.72 39.43 Mudhārabah
Mud. financing/TA (%) 2.93 3.72 5.75 1.91 2.26 3.31 deposit/financing for
selected Islamic banks
Note: aTA, total assets over the period 2005-2009

Mudhārabah financing should be adjusted too to accommodate its specificities (Hasan,

2002).
On the liability side, the bulk of deposits are taken under Mudhārabah concept for
many Islamic banks. Usually, there are two types of accounts:
(1) The unrestricted investment account (UIA). Holders of these account allow
Islamic bank to invest their funds in a way it deems appropriate without
restrictions.
(2) The restricted investment account (RIA). Holders of these accounts impose
certain restriction as to where, how and for what purpose the funds should be
invested (AAOIFI, 2004, FAS 5).

As pointed out by Abdel Karim (1996), through a bilateral Mudhārabah some of the
Islamic banks’ assets are co-financed by their equity and the investment accounts’ funds,
while the remaining assets are exclusively financed from the banks’ equity and/or from
funds which they have the discretion to use. Hence the bank’s decision on the funds
allocation to the assets financing has direct bearing on the allocation of realized profits
and losses between holders of investment accounts and the Islamic banks. This point is
crucial if we take into consideration the fact that investment accounts holders (IAH), like
the equityholders, are exposed to the risk of loss and yet they do not have voting rights
that give them authority over the banks management as the case is for the equityholders.
Moreover, since the depositors come to the Islamic banks individually, they may not
have the possibility to bargain about the profit sharing ratio which significantly affects
their return.
Another issue of importance for the investment accounts is the use of reserves to
“smoothen” the returns on these accounts. Thus, some Islamic banks have established
two types of reserve, namely the profit equalization reserve (PER) and the investment
 HUM risk reserve (IRR). The former is used by Islamic banks to pay a competitive rate to the
27,4 IAH when the earnings from their operations do not allow them to do so. The provision
for this type of reserve is taken from the Mudhārabah income before the allocation of the
Mudhārib’s share. On the other hand, the provision for IRR is directly taken from the
IAH’s share of profit in period of good performance with the objective of making
payment to them when the assets financed with the Mudhārabah funds incur loss. These
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232 reserves are potential source of unfairness among generations of IAH and also between
the IAH and the Islamic banks, as already discussed in the literature.
It is certainly these reasons, among other, that led organizations like AAOIFI and
Islamic Financial Services Board (IFSB, 2005a, b, 2006, 2007) to pay particular
attention to the case of investment account holders with the objective of protecting
their rights.
In four of its standards[1], IFSB addresses issues related to these investment
accounts. Thus, in its standard on corporate governance, IFSB exhorts Islamic
Financial Institutions (IFI) to adopt appropriate investment strategy with respect to the
Mudhārabah deposit funds and to make adequate and timely disclosure of all material
information. Such steps are of nature to encourage market discipline, in the Islamic
finance industry, as the depositors would be, thus, enabled to get the right information
to subsequently take the right decision.
IFSB has also come up with a capital adequacy ratio formula adapted to the
specificities of Islamic banks whereby assets financed by Mudhārabah funds will
qualify for capital relief, to some extent, as only operational risk will be accounted for
them. This is in conformity, in part, with the Mudhārabah principle stipulating that loss
should be born by the capital, unless it is due to negligence or misconduct.
With this capital relief, granted to them due to the presence of Mudhārabah
deposits, Islamic banks, in this respect, have a clear advantage over their conventional
counterparts as they dispose of more funds available for use. With this in mind, the
establishment of PER and IRR by Islamic banks to enhance return when they
underperform their competitors seems redundant and may favor inefficiency in the
industry. This is because with that capital relief Islamic banks are expected to achieve
greater earnings if the assets are efficiently employed. Furthermore, the contractual
relationship between conventional banks and their depositors is different from the one
between Islamic banks and the IAH. Conventional deposits are theoretically riskless as
the return is guaranteed as well as the capital, whereas for Mudhārabah deposits the
opposite is true. Hence the rate paid to IAH is supposed to be higher than the rate on
conventional deposits.
AAOIFI had also paid particular interest to the investment accounts, as manifested
through the issuance of three financial accounting standards (FAS)[2] that directly
address the aforementioned issues pertaining to these types of accounts. It appears
from the issuance of all these guidelines that AAOIFI is not only concerned with the
provision of accurate and relevant information to the stakeholders but also with the
achievement of justice and fairness to all parties, thus it emphasized:
[. . .] the importance of the issue of profit allocation between owners’ equity and investment
account holders because it deals with a fundamental and ethical issue relating to the core of
the concept of fairness in the Islamic alternative that Islamic banks offer as opposed to what
usury-based banks adopt. In addition, this subject affects the allocation of wealth in the
society among individuals who deal with Islamic banks (AAOIFI, 2004, FAS 5).
 There exist some empirical works that compare the returns on these two types of Mudhārabah
funds. Rosly and Zaini (2008) compared ROMD and ROE for six Malaysian Islamic deposit
banks in 2005. They found that ROE is higher than ROMD which exhibits a behavior
similar to that of conventional-fixed deposit. and equity
Sundararajan (2005) went a step further by examining the relationship among the
returns on investment accounts, the returns on bank deposits generally in the banking
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system, the return on assets (ROA) and equity, and the level of risks. His analysis 233
showed that in practice there is considerable smoothing of returns on investment
accounts despite wide divergences in risk, and hence very little risk sharing with
investment accounts. Sundararajan study was based on data for 14 Islamic banks in
eight countries.
This paper also compares the ROMD and ROE using different set of data and
methods. Its scope is wider than that of Rosly and Zaini (2008); the methods and
variables considered are also different from that of Sundararajan (2005). The details of
all this will be discussed in the remaining parts of the paper.

