The Differences between Islamic and Conventional Banks - Research Paper Example

The differences between Islamic and conventional Banks due: A number of professional and academic research projects have been conducted to ascertain the differences between Islamic and conventional banking systems. The objective will be to establish the differences between these models. The study will be examined by comparing performance of Islamic and conventional banks based in Qatar. Financial ratios will extensively be used in the research and will be clustered into profitability and asset quality ratios. Key Words: Islamic banks, conventional banks, differences, financial ratios, profitability, assets Table of Contents Abstract 2 Table of Contents 3 List of Tables and Figures 4 Introduction 5 Literature Review 5 Objectives of the Research 10 Data Methodology 11 Empirical Analysis 12 Assets Quality Ratio 13 Conclusion 15 References 17 List of Tables and Figures Figure 1.1: Yearly Profitability Growth Rate (2007-2010) 5 Table 1.1: Year to Year Total Assets Growth Rate in Percentage 14 Figure 1:2 Total Assets Growth Trend 14 Introduction The past years have not only been characterized by uncertainties on accurate operational structures of conventional banking but also amplified attention on Islamic banking. Financial scholars have surpassed lasting ambiguous loan contracts practiced by drawing attention of the financial world to the benefits presented by bank products that meet the requirements of Sharia. Most of these products conform to religious backgrounds of the local people; and hence turn out to be attractive to wide fragments of the population in need of financial services they can identify with their cultural beliefs and way of life. Despite these existing trends, little academic evidence and research on the functioning of Islamic banks is recorded. Since its establishment in 1970, Islamic banking has witnessed a significant growth. With the establishment of its operational foundations a few decades ago, the banking model acted as a major vehicle that offer products similar to convenient banks. Numerous academic research and literature have gone further to establish the viability of these types of banks in dealing with finances. It is also evident that the last few decades the banking model has been characterized by an increase in its financial institutions that are spread in all continents. Most importantly financial institutions, in Europe and Asia, operate on Islamic windows and thus provide a convenient banking framework to their clients. Therefore, this paper describes some of the common differences between Islamic and conventional banks (Ali, 2005). Literature Review Despite the fact that there is growing interest on Islamic banking and Islamic finance literature, a few academic papers about the subjects exist. A policy research working paper by Beck, Demirgüç-Kunt & Merrouche (2010), confirms that there is a deficiency of academic work highlighting Islam finance trends. This trend contrasts with the increased importance played by Islamic banking in a majority of Muslim countries across Asia and Africa. Based on the details presented, this paper will, hopefully, contribute to the rising literature in Muslim banking and finance by discussing the main key areas that conventional and Islamic banks differ (Beck et al., 2010). The business idea that banks are profit-making institutions has been characterized by the formulation of a number of profit-generating strategies. Convenient banks operate on strategies that make them income generating institutions providing competitive products to the market. According to Mohamad, Hassan, & Bader (2008), convenient banks operate on income generating basis notwithstanding the interest rates and fees either charged or paid to debtors and depositors respectively. A number of convenient banks use non-traditional approaches that are defined by deposit and lending principles. These activities are carried out through products such as credit cards, loans, and mortgages. In so doing, income is generated through charging debtors fees from loan repayment schemes. Islamic banking model derives all its operational structure from the Holy Quran and the Sharia, a set of laws that govern the Islam religion on their moral duties and obligations to each other as well as to the world (Samad, 2004). The growth and maturity of Islam have enabled people gain confidence and hope in the banking model. Islamic banking is a manifestation of the execution of Sharia laws, the legal codes that guide the day to day activities of Muslims worldwide. Their banking system is not established upon interest on loans and deposits like their counterparts. This marks a major difference in the operation and income generating traits of financial institutions. The model incorporates the time value for money by giving its financiers suitable income on money. By doing this, the bank does not determine its benefits from lending. Islamic banking, also referred to as Sharia-compliant banking does not consider borrowers as creditors who earn the institution income, but rather view them as associate business