Comparative Analysis of Islamic Banking with Its Conventional Counterparts - Research Proposal Example

Contents Introduction 2 Aims and Objectives 5 Literature Review 6 Islamic finance 6 Conventional vs. Islamic Finance 7 Conventional Banking System 7 Islamic Banking System 8 Diminishing Musharakah 9 Methodology 9 Research Philosophy 9 Research Approach 11 Non-Empirical research 11 Quantitative/Qualitative 12 Research Design 12 Purpose of study 12 Study settings 12 Time Horizon 12 Conclusion 13 References 13 Introduction The global financial system has seen some tough times in the recent past. The global economic meltdown has created many doubts about the financial systems being used in the world. The most suspicious has been the fact that the recent global meltdown was not anybody’s mistake. This means that it was basically due to inherent faults in the system that the recession was caused. Therefore the doubts are raised and people are now open to ideas of economic systems which are more socially considerate. The current financial system is spawned from the capitalist economic system which itself is ruthless in nature. The capitalist system increases the wealth of the rich and makes them stronger. This is why class differences have become so wide in our societies. The market economy system is usually confused with the ruthlessness of the capitalist society. The two however are very different. The phenomenons of supply and demand are the same in both capitalist and socialist economies. Many different researchers have conducted research on the social problems being caused world over by the capitalist economic system. According to many studies the current international banking system is the reason that many third world countries are not able to even sustain themselves (Diwany, 2002). The basic problem in current banking principles when it comes to the social aspect is the close and emphasized relationship between risk and return. The relationship is negatively correlated. Thus as the risk with an investment increases so does the return. Therefore it can be said that this phenomenon sometimes totally ignores the social aspect as people with high risk are charged a higher return. The risk which affects the risk to such an extent is called the Default Risk Premium (DRP). DRP or risk of being defaulted is usually very high with nations in economic trouble which are usually the third world countries. Therefore although their financial troubles are already very high the rate charged to their loans is increased many times over. Moreover as the rates are increased they have no chance or very little chance to pay back those loans. The phenomenon of compounding means that an interest rate is charged on accumulates interest rate income. This compounding increases the original loans many folds therefore trapping them in a continuous cycle of servicing debt. There are many different examples of these types of arrangements where nations are taking loans at high rates only to service debt. As mentioned before most of these are third world countries mostly African (Diwany, 2002). According to a recent study taken by Terk Al Dewany, if these nations spend the money (used up on servicing debt) on welfare of their nations, the lives of almost 21 million children can be saved. Moreover it can be used to provide basic educational facilities to almost one hundred million females. This is only a small preview of the social impacts of the current financial system. The importance of the social impact to the financial systems has increased over the years. This is why the discussion has been initiated with a review of the social aspect. The increased importance is mainly due to the integration of the world through information technology. The people living in different parts of the world have started to develop a global approach to problems rather than a local one. Therefore both developed and developing nations are now considering financial system which is more focused on creating a peaceful society rather than accumulating wealth. This new system should be focused on building societies rather than profiting from destroying them. This would automatically reduce economic disparities between wealthy nations and third world countries. However this is not any easy task because the current financial system is integrated deep in everyone’s life. Therefore we can also say that any efforts to create variants of the current system would be totally useless because consumers and bankers alike would not be able to stop greed that is inherent in this system. Therefore the only solution available is to develop a separate financial system. This new system should work parallel to the current system. There are a number of different reasons for this strategy. The current financial system works because the people trust it and consider it safe. To prove its effectiveness and feasibility any new system will have to prove itself in the market. Therefore once the new system proves that it is reliable and viable only then can it be widely adopted. Therefore a strong and stable investment base willing to invest in this new concept would be necessary. This is only because a strong economic base would be able to support it in its initial phase. The problems and solutions discussed above show that the Islamic financial system