Comparison of returns on Mudhārabah deposit and on equity in selected

Islamic banks
Data and method
The study covers nine Islamic banks in seven different countries, over a period of five
years (2005-2009). The banks involved are: Al Baraka Banking Group and Bahrain
Islamic Bank (Al Baraka/BIB – Bahrain), Bank Islam Malaysia Berhad and Bank
Muamalat Malaysia Berhad (BIMB/BMMB – Malaysia), Al Rajhi Bank (Al Rajhi –
Saudi Arabia) Kuwait Finance House (KFH – Kuwait), Qatar Islamic Bank (QIB –
Qatar), Faisal Islamic Bank (FIB – Sudan), and Dubai Islamic Bank (DIB – United Arab
Emirates). For all banks, we made our own computation of ROMD and ROE, except for
KFH where the returns on various types of Mudhārabah deposits are given in the annual
reports. Only four banks in the sample adopt AAOIFI standards (Al Baraka, BIB, QIB,
and FIB), the remaining have different ways of presenting the financial statements. This
results in difference in the types of Mudhārabah deposits but also in the accounting
treatment. For instance, UIA are on-balance sheet while RIA is off-balance sheet within
the AAOIFI framework; for Malaysian banks, Mudhārabah deposits comprise general,
special and saving (for BIMB only). As for profit allocation, KFH and DIB deduct all
costs from the pooled incomes before distribution to depositors and equityholders. On
the other hand, those banks following AAOIIFI standards and the other remaining
banks in the sample treat Mudhārabah investment separately from other banking
operations.
We consider the mean-variance framework to carry out the comparison
between ROMD and ROE. Within this framework, the average returns of investments
and their risks, as measured by the standard deviations, are looked into to determine the
most beneficial investment. Even though mean-variance framework provides some
interesting insights, it comports some drawbacks that warrants the consideration of the
context. Thus, an investment with a return of 20 percent and a standard deviation of
5 percent is clearly better than the one with a return of 6 percent and a standard deviation
of 1 percent although the reward per unit of risk for latter is higher.
In finance, the risk-return framework constitutes an appropriate context to measure
the fairness of a transaction or a product. Within this framework, risk and return
 HUM are positively related. Thus, high-risk investments are expected to provide
27,4 higher return, and investments with similar risk profile should yield comparable
return.
From pure finance viewpoint, the risk profiles of IAH and equity owners (of Islamic
banks) are similar in many respect, since for both neither capital nor profit is guaranteed.
The main difference between the two resides in the maturity which is limited for the
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234 former and perpetual for the latter. Consequently, one is reasonably founded to expect
similar returns on Mudhārabah deposit and equity.

