Chapter 03

Methodology of the study

 Sources of Data
The data used in this research is secondary data that were obtained from annual report from 2015
to 2019 by searching each bank official website. Data of ratios directly collected from annual
report if not found then calculated. Data of GDP growth rate, Inflation rate and Real interest rate
collected from world bank official websites. Data collected from the study of literature through
journals, thesis research and others related to the topic to get the basic theory and analysis
technique in solving the problem.
The sample of this study are 8 sharia banks in Bangladesh which are:
Serial No Name of the bank
1 Islami Bank Bangladesh limited
2 Al-Arafah Islami Bank Limited
3 Export Import Bank of Bangladesh Limited
4 Social Islami Bank Limited
5 Shahjalal Islami Bank Limited
6 First Security Islami Bank Limited
7 Union Bank Limited
8 ICB Islamic Bank Limited

Variable Specifications
Dependent Variables: Profitability ratios are ratios to measure a company's ability to generate
profits at the level of sales, assets and share capital. In the discussion of profitability, there are
three ratios that are often discussed namely net profit margin, return on asset, and return on
equity. The study considers three measures of profitability as dependent variable which are
explained below.
Return on Assets (ROA): ROA shows the ability of management to acquire deposits at a
reasonable cost and invest them in profitable investments. This ratio indicates how much net
income is generated per dollar of assets. The higher the ROA, the more the profitable the banks
are. This ratio is widely used as a proxy for profitability. In this repor t ratio of ROA directly
collected from the annual report of each bank.
Return on Equity (ROE): ROE is the most important indicator of a bank’s profitability and
growth potential. It is the rate of return to shareholders or the percentage return on each dollar of
equity invested in the bank. A higher ratio indicates better use of capital. The ratio of ROE
directly collected from the annual report of SJIBL, IBBL, EXIM bank, AIBL for rest of the bank
it was calculated by dividing net income by total shareholder equity.
Net Interest Margin (NIM): Net interest margin (NIM) is a measurement comparing the net
interest income a financial firm generates from credit products like loans and mortgages, with the
outgoing interest it pays holders of savings accounts and certificates of deposit. Expressed as a
percentage, the NIM is a profitability indicator that approximates the likelihood of a bank or
investment firm thriving over the long haul. This metric helps prospective investors determine
whether or not to invest in a given financial services firm by providing visibility into the
profitability of their interest income versus their interest expenses.
A positive net interest margin suggests that an entity operates profitably, while a negative figure
implies investment inefficiency. In this study ratio of NIM calculated by deducting investment
income from profit paid on deposit and borrowing then dividing the result with total investment.
Bank Specific Variables and Macro-Economic variables
The explanatory variables of the study include both bank level variables and macro-economic
variables. Bank level variables are Capital Adequacy, Credit Risk, Liquidity, Operational
Efficiency and Bank Size. Macro-economic variables GDP Growth, Interest Rate and Inflation
Rate.
Capital Adequacy: Strong capital structure is essential for banks in developing economics, since
it provides additional strength to withstand the financial crises and increased safety for
depositors during unstable macroeconomic conditions. Furthermore, a lower capital ratio in
banking indicates higher leverage and risk, therefore, greater borrowing cost. Thus, the
profitability level should be higher for a better capitalized bank. Higher the ratio, more stable and
efficient the bank is. While the relationship of this variable to profitability may vary across the
stages of the business cycle. It is expected that it will have an overall positive relationship to
profitability.
Credit Risk: To measure credit risk I have used ratios of Non-performing loan to gross loan
(NPLGL) and Loan loss provision to total loan (LLPTL).
NPLGL is a ratio used to measure the ability of bank management to manage problematic
financing provided by banks. NPL is one of the biggest problems for banks because it is the main
cause of bank failures. NPL increases, the risk of problem financing for the bank. The risk of
financing can increase if the bank provides loan to customers who are not right so that the funds
provided are not returned. An increasing NPLGL ratio will reduce the level of bank performance
and operations, so that the level of profitability obtained by banks will also decline. NPLGL is
collected from the Annual Report of all banks.
LLPTL ratio is described as the ratio that is used in the bank in order to represent the reserve that
the company has in percentage terms in order to cover the estimated losses that they would have
suffered as a result of defaulted loans. The coefficient of credit risk is expected to be negative
because bad loans reduce bank profitability. The greater the financial institutions exposure
towards high – risk loans, the higher would be the accumulation of unpaid loans resulting in a
lower profitability. LLPTL is calculated by dividing loan loss provision to total loan.
Liquidity: The ratio of the total loans to total assets is used as a measure of liquidity risk. Loan
constitutes the largest interest earning assets of the bank and expects to effects profitability
positively. If major segment of the deposit is used for loan creation, it is expected that the ratio
increases interest income and effects profitability positively. However, high ratio may reduce
liquidity level of the banks which may increase funding cost and also increase the credit risk of
the bank. In that case, the effect of liquidity ratio may be negative. Therefore, the expected
relationship between liquidity and profitability is unclear. In this study liquidity risk is measured
by dividing total loans to total assets.
Operational Efficiency: Operating efficiency ratio is measured by taking the ratio of total
operating expense to total operating income. This ratio indicates how efficiently firm uses its
assets, revenues and minimizing the expenses. In other words, it shows how well firm could
reduce the expenses and improves productivity. The relationship between the cost to income
ratio and profitability level is expected to negative as banks that are productive and efficient
should keep their operating cost low.
Bank Size: The size of the bank effects the bank profitability but it remains unclear the optimum
level of bank size. Because, it is proven that the effect of growing size is positive but the sign
may change due to rise of inefficiency and bureaucracy with the increase of bank size. Therefore,
the effect of bank size also remains unclear. In this study bank size is measured as the natural
logarithm of total assets.
GDP Growth: A GDP is the amount that most commonly used macroeconomic indicators to
measure economic activity within an economy. The first macroeconomic variable real GDP per
capita is expected to affect the banking profitability positively by influencing the factors which
indirectly affect the demand and supply of loan and deposit conditions. Such as during the
recession when GDP growth rate slowdown, the deposit mobilization, loan creation and credit
quality decline which downsize the profitability of the banks. GDP growth rate is collected from
the world bank website.
Interest Rate: High real interest rate increases the loan interest rate which leads to affect the
profitability positively. Moreover, high real interest rate may also increase Islamic banks’
profitability if large portion of the income comes from direct investment. However, high real
interest rate influences profitability negatively too if higher loan interest rate reduces the demand
of the banking loan. Moreover, market turnover is the indicator of business cycle movement of
the country which may also influence on the profitability of the banks. It may affect the
profitability positively. Interest rate also collected from world bank website.
Inflation rate: Previous studies have reported a positive association between inflation and bank
profitability. High inflation rates are generally associated with high loan interest rates, and
therefore, high incomes. However, if inflation is not anticipated and banks are sluggish in
adjusting their interest rates then there is a possibility that bank costs may increase faster than
bank revenues and hence adversely affect bank profitability. Inflation rate also collected from
world bank website.
 Model Specification
The proposed models for the present study are as follows:
Z¿ =α + β ¿ ( Bank Specefic variables ) + β t ( Macro−Economic Variables ) +έ

