Islamic banks and Conventional Banks - Term Paper Example

Islamic banks and Conventional Banks The title of the project report is “Comparison of the performance of Islamic banks with the performances of the conventional banks as evaluated over the past 30 years of operation of these banks”. The report is aimed at identifying and assessing the performances of the Islamic banking system on the metrics of financial performance, productivity, liquidity, efficiency, profitability and growth as well as on other ancillary factors like management efficiency and cost management in the banking operations. The analysis clearly indicates that the Islamic banks are growing consistently and are displaying impressive financial and managerial performances over the last 30 years of their functioning in the global financial markets. However, it cannot be said in direct terms that the Islamic banks have been performing more efficiently than the conventional banks because the results vary from region to region. But, it can be identified that in the countries in which dual banking systems are present, the growth and stability of the Islamic banking systems have been better than that of the conventional banks over the selected period for study. These findings hint at the higher growth prospects and expected consistency and stability in the operations of the Islamic banks in the future. Introduction and Background The research is aimed at evaluating the performance of the Islamic banks and comparing the financial and economic performance of these banks with the conventional interest based banking institutions. The Islamic banks are consistently growing in number and are becoming more prevalent in the contemporary economic and financial sectors. The fact that the countries in which Islamic banking and financing system are employed were among the least affected economies during the Great Financial Crisis of 2007-2008 have highlighted the sustainability and financial strengths of these banks to a high degree. As such, the evaluation and assessment of the performance of Islamic banking system against that of the conventional banking system is identified to be a relevant and interesting area of study. The research is conducted by reviewing the literary works that have been prepared and presented on Islamic banking and the global banking sector, followed by setting the research objectives and questions for the study. The report also includes a discussion of the research methodology including the data collection and analysis methods. The findings and interpretations are presented by analyzing the collected information and a relevant conclusion is reached from the analysis and the overall findings of the research work. Literature Review As discussed by Shahid, Rehman, Niazi and Raoof (2010), the Islamic banking system involves the banking activities that are compliant with the principles of Islamic law or Sharia. The Islamic banks function on the principle of the application of Sharia compliant finance and the development of the Islamic economics (Shahid, Rehman, Niazi and Raoof, 2010). Since the Islamic law prohibits the acceptance of any forms of fees or interests on loans of money, therefore none of the Islamic banks practice the principle of interest or usury on the loans given, irrespective of whether the interest are to be paid in fixed or floating formats. Another key principle of Islamic banking is that no investments are to be made in businesses which manufacture or provide products or services that are considered to be prohibited by Islamic principles. These products are categorized as Haraam which means sinful and prohibited and may include products like pork or alcohol. As per Olson and Zoubi (2008), the contemporary movement of Islamic banking and finance systems is based on the fundamental belief of all forms of interest to be sinful and as such are strictly prohibited in all the banking institutions functioning under Islamic finance (Olson and Zoubi, 2008). Furthermore, these banks also prohibit the use of “Maysir” and “Gharar”. Gharar refers to the speculative transactions and arbitration which are commonly used in the conventional banking systems. Maysir refers to those contracts in which the ownership of any product is dependent on the occurrence of an uncertain and pre determined event in the future. Both these concepts are widely used in the conventional banking systems but are not included in Islamic banking because these involve excessive levels of risk and are likely to support fraudulent behavior and uncertainty in the financial transactions. As such, the use of all types of conventional derivative instruments is strictly prevented in Islamic banking. The purpose of the Islamic banks is same as that of conventional banks which is to make money for the specific banking institution by lending out capital. However, the primary difference between the two forms of banking is caused by the requisite of the Islamic banks to adhere to the Sharia or the Islamic law. The basic principle of Islamic banks is developed on the concept of risk sharing as a component of trade. This is in contrast to the fundamental principle of risk transfer used in the non Islamic banking sectors. Additionally, the Islamic banking and finance domain has introduced concepts like safe keeping (wadiah), profit sharing (mudharabah), cost plus (murabahah), leasing (ijar) and joint venture (musharakah). The interpretations of Islamic law or Sharia are likely to vary as per the Islamic traditions followed in different countries. For example, the interpretations of Islamic law are highly stringent in the Arab countries and Turkey while the Islamic republic of Iran and Malaysia follow much lesser stringent interpretation of the Islamic law. Depending on these interpretations there are certain degrees of changes permissible in the nationalized Islamic banks in some of these countries. The history of Islamic banking started with Islamic capitalization. As per some Islamic modelists and secular historians, Islamic banking can be categorized as an invented tradition or modern phenomenon. During the early years of Islamic capitalism, a number of varied economic techniques and concepts