Analysis of the results

A look into Table II reveals that the average ROE for all the banks in the sample
(except BMMB) is of two digits, whereas none of the average ROMD is greater than
9 percent. The average ROE ranges from 6.98 percent (BMMB) to 30.60 percent
(Al Rajhi). The corresponding figures for ROMD are 2.71 percent (BIMB) and
8.01 percent (FIB). As expected the standard deviations for ROE are greater than those
for ROMD.

2009 2008 2007 2006 2005 Average SD

Albaraka
ROMD 6.02 6.86 5.95 5.82 5.34 6.00 0.55
ROE 9.64 12.97 12.80 10.21 13.41 11.81 1.74
Alrajhi
ROMD 3.02 3.76 8.71 5.82 2.20 4.70 2.61
ROE 23.55 24.14 27.32 36.18 41.82 30.60 8.05
BIB
ROMD 2.59 2.84 3.87 4.16 2.56 3.20 0.76
ROE 0.00 a 13.41 13.37 17.42 10.28 10.89 6.60
BIMB
ROMD 1.89 2.78 3.51 3.08 2.32 2.71 0.63
ROE 10.57 29.35 24.06 0.00 0.00 12.80 13.54
BMMB
ROMD 2.06 2.92 3.95 2.68 2.35 2.79 0.72
ROE 7.40 4.31 6.69 10.35 6.18 6.98 2.20
DIB
ROMD 2.36 2.64 4.34 3.34 3.52 3.24 0.78
ROE 13.50 17.76 23.56 17.88 27.70 20.08 5.56
FIB
ROMD 7.17 7.08 10.50 7.33 7.96 8.01 1.44
ROE 37.04 32.86 32.35 31.20 16.84 30.06 7.71
KFH
ROMD 2.26 3.50 7.03 6.89 5.55 5.05 2.10
ROE 4.59 10.95 23.14 23.01 18.96 16.13 8.13
QIB
ROMD 3.74 3.38 4.39 4.05 3.00 3.71 0.55
ROE 14.68 23.00 27.12 23.79 24.39 22.60 4.69
3- to 12-month time deposit IR (Bahrain) 1.36 1.29 3.47 4.40 3.70 2.84 1.43
Table II. 12-month fixed deposit IR (Malaysia) 2.50 3.50 3.70 3.73 3.70 3.43 0.53
ROMD and ROE for 12-month inter-bank IR (Saudi Arabia) 3.16 4.86 5.28 4.17 4.37 0.93
selected Islamic banks
from 2005 to 2009 Notes: This corresponds to situation where net profit is negative; we prefer to put zero instead of N/A
 A comparison between ROMD and the corresponding local interest rate (IR) shows that Mudhārabah
the average returns as well as the standard deviations are very analogous. This premise deposit
is further supported by the analysis of the correlation between the local IR, on the one
hand, and the ROMD and the ROE, on the other hand. For three Islamic banks in and equity
Table III, the correlation coefficient between ROMD and the corresponding local IR is
greater than the correlation coefficient between ROMD and ROE.
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This is a source of concern, if we recall that Mudhārabah deposits and time deposits 235
are completely different in terms of risk profile. While for the former the claim is
residual, making it a risky investment, time deposits are contractually riskless since
the offering banks guarantee both return and principal. Hence the returns on the two
should not be by any way analogous.
We have already pointed out the similarities in terms of risk profile between
Mudhārabah deposits and equity and also the established finance theory on risk return.
However, the results in this section show that these two investments are rewarded
differently. While the ROEs in the sample behave in a similar fashion than equity
(high risk and high return) the returns on Mudhārabah deposits seem to mirror the
local IR.
One may argue that frequent and large fluctuations of the returns on Mudhārabah
deposits could cause depositors funds to move out of Islamic banks; such a behavior would
be harmful to the economy given the crucial role of the banking sector in a country payment
system. If the assumption is plausible, then Islamic banks should use other concept than
Mudhārabah which accommodates the risk-return profile of conventional banks deposits
that they want to mimic. In this respect, the concept of Wakālah provides more flexibility.
On the other hand, the launch of a product that reflects the characteristics of
Mudhārabah in terms of risk and return would enable Islamic banks to tap a niche
market which is lacking in the conventional system. We submit that there exist
depositors who would be happy to bear the same risk as equityholders provided that
they are rewarded accordingly.
In the following section we take the study a step further by investigating the factors
that would be at the origin of the above-mentioned disparity between ROMD and ROE.