can be the new system. This is because the Islamic finance system is based on social equality. This mode of banking has been around for many hundred years. This is why it has a very strong theoretical base. Most of the concepts of Islamic finance are driven by Islamic Fiqah (Islamic jurisprudence). As mentioned above the initial period for any new system is always difficult. More than a billion people are Muslims in the world. This gives a ready market for the system; therefore it would not face the same difficulties other systems can be expected to face. One of the most important aspects of the current financial system is corporate governance. This is because corporate governance established trust in the financial system thus attract investments. The Islamic finance system is backed by Islamic Law therefore it has an inherent system of corporate governance. This system would establish and build trust in user of Islamic finance and support its growth in consumer markets. Aims and Objectives The aim of this research is to understand the very old phenomenon of Islamic Finance which has evolved in recent years. The success of Islamic finance in international market has increased the importance of understanding it concept and ideas. However this comparison would be useless without a comparative perspective. This is because Islamic finance should be seen as a competitor of conventional financial systems. The current financial system has evolved over the years to its current financial state. Similar to other free market phenomenon, the need in the market drives the evolution and introduction of features and characteristics, until it evolves into what the market desires. Therefore we can say that any new system that can be considered as a potential replacement for our financial system must satisfy all the needs catered by the current system. The current financial system offers a wide range of products, which cater both consumer and corporate needs. The Islamic finance system also provides its consumers with a variety of products used by both corporate and consumer. Therefore it can be said that any comparison between the two different modes of financing should start with comparing their different products. Thus the aim of this study is to compare and contrast products of Islamic finance in order to understand feasibility of Islamic finance as a potential replacement for conventional finance. Moreover study would also aim to clarify the driving forces behind Islamic finance and its current success of the products. The study would take an example from each modes and compares both theoretical and practical backgrounds. Moreover financial institutions which deal in those products would also be compared in terms of different performance measuring benchmarks. The following objectives have been formulated to satisfy the aims of this study: Understand the factors which drive the need for Islamic finance Compare and contrast products from both modes of financing Understand potential constraints of transition between different products Literature Review The literature review is the most important aspect of this research. It will fulfill a number of different roles during this process of research. The primary role of the literature review is to display an in-depth understanding in the area finance and banking for both Islamic and conventional finance. This role of the literature review would be the key in developing understanding of the topic to readers which are unfamiliar with concepts of Islamic finance. As mentioned above the ideas of Islamic finance are still not common and therefore it would help them understand and grasp the discussion. Moreover the literature review would also provide non-empirical evidence for the research. Islamic finance The area of finance has evolved over the last few decades due to the increased need of consumers and new economic systems. This evolution of conventional finance unlike Islamic finance is centered on consumer needs. Thus the system continuously evolves to reflect current needs of the society. The ideas of Islamic finance have not gained worldwide momentum and recognition because of their inability to change and evolve according to consumer needs. This inherent rigidity in the Islamic finance system stems from the fact that it is a system based on religious practices and beliefs. The recent growth in Islamic finance has therefore been due to innovation and consumer centric thinking of Islamic finance institutions based in secular Muslim countries such as Pakistan, Malaysia, and UAE etc. Due to their efforts Islamic finance industry is one of the fastest going industries in the world. This growth has triggered interest of international investors in Islamic products. Currently the size of the global Islamic finance industry is a promising 1000 USD. Even more promising is the fact that the industry has shown a growth of almost fifteen percent in the last decade. According to critics of Islamic finance this growth is mostly due to the boom seen by the oil industry during the last few years. The prices of crude oil barrel rose to as high as 143 USD in 2006-07. As most investors of Islamic finance are located in middle Eastern countries the growth in the oil industry resulted in a direct impact on Islamic finance according to investors. This explains