members who are included in the banks’ undertakings. Islamic codes of conduct strictly refrains individuals from involving themselves with transactions whose end product would initiate an interest (Elsiefy 2013). The business of lending in Islamic banks lays its foundation on Profit and Loss sharing systems (PL) (Khan, 2012). The nature of this arrangement sees to it that both the parties agree to share either profits or losses basing it on their sacrificed efforts as well as the capital. Therefore, a return rate on an asset is not fixed by the lender. The above system contrasts with the basic operational principle that guides conventional banking systems in that Sharia-compliant banking system are not committed to returning rates. Most importantly, transactions in this model of banking are assisted by tangible assets, a characteristic that differs from conventional banking that backs its assets with fiscal transactions (Ali, 2005). Islamic banking is also based on the ideologies that banks should not involve themselves in activities that are not allowed by Islam (halal), and are to refrain from all forbidden activities (haram). In addition, banks operations under this model are not supposed to indulge in speculated transactions (gharar). A number of comparison research have been conducted to ascertain the relationship between Islamic and conventional banks. This section will mainly focus and highlight recently conducted studies on Islamic banks in order to present a picture of the performance of Islamic and conventional banks on different regions and periods of time. Studies conducted in 2009 by Parashar and Venkatesh (2010) through comparing 12 banks on equal basis in the Gulf Cooperation Council established that the global crisis directly affected Islamic banking systems in terms of their capital ratio and average equity returns. Likewise, conventional banks’ returns on average assets and liquidity were affected. In addition, the years following 2006, Islamic banks outperformed their counterparts in the region (Cited in Merchant 2012). A similar study conducted by Zeitun (2012) in the same period and region to assess factors that affects the two models of banking based on bank-specific and macroeconomic variables revealed that their cost to income performances and ratios had a negative correlation. The issue of equity was elevated as an important factor that maximized the profitability of Islamic banks. Even though comparison indicators related to stability, asset quality, business operation and the effectiveness of expenditure of conventional and Islamic banks present insignificant variances, there is evident proof indicating that the two differ. Among the key differences included the manner through which either of the banks earns interest and fees for services. Islamic banking is based on free of interest systems and features. According to Toumi, Viviani & Belkacem (2011), the Islam finance theory is based on a mutual relationship of profit and loss sharing between investors and financial bodies (PLS) principle (p. 325). Its banking functions conform to Sharia-compliant statutes which do not conform to rating of interest payments. In this case, only goods and services offered to consumers carry prices (Petersen & Schoeman 2008). Conversely, Sharia-compliant banking operates with the notion of sharing profits, losses and risks on both liabilities and assets in line with the Koran’s specifications of profit-loss-risk sharing (Beck, Demirgüç-Kunt & Merrouche 2010). The products are aimed at substituting interest rate payments. Islamic banks are also prohibited to trade in financial risk products, among them unoriginal products. It ought to be noted that a number of modeled products that comply with Sharia have been developed to fit and resemble conventional banking version. Most importantly, these models have embraced the risk channel between depositors and borrowers. One of the most common banking products includes the bank and borrower partnership, Mudaraba, through which banks grants loans to clients in exchange for expertise. Profit sharing ratio is agreed upon by the parties while the bank bears any losses. Therefore, the provisions present clients with limited liability. However, major investment decisions must be approved by the bank. Musharaka, another form of agreement conforms to the sharing of profits and losses among all investors. Alternatively, Murabaha agreements are a replica of leasing contracts present in conventional banking. This agreement avoids the ban to make profits through lending money just as lease contracts in conventional banking, which involve acquisition of investments on behalf of clients, and reselling it to them with payments spread over a period inclusive of applicable fee that serves as profits. It would be right and wise to justify that a number of products offered and structured by Islamic banks are same as those offered by conventional banks. This means that many banks offer financial products that are Sharia compliant, but are similar to conventional banking products (Sole, 2007). However, the strong element of equity participation practiced by Sharia