Financial Stability of Islamic Banks - Research Proposal Example

Contents Contents 2 Summary 3 Problem ment and research questions 4 Aims & objectives 4 Rationale/justification 5 Literature review 6 Research methods 10 Ethical considerations 12 Timescale/plan 13 Resources/Costs 13 References 14 Summary The introduction of Islamic banks saw the emergence of a new type banking paradigm come into play. In this paradigm, the sharing of profit and loss on loans was the most outstanding feature. This implied that these banks charged no interest on loans and took deposits from clients. The Islamic banks are also used in these countries as tax collection centers. The tax that is collected by these banks is known as Zakat. This mode of operation is what sets this type of banking apart from the conventional system of banking. In the conventional banking system, the major driving force is capitalism and interests are charged on loans given by the banks (Schoon, 2009, p. 19). The impact of the financial crisis on these two types of banks within the gulf cooperation council could be different due to the difference in mode of operation of the banks. This implies that their future financial stability going forward could also take a different trend. This paper seeks to give a research proposal on the financial stability of these banks during the global financial crisis in the GCC. It also reviews the financial stability of these banks after the economic crisis going forward. Apart from the stability aspect that is influenced by the economic crisis, the paper also examines a brief literature review on the factors that lead to instability of both conventional banks and Islamic banks in general. It should be noted that the climax of the global financial crisis happened in 2008. As such much of the comparison and literature review is going to cover the years that run from 2006 to present. This study will try to analyze the impact of the crisis on the conventional banks and Islamic banks in the region. A postulation on the effect of the crisis will then be used to understand the effect of the crisis on the future stability of the Islamic banks in the GCC. Problem statement and research questions Islamic banks operate a type of banking that is defined by the principles of sharia law. In this type of banking, the most notable feature is the lack of interest that is charged on the loans offered. Apart from this feature, the Islamic banks do not operate interbank borrowing or foreign exchange swaps and treasury bills. This makes this type of banking unique in typology. During the global economic crisis of 2008, the impact on the stability of these banks operating in the Gulf corporation council was different. Several aspects of this impact have been studied including a comparison of the impact of interest rates on the two forms of banking in Turkey. The gap of literature that remains is based on a projection of the future stability of the Islamic banks after the recession. Most gulf cooperation council countries operate both conventional banking system and Islamic banks (Warde 2010, p.2). It is important to make a comparison between these two forms of banking in order to determine the trends that are expected in the future in terms of financial stability. As noted earlier, the difference in modes of operation will lead to different forms of risks and crises that can indicate the level of stability. To project the future of is Islamic banking in the Gulf Cooperation Council countries, a comparison of this nature is imperative. Aims & objectives I propose a detailed survey into the indicators of stability of financial institutions operating in the gulf cooperation council countries. The survey will involve a number of conventional banks and Islamic banks operating in the region selected randomly in different countries. The survey will lead to a generation of insights into the following question: Does the global economic crisis of 2008 have an impact on the future stability of Islamic banks in the Gulf Cooperation Council countries? Are conventional banks more stable than Islamic banks in the Gulf Cooperation Council countries after the global financial crisis? Rationale/justification Islamic banking has risen steadily in the recent past from its inception in 1968. This implies that this form of banking controls a vast amount of assets over several territories. Therefore, the impact of this form of banking in the global economy cannot be left unnoticed. The level of competition that this form of banking places on the conventional banks is another factor that justifies this study. Islamic banking is a unique form of banking that does not charge interest and operates on the profit and loss sharing platform. It is essential to see how this form of banking will survive and operate over the next few decades. Policy making is also a main motivation of this research. Islamic banking being a relatively new form of banking will require upgrading of its operational policy to cope with the dynamic financial market. The major reason is the complexity of integrating this type of banking in the international market from its unique form (Salem, 2013, p. 1999). In its operation, Islamic banks do not take interbank deposits. This makes it difficult to integrate this form of banks with conventional banking system. It also provides the banks with limited means to counter risks resulting from liquidity-related issues. Finally, the available literature explores a different perspective of this type of banking. These include the banking model, the differences between this type of banking and conventional banks (Fahim Khan & Porzio, 2010, p.63) and many other perspectives. The literature gap that remains is the impact of the global economic crisis on the future stability of this type of banking in the Gulf region. Literature review There is a significant difference between conventional banks and Islamic banks. The main differences stem out of the fact that the driving principle behind the Islamic banking system is the sharia laws. In the conventional banking system, the driving force is capitalism. The difference in mode of operation raises a number of concerns that could affect the banks stability. This difference in operation mode can also result in the difference in stability of these two types of banks despite being in the same economic zone. To measure the stability of a banking system or a standalone bank, the key indicators are the risk of insolvency and the volatility of its finances. Several studies have tried to find a common ground to define the measures of stability but have failed to deliver a single measure for stability. Goodhart & Segoviano (2009 p. 5) and European Association Of University Teachers Of Banking And Finance, Lindblom, SjöGren, & Willesson (2014, p. 30 ) are common examples. Both these