were applied in the Islamic banks. This included capital accumulation, bills of exchange, and forms of capital, promissory notes, transactional accounts, limited partnerships, ledgers, loaning and assignments. Till the 20th century the function and number of Islamic banks was negligible as compared to the conventional banks. However, since the 20th century, a gradual evolution and upsurge of the Sharia compliant financial enterprises has been noted across the world. Mokhtar, Abdullah and Al-Hashi (2006) have noted that by 2008, the number of Islamic banks started growing at a rate of 10-15% per annum and displayed the signs of stable future growth. Currently there are more than 300 Islamic banking institutions operating in 51 countries and also include 250 mutual funds which are compliant with the Islamic principles. The 21st century has been marked with the accelerated growth and stability of the Islamic banks and the inclusion of the Islamic indexes in the leading stock exchanges of the world like Standard & Poor, FTSE and Dow Jones (Mokhtar, Abdullah and Al-Hashi, 2006). Research Objectives and Research Questions The primary objective of the research is to compare and contrast the Islamic banking system and the conventional banking system on the basis of their core working principles, functioning, performances and future prospects, with extensive focus given on the performance aspect. The main research question formulated for this study is Are the performances of the Islamic banks above, below or at par with those of the conventional banks? The secondary research questions formulated for this study include What are the fundamental differences between the functioning of the Islamic banking systems and the conventional banking systems? What are the primary principles followed in the functioning of the Islamic banking systems and the conventional banking system? Are the financial and managerial performances of Islamic banks better than that of the conventional banks or vice versa? What are the future prospects of the Islamic banks as compared to that of the conventional banks? In a dual banking system, which of the two types of banks perform more efficiently? The null hypothesis i.e. H0 and the alternative hypothesis i.e. H1 are selected for the study. The null hypothesis and the alternative hypothesis selected for the research work are given as follows: H0- the functioning principles, performances and future prospects of the Islamic banks are better than those of the conventional banks. H1- the functioning principles, performances and the future prospects of the Islamic banks are weaker in comparison to those of the conventional banks. Research Design - Methods and Methodology The research methodology employed in the case research involves the collection of secondary data from different academic sources like journals, articles, academic books and other forms of literary and informative publications. Some case studies, newspaper reports and economic reports published in the domain of banking and finance have also been considered for collecting relevant information for the research. Data is collected by focusing on the banking segments of the GCC, Malaysia, Pakistan and Iran (Pillai and Sirj, 2012). Different statistical and analytical tools have been used for analyzing and processing the collected data. Cross sectional analysis is done by comparing the Islamic and conventional banking systems prevailing in different economies including Malaysia, Iran, GCC, Pakistan and some European countries. The overall financial performance of a selected number of Islamic banks and conventional banks operating in the selected financial markets are observed over the last 30 years. For this purpose, 6 Islamic banks and 6 Conventional banks are selected for assessment. Then these banks are segregated under the two broad categories of conventional banks and Islamic banks. The financial performances of these two types of banks are assessed and compared on the basis of the profitability, liquidity and growth prospects of these banking segments. The market shares of these two types of banks, the trends in the economic and managerial performances and the ways in which these banks perform during financial and economic crises situations have been considered as the referring metrics for the assessment and comparison. Analysis and interpretations The collected data are analyzed and interpreted in the most relevant manner through the use of appropriate analytical techniques so that the research objectives set for the study are sufficiently attained. The analysis shows that the performance of the Islamic banks are consistently improving and these banks have remained stable and less affected even in the face of weakening global financial conditions and economic downturns. It is identified from the analysis of the data that Islamic banking is growing at a significant rate in different parts of the globe, especially in the Middle East, Southeast Asia, North America and some European countries. Some countries like the Gulf Cooperation Council Countries (GCC) employ a dual banking and financing system in which both the conventional and the Islamic banks operate simultaneously. Other Islamic countries like Iran, Turkey and Arab focus on developing only the Islamic banking and economic systems. It can be seen from the comparisons made between the performances of the Islamic banks and the conventional banks operating worldwide that the Islamic banks are growing consistently in terms of profitability and market share. The increase in the profitability and growth of the Islamic banks are higher than those of the conventional banks in all the five years taken for the study. The analysis shows that there are significant differences between the profitability of the Islamic banks and the conventional banks. Figure 1: Comparison of profitability based performance of the Islamic banks and the conventional banks. However, the Islamic banking institutions are less exposed to the liquidity issues because of the fundamental principles of risk sharing and the absence of any kind of interest taking on the loans. Since, the functioning of the conventional banks are more reliant