the perceptions that Islamic finance should be considered a regional or religious phenomenon rather than an economic one. Conventional vs. Islamic Finance Conventional Banking System Interest rates are the basis of the conventional banking and finance industries. Many different products exist in the conventional markets ranging from notes, bonds to mortgages (Madura, 2007). The idea behind all these concepts is the effective and efficient relationship between risk and return; as the risk of an entity increase so does the expected return from investments. The effective governance system of conventional banking system ensures that the system runs smoothly (Madura, 2007). Many of these regulations have been adopted through trial and error. For example the Great Depression reveals that investment banking should be kept separate from conventional operations (Madura, 2007). Therefore many restrictions have been imposed on conventional banks either due to failure of the system or create of unfair monopolies. Trading in commodities and goods for instance is not allowed to conventional banks. This is because using their vast spares of cash, they can form monopolies (Madura, 2007). The recent financial crisis and global recession which stemmed from America was centered on a financial market product known as mortgages and its financial derivates Sub-prime Mortgages. The mortgage is actually a secured transaction. The property on which the mortgage is applied goes into the partial ownership of the lender. The lender receives periodical installments from the borrower to clear the debt. These installments are a combination of the actual debt and interest charged. The installments are structured in a manner to form equal streams of cash (Resnick, 2004). Thus the borrower pays the same amount of cash each period until the debt is totally cleared. Many banks bundle service charges into these cash payments. The conventional banking system has been a source of controversy because of mortgages. The employee appraisal methods are usually the main reason behind fault mortgage transactions (Resnick, 2004). As the employees have incentive to make the maximum number of loans they end up making unethical valuations. The property valuation is the key in mortgaging. If the property is overvalued by the loan officer the borrower would not be willing to pay back to loan. Islamic Banking System The base of Islamic finance is different as compared to conventional finance. The exchange of fixed income is haram (illegal) according to Islamic Fiqah (law). Therefore Islamic finance institutions cannot exchange in direct interest rate products such as conventional finance (Usmani, 2006). The only route for Islamic finance products is thus profit sharing. There are many different products made on the concepts of profit sharing. Diminishing Musharakah As the only mode of financing allowed in Islamic finance is through profit sharing, which is why most Islamic finance deals are referred to as partnerships (Usmani, 2006). The Islamic finance substitute of mortgage is Diminishing Musharkah. The contract of Diminishing Musharakah is a partnership contract between two different parties. These two partners jointly buy a property; the proportion of partnership is not equal. The total ownership of the partnership is divided into equal pieces (usually considered in percentages). Thus each unit is equal in amount in terms of price of the unit. The property owner thus buys each unit from the bank in increment pre fixed period. However the bank cannot charge an interest rate therefore it charges a fixed rent (Usmani, 2006). This rent is in proportion to the remaining share of the bank in the property. Thus at any given time both partners are owners unlike the mortgage. Methodology The cost of research is a point of concern for many different research studies. This is why it is important to establish a consistent research methodology (Sekeran, 2004). The different aspects of a research methodology have been described below under respective headings. Research Philosophy The research philosophy of any research creates a link between different aspects of research. Therefore it plays an instrumental role in building an effective and theoretically consistent research. The research can also use the research philosophy to establish clear guidelines and road map for other aspects of research. The positivist research philosophy and Phenomenological research philosophy are the two different types of research philosophy (Sekeran, 2004). These approaches stem from a varying perspective or opinion of the world. The table given below summarized important aspects of the research philosophy:   Positivist paradigm Phenomenological paradigm Basic Belief The world is external and objective The world is socially constructive and subjective   Observer is independent Observer is part of what observed   Science is value-free Science is driven by human interests Researcher should Focus on facts Focus on meaning   Look for causality and fundamental laws Try to understand what is happening   Reduce phenomenon to simplest elements Look at the totality of each situation   Formulate hypotheses and then test them Develop ideas through induction from data Preferred methods include Operationalising concepts so that they can measured Using multiple