studies, however, agree with the fact that the indicators of a banks instability are a host of factors that point at financial instability. Hesse and Cihak, (2008, p. 7) introduces a variable known as the Z-score to measure the stability of banks. This is a variable that indicates the riskiness of a bank or the likelihood of the bank to fail. The variable is inversely related to the insolvency probability of the same bank that it describes. In this concept again, the idea is the risk level of a bank that will determine its stability. This study describes the variable as an objective measure. This is because the variable is strictly focused on the likelihood of insolvency of the financial institution and is applicable to all type of financial institutions. However, criticisms to this variable argue that the Islamic banking system provides for profit and loss sharing and as such the risk is minimized by this strategy. This is solved by making additions to the equation that produces the Z-score to cater for the Islamic banking typology (Hassan & Lewis, 2007, p. 380). The Z- score is also an indication of the strength of the bank. In the likelihood that the score is high, then the finances of the institution are strong. A strong financial baking is an indicator of a stable bank or banking system Various indicators of the stability of banks can be reviewed in order to determine the direction of the stability of the Islamic banks. The most common indicator of financial strength is the liquidity ration. In Smart and Graham (2012 p. 41), the discussion about the ratios indicate that the higher the ratios the more solvent a financial institution is. As such a financial institution is seen as more stable if it has a high liquidity ratio. The management of liquidity risk within the conventional banking system and the Islamic banks remains a challenge to both banking systems. Ruozi and Ferrari (2013 p. 4 ) describe this type of risk as that which results from the difference in maturity of assets and liabilities of the financial institution. If this condition happens, banks are supposed to respond as soon as possible or face the risk of selling a large portion of their assets at low prices. The result of this action is a considerable amount of loss. The risks resulting from liquidity can be managed by tools like interbank deposits, treasury bills, foreign exchange swaps, commercial papers and repo operations. In critical situations, conventional banks do not have to sell their assets at a lower price but turn to the interbank market for assistance. In the Islamic banking system, such tools are unavailable leaving the banks to be fairly exposed to the risk of liquidity. However, the Islamic banks rely on the commodity Murabaha that uses metals as the commodity to manage liquidity issues (Schoon, 2010, p. 74). To understand the impact of the global economic crisis in Saudi Arabia, a study has been conducted on Islamic banks in this country (Tabash and Dhankar, 2014, p. 368). The study indicates that the in the period up to the financial crisis of 2008, the Islamic banks grew considerably. There was no effect of the global crisis on the banks at an adverse level. In fact, the study indicates that the banks received insulation from investment that led to the actual cause of the crisis. In this study, the progressive growth and stability in the face of a global crisis is the central focus of discussion. It should be noted that while sharia law prohibited the investment into such risky stock that caused the crisis, the conventional banks did invest in such stock. As such the effects of the global financial crisis did affect the conventional banks leading to bailouts and instability. Almukharreq and Amba (2013, p. 92) gives an analysis on the effect of the financial crisis on the conventional banks and Islamic banks in the Gulf corporation council. The study uses data obtained from Bank Scope database and reviews a total of 92 banks in the region. The period of the study runs from 2006 to 2009. The study also employs a set of three ratios to determine the profitability of the banks. These are return on equity, return on asset and the net interest margin. A set of two variables each was used to measure the characteristics of the banks. In this study, tangible equity and equity was used as a representative for capital, liquid assets, and loans a representation for liquidity and overheads and deposits as liability. The outcome showed that there was a negative impact on profitability of both the conventional and Islamic based types of banking. The other results showed that Islamic banks had strong capital structure as compare to conventional banks. Conventional banks on the other hand did have better liability and liquidity ratios. Cihk, Wolfe & Schaeck(2006, p. 1) raises issues of competition as the major source of instability. In this study, the idea of competition is seen as the driving force behind the banks engaging in risky business. Due to this, when disasters happen, the banks are left at a state where they cannot deal with their liability and are almost insolvent. The result is a continued borrowing that will lead to even more liabilities. As such the banks become unstable through crises resulting from risky behavior or investment. The bottom line is that the bank will have at some point to sell its assets to offset the debt leading to the institution being unstable in its operation. Interest rates is another source of instability that could affect both conventional and Islamic type of banking. This is due to the shocks that these rates have over the deposits and loans held by the banks. However, in Islamic banking, the basic principle is the sharing of profits and loss and the absence of interest in their loan (Ariff, & Iqbal, 2011 p.67). As such it is difficult to quantify the level of impact that interests have on the Islamic banks deposits and loans. This implies that the Islamic banking system has a positive impact on the protection of the banks from the adverse effects of interest fluctuations. The sharing of profit and loss limits the possibility of bankruptcy and also makes it difficult for the banks to be integrated with the mainstream international market. The lack of interest on their loans also makes the banks resist speculations in their actions (Gulumser and Hakan, 2011, p. 3). This study also reveals that the Islamic banks are not affected by interest rate fluctuations, but in states that operate dual banking systems, the fluctuations could affect their deposits leading to an equivalent impact as in conventional banks. The result remains similar, and the risk associated with this fluctuation will play a significant role in determining the stability of the banks. Finally, the role of business models in the stability of the banks cannot be left out. In this case, the use of