ROMD and ROE at KFH: a case study

Method and data
In the previous section, our findings confirm that of Rosly and Zaini (2008) on the
abnormal gap between ROMD and ROE despite the similarity between Mudhārabah
and equity in terms of risk. In this section we proceed to find out the factors that may
explain this difference of returns through the use of regression analysis. To carry out
this task we managed to get the needed data for one Islamic bank, the KFH.

Cor. coef. (ROMD, ROE) Cor. coef. (ROE, IR) Cor. coef. (ROMD, IR)

Albaraka 0.032 0.094 2 0.713 Table III.

Alrajhi 20.203 0.403 0.592 Correlation coefficients
BIB 0.703 0.622 0.655 between ROMD, ROE
BIMB 0.358 2 0.036 0.742 and IR for selected
BMMB 20.161 0.03 0.557 Islamic banks
 HUM KFH is a Kuwait-based company mainly engaged in banking, financial, commercial
27,4 and investment activities in compliance with Islamic Sharı̄’ah within Kuwait and
abroad. The data for this study are taken from the annual reports of KFH since its
establishment, in 1978 until 2009. Over these 32 years, there are actually 31 AR, with
one missing, that of 1990, certainly as a consequence of the invasion of Kuwait by Iraq.
Regression analysis is a popular method used to look into the relationship among a
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236 set of variables. According to Gujarati (2003):

Regression analysis is concerned with the study of the dependence of one variable, the
dependant variable, on one or more other variables, the explanatory variables, with the view
to estimating and/or predicting the (population) mean or average value of the former in terms
of the known or fixed (in repeated sampling) values of the latter.
Thus, by using regression analysis, we want to investigate: first the influence of ROA,
profit attributable to depositors as percentage of operating profit (PADOP) and total
deposit as percentage of total assets (TDTA) on ROMD; second, the influence of ROA,
profit attributable to equityholders as percentage of operating profit (PAEOP) and total
equity as percentage of total assets (TETA) on ROE.
The claim on Mudhārabah deposits and that on equity are residual, meaning that
the return can be positive or negative depending on the performance of the company.
Thus, the choice of ROA as explanatory variable is meant to show the relationship
between the bank performance and ROMD and ROE, respectively. On the other hand,
the allocation of profit is considered, in the relevant literature, as a crucial factor for the
return on both depositors and equityholders. Based on that premise, we include PADOP
and PAEOP as explanatory variables. Finally, TDTA and TETA are also included to
see the leverage effect on the return.
The models are as follows:

ROMDt ¼ b1 þ b2 ROAt þ b3 PADOPt þ b4 TDTAt þ 1t ; t ¼ 1; 2; . . . ; 31: ð1Þ

ROEt ¼ b1 þ b2 ROAt þ b3 PAEOPt þ b4 TETAt þ 1t ; t ¼ 1; 2; . . . ; 1: ð2Þ

The variables are constructed as follows:
(1) Total assets (TA), as it appears in the AR.
(2) Total equity (TE).
(3) Total deposits (TD), which comprise:
.
Non-investment deposits in the form of current accounts. These deposits are
not entitled to any profits nor do they bear any risk of loss as the bank
guarantees to pay the related balances on demand.
.
Investment deposits comprise deposits for unlimited periods and savings
accounts. Unlimited investment deposits are initially valid for one year and
are automatically renewable for the same period unless notified to the
contrary in writing by the depositor. Investment savings accounts are valid
for an unlimited period.
In all cases, the investment deposits receive a proportion of the profit as
the board of directors of the bank determines, or bear a share of loss based on
the results of the financial year.
 Until 1993 the portion of current account in TD could be computed Mudhārabah
as the figures were presented in the AR. Except for the first year, the deposit
portions used to vary from 10 to 20 percent of TD. Being unable to get the
exact figure for Mudhārabah deposits over the period, we took TD as proxy. and equity
(4) Operating profit (OP): is the remaining amount available for distribution after
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deducting the operating expenses.

237
(5) ROA: OP divided by TA times 100.
(6) ROMD: the average of the profit rates to the holders of investment accounts, as
given in the annual reports.
(7) ROE: PAE divided by TE times 100.
(8) PADOP: PAD divided by OP times 100. This ratio determines the percentage of
PAD in OP.
(9) PAEOP: PAE divided by OP times 100: this ratio measures the proportion of
PAE in OP.
(10) TDTA: TD divided by TA times 100: TDTA gives the percentage of TD in TA.
(11) TETA: TE divided by TA times 100: this ratio measures the percentage of TE
in TA.