methods to establish different views of phenomena   Taking large samples Small samples investigated in depth or over time Figure: 1 (Source: Easterby-Smith et al., 1991:27) The comparison of the two different research philosophies reveals that phenomenological approach is the most suited to this research. As compared to the positivist philosophical position which is objective in nature, phenomenological approach is more subjective (Sekeran, 2004). This suits our research because it too does not look for a definite precise answer but in fact for a qualitative analysis. Research Approach The direction of any study is determined by the research approach. This is because the research approach defines and determines the strategy for conducting the research (Sekeran, 2004). Thus it also decides the resources, time etc needed for the research. There are different factors important to a research approach: Non-Empirical research Most areas of research have already been explored and studied. This information is available in form of research papers, books and journals. To conduct a successful research a research must first of all research and study all these areas. This is the non-empirical aspect of a research study. This aspect is critical to conducting a reliable research, as different opinions exist on each are of study. The research must take into account all these different opinions. Until the researcher appreciates and understand these opinions, a consistent research cannot be formulated. The literature review gives a detailed commentary and analysis of the already body of knowledge available on this topic. Quantitative/Qualitative There are three different approaches to a study in this regard. These are the qualitative, quantitative and mixed method study. The quantitative aspect of the research only discovers and explores the numerical proof and data available on topic. Qualitative research on the other only depends on data gathered from observations, surveys and non-empirical sources (Sekeran, 2004). As the main sources of data for this study is non-empirical the research would be qualitative in nature. Research Design Purpose of study The purpose of this study is exploratory in nature. This is because the research aims to explore an area of study which has not been explored before. Exploratory studies are undertaken as a preliminary step before further research can be conducted on any research topic (Sekeran, 2004). Thus once an exploratory study has established a base of study further research can be carried out on the topic. Study settings The study setting for the study in question would be non-contrived. This is because contrived settings are mostly useful for correlation studies. There would be minimal interference in the data collected from the field study. Time Horizon The time horizon for this study is cross sectional. This is because interference is minimal in this study thus a longitudinal study is not necessary (Sekeran, 2004). Moreover as the phenomenon of both banking systems is expected to remain consistent over a long haul, the study should be cross sectional. Conclusion The study conducted would aim to analyze and compare different aspects of both banking systems. The study would provide a guide for investors in deciding best alternative in both forms of finance. Moreover it would also explore the social aspects of Islamic finance which make it different and unique as compared to conventional products. References Sekaran, U (2004). Business Research Methodology: A skill building approach. Illinois: John Wiley& Sons. (2008).Types of Designs. Research Methods Knowledge base. (http://www.socialresearchmethods.net/kb/destypes.php) Brannen, J. (2006). Mixing Methods: The Entry of Qualitative and Quantitative Approaches into the Research Process. International Journal of Social Research Methodology. Froot, K. David, S. Stein, J (1994). A Framework for Risk Management. HBR. Reprint 94604 Resnick, B. (2004). International Financial Management. Singapore. McGraw-Hill Madura, J. (2007). International Financial Management. New York. Daves, P. & Brigham, E. (2005). Intermediate Financial Management. McGraw-Hill Debt vs. Equity. Venture Capital Focus magazine (http://www.dynamic-equity.com/vcmag03.htm) Usmani, T. (2007). An introduction to Islamic Finance. Mehran Printers: Karachi. Diwany, T. (2006). Third World Debt: One World Week. Cambridge University Ayub,M. (2007). Understanding Islamic Finance. Wiley finance El-Gamal, M. (2006). Islamic Finance: Law, Economics, and Practice. Cambridge Iqbal, Z & Mirakhor, A. (2009). An Introduction to Islamic Finance: Theory and Practice. Wiley finance Abdul-Rahman, Y. (2006). The Art of Islamic Banking and Finance: Tools and Techniques for Community-Based Banking. Wiley finance Rahaman, A. (2007). Gulf Capital and Islamic Finance: The Rise of the New Global Players. Dubai. Saleem, M. (2009). Islamic Banking - A $300 Billion Deception. Thomas,A. Cox, S. & Kraty, B. (2008). Structuring Islamic Finance Transactions. Euromoney Books. Askari, H. Iqbal, Z & Mirakhor, A. (2009). New Issues in Islamic Finance and Economics: Progress and Challenges. Wiley Finance. Warde, I. (2008). Islamic Finance in the Global Economy. Malaysia Toutounchian, I. (2007). Islamic Money and Banking: Integrating Money in Capital Theory. Wiley Finance Read More