various platforms such as internet or mobile banking and an expanded customer base is the central forces of review. The use of information technology can be used to support even more complex and dynamic business models in the wake of increased customers (unknown 210, p. 168). The use of ICT is another source of risk that could cause instability. Further research could address the difference in business model between these two types of banking. Research methods There are many types of research methodologies to choose from. The two main methodologies to choose from are the qualitative research and quantitative research methodology. To make a good decision, it is essential to determine whether the data to be collected is for purpose of quality of a phenomenon or to quantify the extent. This is guided by the type of data that is requested in the research question (Kumar 2008, p. 8). Quantitative approaches are mainly for collecting data about variables that are to be tested in order to verify formulated hypotheses. It is also possible to use these data for purposes of verifying existing theoretical frameworks. In most cases in quantitative research data that is collected is can be quantified and is often in numeric form. The most common tools of analysis are statistical tools. Qualitative research, on the other hand, is mainly done with the aim of developing the meaning of a phenomenon. Most of the data that is collected through this methodology are meant to describe intangible things like experiences, belief, and meanings. The methodologies above can stand alone in a research as the only method that is used by the researcher. However, if the scope of the research allows, both methodologies can work in a single research work (Tracy, 2012, n.p). After selecting the research methodology, the next important task to undertake is the selection of the appropriate data collection methods to use. Secondary research will be the initial part of this research. The main reason for this is that secondary research gives a clear picture of the background of the study and guides the direction of the study accomplishing this will require a literature review (Rugg & Petre, 2007, p. 32). A quantitative research is the best methodology to accomplish this task. The reason for employing a quantitative research in this study is due to the large amount of empirical data that is to be analyzed. For the data source, the research will use the Bank scope database for information about the financial status of the banks. The data from the Bank Scope database will then be used to project the past, current and future of the Islamic banks in the Gulf Corporation Council countries. The most commonly used models for measuring financial stability of financial institutions include the Z- score, Moody’s financial ratios and the Varizi model. In this study, the most appropriate model that will be used is the Z-Score model. A comparison of the average Z-Score will be done for both types of banks to show the difference in stability over the same period. The Z- score model is defined by the equation (Varizi, M.Bhuyan, & Manuel, 2012, p. 123), Z=6.56x1+3.26x2+6.72x3+1.05x4 Each of the variables x1, x2, x3 and x4 represent distinct ratios that can be used to predict the financial capability of the institution. x1 represents the ratio of working capital to the total assets used in a business (Varizi, M.Bhuyan, & Manuel, 2012). Its main use is to measure the ability of the firm to pay its debts. The second variable, x2 gives the ration of retained earnings to the working assets. Its main use is to show the cumulative or overall profitability of the institution over the years of existence. X3 represents the total earnings before any deduction as a ratio of the working assets. The main use of this variable is to show the earning power that is generated by the assets of the firm that are working. Finally the ratio of the book value equity to the book value total liabilities is mainly applicable to firms that are not traded publicly. In order for a firm to be considered non bankrupt and able to pay off its debts, the value of the Z-Score must be greater than 2.6. Ethical considerations (The main ethical considerations in this study are directly related to the confidentiality policy of banks. In the banking sector, all information regarding clients and financial information is treated as confidential (IMF, 2005, p. 250). As such it will be important to maintain the confidentiality of the banks by handling and conducting the research in a professional manner. This implies that the information retrieved from the Bank Scope database that pertains to balance sheets, income statements, or any other record is treated as confidential. An exception is when this information is already published by the bank It is also essential to protect the confidentiality of persons who have responded with personal or corporate information and keep their identification and information private and confidential. Lune, Pumar & Koppel (2010, p. 152) opines that the use of such information must be done with prior consent of the individual whose information is to be published. Timescale/plan The main activities that are involved in this research include the following: literature review, research design, financial planning, developing questionnaires, testing the questionnaires, data collection, evaluation, writing the report and publishing the report. Each of these activities have a specific timeframe attached to them and some can run concurrently. Resources/Costs Before conducting a research, it is essential to make a plan that will guide the course of the research and allocation of the available resources to the different perspectives of the research. This will ensure that both the time and resources are well spent on the research process (Lee, 2009, p. 288). Without a proper plan and a clear direction of activities in a research, the research process will not accomplish its objectives and goals at the required time and resources. The main resources that the research will require include: stationery, statistical software like SPSS, Human capital or labor and financial resource. These come at a relative cost depending on the market prices at the time of acquisition. The SPSS software will majorly be used for statistical computations and comparisons between the data. References ALMUKHARREQ, F. AND AMBA, S. M. (2013). Impact of the financial crisis on the profitability of the Islamic banks vs conventional banks, Evidence from GCC. International journal of Financial Research. Vol. 4. No. 3 ARIFF, M., & IQBAL, M. (2011). The Foundations of Islamic Banking Theory, Practice and Education. Cheltenham, Edward Elgar Pub. CIHK, M., WOLFE, S., & SCHAECK, K. (2006). Are More Competitive Banking Systems More Stable? 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