financial systems still remains a significant distinction between the models. The characteristics presented by the banking models presents a number of differences in their stability, asset quality, business operation and the effectiveness of expenditure. Widespread rumors reveal that the high complexities presented by Islamic banking may affect its costs and hence reducing its efficiency. This has been disapproved by empirical studies conducted the World Bank (WB) in 2010 through which Beck, Demirgüç-Kunt & Merrouche claimed that insignificant differences in the stability were found between Islamic models and the convenient banks. Recent studies conducted by International Monetary Fund on the changes of the financial crisis on profitability and asset growth documented justifiable evidence that the crisis differently affected the two banking models. According to their findings, a number of factors related to Islamic models of banking helped in limiting the impact on profitability and their weak risk management practices hastened their decline in profitability compared to their counterparts, convenient banks. Their findings also revealed that the credit and asset growth of Islamic banks were higher than those of conventional banks. Hence, their economic and financial stability was more favorable (Hassan & Dridi, 2010). A similar cross-country empirical research on the role of Islamic banks in the market share revealed that the model did not have any significance impact on the financial power of other banks. Evidence presented also revealed that large conventional banks were stronger that large Islamic banks (Chihak & Hardy, 2008). Other studies conducted by Olson and Zoubi (2008) revealed that profitability ratios between the two models did not differ in significant margins. Nevertheless, Sharia compliant models gave impressions of less efficiency and high risk operational standards. The risk rate of Islamic banks was determined by the sustenance of funds to be used lest they incurred bad loans while conventional banks offered interest predetermined deposit funds. These results were also shared in a World Bank research conducted by Beck, Demirgüç-Kunt & Merrouche in 2010. However, similar studies conducted by Ansari and Rehman (2011) disapproved the latter findings. Using different financial ratios among their operational efficiency, the researchers established that Islamic banks were less operational efficient and less risky as compared to their counterparts. Theoretical summaries may not provide clear answers whether and how interest-free equity-based systems, concepts of transactions and banks’ relationships with its clients differ between conventional and Islamic banks. The intensity of this uncertainty has been created by lack of clarity on whether products designed by Islamic banks are offered within the context of Sharia laws. Based on this background, we turn to pragmatic scrutiny to explore the discrepancies surrounding the two bank groups. Objectives of the Research The enormous growth in Islamic banking since 1970’s has been characterized by a number of changes. Through its principles, the model is assumed to serve as a banking foundation that was redecorated to offer convenient banking products. However, numerous academic literatures have revealed the visibility of Islamic banking in dealing with finances through the multiplication of such banks in different parts of the country. The development of these types of finances has generated increased interest among scholars and economists. The recent global crisis of 2008-9 paved way for the increased importance of creation of stable and solidified financial system. There is a global effort to reduce risks presented by the banking sector in order to increase efficiency and equity. The objective of this research is to provide an empirical assessment of the stability, profitability, asset quality, business operation and the effectiveness of expenditure of Islamic banks in comparison with their conventional counterparts. In our analysis, we will try to address two broad questions: 1. Are the growth rates and efficiency standards of Islamic banks compete with conventional banks? 2. How different were Islamic banks compared to their counterparts affected by the financial crisis? To address the first question, the paper will briefly highlight the interest earning rates and service fees of the two banks. To address the second question, I will attempt to highlight and examine the performance of the two banks based on stability, profitability, asset quality, and business operation. Data Methodology Sounders, Lewis & Thornbill (2009) define data analysis as the processing of information to formulate meaningful information. Likewise, Burns and Grove (2003) believe it is the mechanism of assembling statistics and facts to yield findings that are interpreted by the researcher. In this case, we shall endeavor to use financial management theories guide researchers and analysts into various directories for measuring bank performances (Elsiefy, 2013). The use of financial ratios has extensively been used in literature. In order to establish the difference between