Analysis of the summary statistics of some variables

Table IV provides a summary statistics of some of the variables that we have already
defined previously.
We can see that over the last 32 years, in average 64.58 percent of the annual OP
realized by KFH were attributed to the depositors whose funds constituted, in average,
around 78 percent of the TA. The corresponding figures for equityholders were
30.24 and 7.48 percent, respectively. The average ROMD was 5.51 percent against
18.18 percent for ROE. These figures raise again the same issue of rewarding
differently two risky instruments whereby those who contribute for around 70 percent
of the assets receive a return three times smaller than those who contribute for only
7 percent of the assets!
A look at the standard deviations may provide an explanation – not necessarily a
justification. Indeed, for ROMD the standard deviation is 2.24 while for ROE, it is 15.45.
If we know that standard deviation is a measure of riskiness, since it determines the
variability of the return, the results for ROE are theoretically consistent in a risk-return
framework. A possible implication of this could be that KFH theoretically take the bulk
of the deposits on the basis of Mudhārabah principle, but in practice they are treated

ROE (%) ROMD (%) ROA (%) TETA (%) TDTA (%) PADOP (%) PAEOP (%)

Mean 18.18 5.51 4.31 7.48 78.63 64.58 30.24

SD 15.45 2.24 1.81 3.41 8.48 25.65 21.99 Table IV.
Median 21.40 5.55 4.49 6.41 79.60 58.58 39.53 Summary statistics for
Minimum 2 45.78 0.000 0.00 3.12 59.08 0.00 257.98 some variables from
Maximum 43.92 11.50 8.07 15.13 90.11 158.20 65.28 1978 to 2009
 HUM like the conventional saving account, where the return is low and almost constant,
27,4 whereas the equity funds have the same treatment as in the conventional framework.
For example, in 1984 profit was not distributed to the shareholders nor to the depositors.
However, in 1991, after the Iraqi invasion, profit was distributed to the depositors at the
expense of the equity holders who incurred a negative return that year.
It is also remarkable, by looking at the Figures 1 and 2, that after 1991, PADOP has
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238 a decreasing trend over the years while the PAEOP has an increasing one. This
paradox could have to do with the fact that the investment account holders unlike

180.00

160.00

140.00

120.00

100.00

80.00

60.00

40.00

20.00

0.00
1978 1983 1988 1993 1998 2003 2008
Figure 1.
Ratios for depositors ROMD TDTA PADOP

80.00

60.00

40.00

20.00

0.00
1978 1983 1988 1993 1998 2003 2008
–20.00

–40.00

–60.00

Figure 2. –80.00
Ratios for equity holders
ROE TETA PAEOP
 the equity holders do not have voting rights and as a consequence their interest is not Mudhārabah
taken care of as it should be during the Annual General Meeting. deposit
Analysis of the regression results and equity
Equations (3) and (4) consist of the results of the regression:
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ROMD ¼26:16 þ 1:03 ROA þ 0:001 PADOP þ 0:09 TDTA 239

ðseÞ ð2:75Þ ð0:15Þ ð0:01Þ ð0:03Þ ð3Þ
p2value 0:03 0:000 0:9 0:01 R
2 ¼0:62; DF¼27

ROE ¼ 0:89 þ 4:04 ROA þ 0:68 PAEOP 22:77 TETA

ðseÞ ð2:71Þ ð0:52Þ ð0:057Þ ð0:35Þ ð4Þ
p2value 0:75 0:000 0:000 0:000 R
2 ¼0:90; DF¼27