on external financing and risk transfer, therefore, these banks experience higher levels of liquidity risks as compared to the Islamic banks. Due to this, many customers who have access to both Islamic banking services and conventional banking services, like the customers in GCC and Malaysia prefer to use the financial instruments that are offered by the Islamic banking institutions operating in the country (Akhtar, Ali and Sadaqat, 2011). Figure 2: Comparison of liquidity based performance of the Islamic banks and the conventional banks. Nonetheless, high degrees of statistical difference are found between the growth rates of the two distinct categories of banks. This is reflective of the fact that the functioning principles of the Islamic banks are more effective in the modern business environment along with the other factors such as the general performance standards and management style than the fundamental principles of functioning which also impact the future growth prospects of the bank. Figure 3: Comparison of the growth based performance of the Islamic banks and the conventional banks. The three main forms of Islamic financing systems including the trade based modes of financing, the loans financed by lending and the investment mode for financing have been successful in the past 15 years and have been employed successfully by a number of Islamic banks in different sections of the world, especially in the Middle East and Pakistan. It can be further identified that the primary differences between the functioning principles of the Islamic banks and the conventional banks have played a major role in enhancing the performance of these banks in the face of uncertainties and complexities prevailing in the external economic and financial environment. The main differences that are pointed out between the functioning of the Islamic banks and the conventional banks are that while the principles of Islamic banking systems are strictly developed on the basis of Shania compliance, the principles of conventional banks are based on profit and trade perspectives. Secondly, the Islamic banking systems propagate risk sharing between the investor or the provider of capital and the entrepreneurs or the users of the capitals while the conventional banking system promotes risk transfer wherein the investors are guaranteed of assured returns on their investments and higher risk levels are borne by the debtors. Also, the Islamic banks aim at making profit by abiding to the Islamic laws while the conventional banks are aimed at profit maximization without any kind of restrictions imposed on their operations. The Islamic banks support the development of investor and trader relations and buyer and seller relationships while the conventional banks prominently function through the development of only creditor and debtor relationships that are employed in the transactional aspects of the banks. The Islamic banks encourage financing based on assets and commodity trading while the conventional banks focus on money trading which is considered as a commodity. On the other hand, in the Islamic banks, money is seen as a medium of exchange and the sale and purchase of money is not allowed as per the Islamic laws. Uncertainties, assumptions and speculations are strictly avoided in Islamic banking while concepts like arbitration and speculation are widely used in the conventional banking and financial constructs. Conclusion Thus, it can be summarized from the above analysis and findings that the null hypothesis selected for the research can be partially accepted and established because the performances of the Islamic banks have been consistent during the economic peaks and troughs and have been much less affected by financial crisis events in which the performances of the conventional banks have dwindled like in the period of the GFC which hit the global economy during 2008-2009. The alternative hypothesis set for the study can be rejected by referring to the findings. The consistent performance and steady growth of the Islamic banks can be credited to the fundamental and effective principles of operating used in these banks. Though these principles and compliance to the Islamic laws restrict the profit maximization and risk transferring capabilities of these banks, yet it can be seen that the new methods of financial market operations introduced by the Islamic banks in different regions of operation have been successful in bringing about positive changes in the financial and banking industries. The efficiency of the Islamic banking system is especially prominent in the markets in which the dual banking systems are followed like Malaysia and the GCC countries. It is also identified that the managerial efficiency of the Islamic banks is a major driver of the continued growth and success of these banks on the global scale. The productivity and performance of the Islamic banks measured on the basis of market share, growth, efficiency, financial performance and cost management show that the Islamic banks are slowly gaining critical positions in the global financial and economic environment and may give tough competition to the sustainability and success aspects of the conventional banking institutions in the future. References Akhtar, M. A., Ali, K. & Sadaqat, S. (2011). Liquidity Risk Management: A comparative study between Conventional and Islamic Banks of Pakistan. Interdisciplinary Journal of Research in Business, 1(1), pp. 35-44. Mokhtar, H.A.S., Abdullah, N. & Al-Hashi, S. M. (2006). Efficiency of Islamic Banking in Malaysia: A Stochastic Frontier Approach. Journal of Economic Cooperation, 27(2), pp. 37-70. Olson, K. & Zoubi, T. A. (2008). Using accounting ratios to distinguish between Islamic and conventional banks. The International Journal of Accounting, 43(1), pp. 45-65. Pillai, P. S. & Sirj, K. K. (2012). Comparative Study on Performance of Islamic Banks and Conventional Banks in GCC region. Journal of Applied Finance & Banking, 2 (3), pp. 123-161. Shahid, H., Rehman, R., Niazi, G. S. K. & Raoof, A. (2010). Efficiencies Comparison of Islamic and Conventional Banks of Pakistan. International Research Journal of Finance and Economics, 49 (1), p.20. Read More