Islamic Banks and Commercial Banks Performance - Essay Example

Difference between Islamic Banks and Commercial Banks Performance in Pakistan Grade (December 3, Abstract Conventional commercial banks have a better opportunity for increasing profitability and shareholder’ returns, since they charge interests and fees on their customers. On the other hand, the Islamic banks have a lower opportunity cost for profit making and increasing the investors’ returns, because they operate on the principle of free-interest. Nevertheless, that is not to say that Islamic banks are not profitable. The low profitability and return on investment for the Islamic banks is largely accounted for by the fact that the Islamic banks operate on a more benevolent basis than the conventional banks. Additionally, the commercial banks have a better grip on the economy of countries than the Islamic bank, since they have a long history compared to the Islamic banking, which is a contemporary phenomenon. Difference between Islamic Banks and Commercial Banks Performance in Pakistan a. Introduction-Background The concept of Islamic and commercial banking has attracted a lot scholarly of attention of late, with different financial scholars trying to understand how the concept of Islamic banking works in relation to both Islamic banks profitability and Islamic banks customer behavior. The interest in studying this area has arises out of the fact that the Islamic banks operate on the basis of the Islamic religious laws, which is a totally different concept from the conventional banking operations (SABIR et al, 2014). Defining the profitability of the conventional banks is more straightforward, because it is based on the banks charging interest rates and fees to their customers of different products and services that the banks offer to the customers. However, defining the source of profitability for the Islamic banks is rather difficult, because one of the principles of the Islamic law under which the Islamic banks operate is the prohibition of charging interest (SABIR et al, 2014). In this respect, it becomes increasingly attractive for financial scholars to try and find out how the Islamic banks operate compared to the conventional banks, and how they generate returns for their investors. This study applies a descriptive qualitative research study design methodology to analyze the performance difference between conventional and Islamic banks in Pakistan. b. Literature Review The Pakistani financial sector is characterized by the operation of many banks, constituted by both commercial and Islamic banks. While the commercial banks accept and advance loans on interest basis thus acting as leasing agencies, the Islamic banks operate on the basis of interest free banking principle, as formulated by the Islamic Sharia Boards (SABIR et al, 2014). The rise of Islamic banking in Pakistan was informed by the need to minimize the cost of banking for the people, through eliminating interest fees charged by the conventional commercial banks. Therefore, a commission was established to formulate the modes under which banks can offer financial services through compliance to the Sharia laws. The commissions Sharia banking formula saw the established of the Meezan Bank Limited in January 2002, as the first Islamic bank in Pakistani, which was followed by the establishment of the State Bank of Pakistani as another Islamic law compliant bank in 2003 (SABIR et al, 2014). Despite the fact that conventional banks are still more in Pakistani, the Islamic banking is growing day-by-day, with new Islamic banks forming almost every other year. On the other hand, most of the Islamic nations have converted all of their banks into Islamic banking, for example is countries such as Sudan, Iran, and Bahrain (SABIR et al, 2014). The major difference between conventional commercial banks and the Islamic banks is that; while the conventional banks operates on the basis of charging interests to their customers, the Islamic banking concept works on the modality of profit and loss sharing between the bank and the customers (SABIR et al, 2014). The basis of operation of the conventional commercial banks and the Islamic banks is the same, only that the two differ in the interest-charging principle. Therefore, while the relationship between customers and conventional banks, is that of lender-to-debtor relationship (SABIR et al, 2014). On the other hand, the Islamic banking concept has prohibited interest/Riba charging, making the relationship between customers and banks under Islamic banking to be that of partnership and benevolent lending (SABIR et al, 2014). The concept of Islamic banking is guided by the laws formulated by the Sharia baking Council, which seeks to formulate suitable laws under which the Islamic banks can operate while remaining compliant to the Islamic religious Sharia laws (SABIR et al, 2014). The rise of the Islamic banking was informed by the global financial crisis, which pushed the Islamic nations to seek for alternatives financial services that can withstand he volatility associated with the global conventional financial system (SABIR et al, 2014). However, since the Islamic banks operate on the basis of minimizing Riba/interest for their customers, these banks highly rely on leverage, thus the degree stability of the Islamic banks is much lower compared o the conventional banks (SABIR et al, 2014). Further, due to the principle of free-interest banking observed by the Islamic banks, they face more intense competition than the commercial banks, thus requires using a large percentage of their assets to generate financing, compared to the conventional banks. The major concept that differentiates the conventional from Islamic banking is the principle of Musharka, which provides that investors and banks operate on the basis of sharing profits and losses (SABIR et al, 2014). The rest of the principles under which the Islamic banks work are the same with the principles of operation of the conventional banks. For example, under the principle of Murabaha, Islamic banking operates leasing contacts that are similar to the leasing contracts operated by