For both regressions (3) and (4), the p-value for the F-test is less than 0.001.
For equation (3) the value of the adjusted R 2 (R
2 ) suggests that 62 percent of the
variability of ROMD are explained by ROA, PADOP and TDTA. The estimates in
equation (3) imply that over the last 32 years, an increase of 10 percent of the
profitability of KFH, as measured by ROA, results, in average, in a similar increase of
ROMD, everything else being constant. On the other hand, an increase of 10 percent of
the TDTA led in average to an increase of only 0.9 percent of ROMD holding the other
variables constant. All the results are statistically significant at 5 percent, except for
PADOP.
These results imply that while the profitability of the KFH was an important factor
for the return on investment deposits, the proportion of the deposits in TA did not play
a significant role in the determination of ROMD. The regression results in equation (3)
did not permit us to be conclusive with respect to the impact of profit allocation policy
at KFH on ROMD.
On the other hand, equation (4) seems to make more sense statistically as well as
economically. In addition to the negligible p-value for the F-test, the R
2 is very high
(0.90), meaning that not only the model fits the data but about 90 percent of the
variability of ROE are explained by the independent variables.
Furthermore, a 10 percent increase of ROA over the period of study led, in average, to
a 40 percent increase of ROE, everything else held constant. The same positive
relationship exists between PAEOP and ROE but at much lesser degree, as it can be seen
in the equation. However, the results of the regression show a negative relationship
between ROE and TETA. Thus, a 10 percent decrease of TETA led to a 27.7 percent
increase, in average, for ROE, keeping the other variables constant. All these result are
statistically significant at 1 percent.
These results corroborate the point that we made earlier the return to investment
accounts – which made up around 70 percent of TD, and which are theoretically risky
like equity – cannot be explained in a risk-return framework, while return equity is in
line with the risk-return theory. It is as if the equityholders of the bank were “rewarded”
for having less equity, whereas the opposite seems to be true for the depositors!
 HUM At this juncture, the use of Dupont System may help better understand the source of
27,4 the gap between ROMD and ROE. Dupont System links between the profitability and
efficiency ratios in financial analysis. Thus, with this system, the ROE can be
decomposed as being:

asset Sales EBIT 2 tax EBIT 2 tax 2 interest

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ROE ¼ £ £ £ ð5Þ
240 equity asset sales EBIT 2 tax
In the context of our study equation (5) would be, when rearranged:

1
ROE ¼ £ ROA £ PAEOP ð6Þ
TETA
If we admit that ROA is supposed to similarly affect ROMD and ROE, the difference in
the magnitude comes then from the product (1/TETA) £ PAEOP which happens to be
4.04, a figure similar to the ROA coefficient in equation (4). Thus, this result shows that
the leverage factor 1/TETA off set more than four times what would correspond to the
“Burden of debt”, i.e. PADOP. Hence, we can deduce from the above result that only
equityholders benefit from the enhancement effect of leverage and that render their
return much higher than that of Mudhārabah depositors. In the context of KFH where
all income and costs are accounted for before any distribution such a profit allocation
policy raises serious concern of fairness and equity.

Conclusion
In this paper we investigate the returns on Mudhārabah deposits and equity in some
Islamic banks. The results show that the ROEs in the sample tend to be at least two
times higher than the ROMD, even though the risk is similar in many respects. In most
of the investigated cases the ROMD are more correlated to the corresponding
conventional IR than to ROE. There is no significant difference, in that respect,
between those banks following AAOIFI standards and those which do not.
The regression analysis carried out on KFH suggests that the ROA affects more
significantly the ROE than the ROMD. Such a difference is explained by the fact that
equityholders benefit from the leverage effect while the depositors do not.
These results are in line with the findings of Rosly and Zaini (2008) and that of
Sundararajan (2005) but they are in contradiction with the established theory on risk return.
As mentioned earlier, these results raise serious issues about the fairness of the
profit distribution policies adopted by Islamic banks. It is clear that the current practice
is hardly justifiable within the Islamic economics framework which is profoundly
concerned about wealth circulation and equitable distribution.
Thus, Islamic banks should use other concept, than Mudhārabah, which
accommodates the risk-return profile of conventional banks deposits, if they are
interested to follow conventional banks. However, we are of the view that the launch of
a product that reflects the characteristics of Mudhārabah in terms of risk and return
would enable Islamic banks to tap a niche market which is lacking in the conventional
system. We submit that there exist depositors who would be happy to bear the same
risk as equityholders provided that they are rewarded accordingly.
This paper is limited by its relatively small sample. Hence, it would be useful to
further investigate the issue with a bigger sample.
 Notes Mudhārabah
1. These standards are: deposit
Capital Adequacy Standard for Institutions (Other than Insurance Institutions) Offering
Only Islamic Financial Services. Issued in December 2005. and equity
Guiding Principles of Risk Management for Institutions (Other than Insurance
Institutions) Offering Only Islamic Financial Services. Issued in December 2005. Guiding
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Principles on Corporate Governance for Institutions Offering Only Islamic Financial Services 241
(Excluding Islamic Insurance (Takaful) Institutions and Islamic Mutual Funds). Issued in
December 2006.
2. These are: FAS 5: Disclosure of Bases of Profit Allocation between Owner’s Equity and
Investment Account Holders. FAS 6: Equity of Investment Account Holders and Their
Equivalent. FAS 11: Provisions and Reserves.

