The nature of smoothing returns practices: the case of Islamic banks

Abstract

PurposeThe purpose of this paper is to examine empirically the nature of smoothing returns practices in a sample of 79 Islamic banks across 19 countries during the period 2001‐2006.Design/methodology/approachPrevious researchers' methods, based on the variation and determination coefficients, are used in this study to detect the smoothing practices.FindingsResults indicate that the revenues from the “Shariah‐based products” derived from the profit and loss sharing principle show higher variability than the “Shariah compliant revenues” and that income from this source is relatively lower. They also show that a large number of Islamic banks engage in natural income smoothing. Based on the determination coefficient results, 70 per cent of banks were found to have less smoothed total revenue than their net income. Results based on variation coefficient further confirm this finding, with 67 banks having a coefficient of total revenue higher than that of the net income.Practical implicationsThe results suggest that Islamic banks should strengthen the use of smoothing techniques, such as the profit equalization reserves (PER) and the investment risk reserves (IRR), as they allow them to further stabilize the revenues payout for the investment account holders (IAH) and therefore mitigate withdrawal risk. Standardizing the smoothing techniques could be a solution to overcome the variability of this category of revenue.Originality/valueThis work is the first of its kind for Islamic banks. It extends previous research by examining whether or not managers may smooth their results naturally or intentionally. It also helped to bridge the gap in the literature by providing the empirical evidence on the smoothing returns in Islamic finance.