Where Zit is the dependent variables (ROA, ROE and NIM)

Model 01
RO A ¿=α + β 1 ( CA R¿ )+ β2 ( NPLG L¿ ) + β 3 ( LLPTL R¿ )+ β 4 ( TLTA R ¿ ) + β 5 ( OE R¿ ) + β 6 ( LNT A ¿ ) + β 7 ( GROWT H t ) + β8 ( ¿

Model 02
RO E ¿=α + β 1 ( CA R¿ )+ β2 ( NPLG L¿ ) + β 3 ( LLPTL R¿ )+ β 4 ( TLTA R ¿ ) + β 5 (OE R¿ ) + β 6 ( LNT A ¿ ) + β 7 ( GROWT H t ) + β8 ( ¿

Model 03
¿ M ¿=α + β 1 (CA R ¿ ) + β 2 ( NPLG L¿ ) + β 3 ( LLPTL R¿ ) + β 4 ( TLTA R¿ )+ β 5 ( OE R¿ )+ β6 ( LNT A ¿ ) + β 7 ( GROWT H t ) + β 8 ( ¿ F

where i refer to an individual bank; and t refers to year; ROA, ROE and NIM refers to the three
dependent variables; CARs refer to capital adequacy ratio; NPLGL and LLPTLP measures credit
risk; TLTAR measures liquidity; OER measure operational efficiency; LNTA refers to bank size;
GROWTH, INF, RIR are three macro-economic indicators and έ refers to error term.
Model 01, 02 and 03 are estimated through random effects regression model takings each bank
ROA, ROE and NIM as the dependent variable respectively. The opportunity to use random
effect rather than fixed effects model has been tested with Hausman test.