References
AAOIFI (2004), Accounting, Auditing and Governance Standards for Islamic Financial
Institutions, Accounting and Auditing Organization for Islamic Financial Institutions,
Manama.
Abdel Karim, R.A. (1996), “Economic consequences of accounting standards and Islamic banks”,
Research in Accounting Regulation, Vol. 10.
Bacha, O.I. (1997), “Adapting Mudhārabah financing to contemporary realities: a proposed
financing structure”, Journal of Accounting, Commerce, & Finance: Islamic Perspective,
Vol. I No. 1, p. 27.
Gujarati, D. (2003), Basic Econometrics, 4th ed., McGraw-Hill, Singapore.
Hasan, Z. (2002), “Mudhārabah as a mode of financing in Islamic banking:
theory, practice, and problems”, Middle East Business & Economic Review, Vol. 14 No. 2,
pp. 41-53.
IFSB (2005a), Capital Adequacy Standard for Institutions (Other Than Insurance Institutions)
Offering Only Islamic Financial Services, Islamic Financial Services Board, available at:
http://ifsb.org/standard/ifsb2.pdf
IFSB (2005b), Guiding Principles of Risk Management for Institutions (Other Than Insurance
Institutions) Offering Only Islamic Financial Services, Islamic Financial Services Board,
available at: http://ifsb.org/standard/ifsb1.pdf
IFSB (2006), Guiding Principles on Corporate Governance for Institutions Offering Only Islamic
Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Mutual
Funds), Islamic Financial Services Board.
IFSB (2007), “Disclosures to Promote Transparency and Market Discipline for Institutions
Offering Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions
and Islamic Mutual Funds)”, Islamic Financial Services Board, available at: http://ifsb.org/
standard/ifsb3.pdf
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and shareholders’ fund”, Managerial Finance, Vol. 34 No. 10.
Siddiqi, M.N. (2000), “Islamic banks: concepts, precepts and prospects”, Review of Islamic
Economics, No. 9.
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Conference on Islamic Economics, Banking and Finance, Jakarta, Indonesia.
 HUM Further reading
27,4 Bodie, Z., Kane, A. and Marcus, A.J. (2009), Investment, 8th ed., McGraw-Hill, Singapore.
Hameed, S. (2007), Accounting and Auditing for Islamic Financial Institutions, AAOIFI, Manama.

About the authors

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Abdou Diaw completed his PhD in Islamic finance at International Centre for Education in Islamic
242 Finance (INCEIF) where he used to be a teaching/research assistant. He holds a Postgraduate
Diploma in Islamic Banking and Finance (International Islamic University Malaysia), a Master’s
and Bachelor’s degrees in Mathematics (Cheikh Anta Diop University of Dakar-Senegal). He has
also received a Brevet d’arabe littéral (Diploma in Literal Arabic – Université de la Sorbonne
Nouvelle /France). Dr Diaw taught Mathematics at the State High School of Djibouti and later at
Malaysia France Institute. He has publications in refereed journals and presented several papers at
international conferences on Islamic finance. A paper that he coauthored won the “best paper
award” of the sub-theme Islamic capital market at the inaugural ISRA Colloquium on “Innovation
in Islamic finance: Sharı̂’ah driven or market driven?” held on June 28, 2011, in Kuala Lumpur.
Abdou Diaw is the corresponding author and can be contacted at: abdoulkarimdiaw@yahoo.com
Abdoulaye Mbow has just completed a Chartered Islamic Finance Professional (CIFP) at the
INCEIF. He holds a Postgraduate Diploma in Economics (Cheikh Anta Diop University of
Dakar-Senegal), and both a Master’s and Bachelor’s degree in Economics (Cheikh Anta Diop
University of Dakar-Senegal).

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