conventional and Islamic banks in Qatar, we shall use financial ratios presented during and after the 2006 financial crisis. We will categorize our ratios as: 1. Profitability ratios 2. Asset quality ratios The data for each year will be extracted from audited reports available at the Qatar Exchange website. Aggregate data presented was extracted from each group of banks. The banks sampled included domestic banks of Qatari banking system consisting of both Islamic and conventional banks. Empirical Analysis 1. Profitability Ratios Profitability acts as a significant indicator of strong performance in bank management systems. According to Elsiefy (2013), profitability represents the efficiency of the bank’s management system in allocating existing resources in relation to its risk profile. It is important to note that constant levels of performance acts as a boost against capital loss in the case of deteriorating economic conditions. Thus, it provides both shareholders and creditors protection from financial depression. Figure 1.1: Yearly Profitability Growth Rate (2007-2010) Figure 1.1 reveals the profitability trend of Islamic Banks (IBs) and Commercial Banks (CBs) over a 4-year period from 2007-2010. A close look at the trends reveals that the two banking models were affected differently before and after the looming financial crisis. It is evident that CBs maintained high profitability rates of above 20% except on one instance compared to IBs whose highest rate was above 40% at once and the rest below 20%. After the crisis, the rate appears to be average for both banks compared to the years preceding the crisis. It is worth to note that in 2007, IBs rate was almost 49% as compared to CBs that scored 34%. The statistics presented bring to light the significant growth rate of IBs constituting its entry into the market in 2007. During the global financial crisis, CB’s witnessed a continuous growth by recording a rate of 33% compared to IBs 11%. The growth rate between the two banks interchanges throughout the period. Significantly, rates of the two banks appeared to recover in 2010. CB’s also had strong profitability ratios of 37% as compared to IB’s ratios of 18%. Thus, the growth rates and efficiency standards of Islamic banks indeed compete with conventional banks as the statistics identify corresponding trends. In addition, the financial crisis similarly affected profitability trends in rations of both the banking models. Assets Quality Ratio The table below reveals the strong growth rate maintained by IBs as compared to CBs. The growth rate for IBs appears to be higher at a rate of 47% compared to that of CBs. After the crisis, the total assets growth of both banking models significantly dropped. Table 1.1: Year to Year Total Assets Growth Rate in Percentage The declining ratios for both CBs and IBs were steeper during the crisis as presented in figure 1.2 below. Statistics reveals that CBs increased from 13% to 17% while IBs increased from 25% to 33%. This shows that the trend in both bank groups increased steadily after the crisis, and there was an improvement in the growth of assets. Figure 1:2 Total Assets Growth Trend The statistics above test the two hypotheses that guide the research. Both figure 1.2 and Table 1.1 clearly explain similar effect rates presented by the crisis to both CBs and IBs. Interestingly, the trends are similar such that when the rates for IBs are high, so are their counterparts and vice versa. Conclusion This paper discussed some of the common emerging differences between Islamic and conventional banks. The researcher sought to base the research on trends presented during the period preceding and after the financial crisis. While theory suggests significant repercussions of the Sharia-compliant banking system for efficiency and stability, empirical evidence suggests that Islam Banking systems are to some percentage convenient and stable compared to their counterparts. Thus, Islam Banks’ models may not have many differences from convenient banks’ models. The empirical estimations presented in the research demonstrate trivial differences between Islamic and conventional banks. The tentative conclusion of cross-bank financial ratio comparisons of the two models presents opposing differences that cancel each other and thus narrowing the difference between these models. Their performance during the crisis elicits very little differences. Together, our empirical research suggests that both conventional and Islamic banks share a number of similarities. Their business models are structured differently, but standard indicators based on financial information have similarities. Academic research studies have provisions for further studies to be conducted or enhanced. This study has been limited to the Qatari locale. In order to get a better and wide understanding of the trends and differences presented by Islam banks and commercial banks, it would be worthy of note to include banks from other localities. This would ensure that the sample size is enlarged, and a detailed outlook on the field of study would be developed. 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