the conventional banks, while under the principle of Ijarah, the Islamic banks have the ownership of investment goods, and gives them to the customers at a fee (SABIR et al, 2014). However, the concept of Qarz-e-hasna as operated by Islamic banking is a little different from that of conventional loaning by the conventional banks, since it entails benevolent loaning that offers financial assistance to individuals under critical financial crisis without a fee (SABIR et al, 2014). c. Research Objectives and Research Questions The objective of this study is: To differentiate the operations of Islamic from non-Islamic banking in Pakistani To determine how the nature of conventional or Islamic banking affects depositors Therefore, research question for this study are: Are there any differences between Conventional banks and Islamic banks? If Yes, What is the difference between conventional commercial banking and Islamic banking? How does the difference between conventional and Islamic banking affect depositors? d. Research Design (Methods and Methodology) This study applies a descriptive qualitative research study design. The descriptive research study design comprises of an inquiry into the characteristics of all banks in Pakistani. The total population of the study comprises of 5 all the 5 Islamic banks in Pakistani and all the 41 conventional banks in Pakistani. Random sampling technique was applied to select the samples recruited for the study form the total study population. Random sampling technique is selected as the sampling technique suitable for this study, because it provides an equal chance for all members f the population to be recruited into the study, thus eliminates study bias (SABIR et al, 2014). Using random sampling, a sample of 6 banks in total, constituted by 3 Islamic and 3 conventional banks is selected for this study. The 3 samples selected under the Islamic banks category include the Meezan Bank, Pakistan Islamic Bank and Dubai Islamic Bank. On the other hand, the three samples selected for the conventional banks include United Bank, Muslim commercial bank and Habib Bank. e. Data Collection and Analysis Secondary data related o the financial performance of the banks selected for the study was obtained from the financial statements of the banks, as published under the SBP site. The choice of SPB site as he source of secondary data for the study is informed by the fact that SPB is the official financial regulatory institution in Pakistani, tasked with the responsibility of maintaining financial data for all banks, thus making this source a credible and reliable source of data. Two basic Ratio Analysis techniques of Return on Asset (ROA) and Return on Equity (ROE) are applied as the data analysis technique for comparing the financial performance of the conventional to the Islamic banks. These ratios are suitably placed for analyzing the data in this study, because they are clear indications of performance of a financial institution, in terms of returns made for investors and returns made for the banks’ assets. f. Results and Analysis The data indicated that the 2012 ROA for Habib Bank was 1.39 compared to the ROA for Pakistan Islamic Bank which was 0.56. On the other hand, the data indicated that the 2012 ROA for Dubai Bank was 0.54 compared to the ROA for Muslim commercial bank which was 2.76. Further, the 2012 data indicated that Meezan Bank had a ROA of 1.28 compared to the United Bank’s ROA of 2.01. On a different scale, the 2012 banking data indicated that the ROE for Habib Bank was 18.78 compared to the ROE for Pakistan Islamic Bank which was 7.4. The banking data further indicated that the ROE for Dubai Bank was 5.1 compared to the ROE for Muslim commercial bank which was 23.43. Finally, the 2012 banking data indicated that the ROE for Meezan Bank was 22.66 compared to the United Bank’s ROE of 22.39. The above data indicates that both the ROE for the conventional commercial banks was much higher compared to that of Islamic banks, indicating that the conventional commercial banks are more profitable that the Islamic banks (SABIR et al, 2014). The major factor contributing to the higher profitability of commercial banks compared to the Islamic banks is the interest fee charged on the customers by the conventional banks, which is prohibited for the Islamic banks (Siraj & Pillai, 2012). The conventional commercial banks are able to make more value for their investors, compared to the Islamic banks, due to a variety of profit tapping products such as loans interests, deposit withdraw fees and lease fees (Saifullah, 2010). Further, the data also indicates that the ROA for the conventional commercial bank is much higher compared to that of the Islamic banks, an indication that the banks earn more returns on their assets compared to the Islamic banks. The major factor accounting for this disparity is the fact that the commercial banks in Pakistani have had a long hold of the total economy than the Islamic banks (Muneeza, Wisham & Hassan, 2010). Conclusion The operations of the conventional banks are entirely based on financial laws and the laws of the state, which guides the bank’s profitability and returns to the investors. The Islamic banks on the other hand depend on Islamic law that prohibits charging interests to guide their operations. The conventional banks are therefore more profitable and make more returns for their shareholders than the Islamic banks. Nevertheless, the Islamic banking concept is increasingly becoming a major part of the financial industry in many Islamic nations. References Muneeza, A., Wisham, I., & Hassan, R. (2010). The Paradox Struggle Between the Islamic and. Journal of Asia Pacific Studies , 188-224. SABIR, R. et al. (2014). Difference between Islamic Banks and Commercial Banks Performance in Pakistan. International Review of Management and Business Research 3(2), 1038-1046. Saifullah, M. (2010). Superiority of Conventional Banks & Islamic Banks of Bangladesh:. International Journal of Economics and Finance . Siraj, K., & Pillai, P. (2012). Comparative Study on Performance of Islamic. Journal of Applied Finance & Banking , 123-161. Read More