Islamic Banking and Finance - Case Study Example

Islamic Banking & Finance NAME: UNIVERSITY: COURSE: INSTRUCTOR: DATE: © 2012 Introduction Islamic banking is a corporate banking activity that operates within the confines of the principles of sharia law in developing Islamic economies. Sharia law as explained by Ansari (2005) does not allow for fixed (and/or floating) payment, as well as interest on loans, otherwise referred to as riba or usury. Any business that provides goods or services against the principles of Islamic law is considered haraam, translated to mean “sinful and prohibited” (Banaji, 2007). However, only in late 20th century have these principles been applied by Islamic banks in private and public commercial banks in most of Muslim communities as noted by Imam and Kangni (2010). Definition of the research problem The aim of this essay is to critically examine and evaluate the corporate governance of Islamic banking in comparison with traditional banking. To achieve this objective, an Islamic bank - Meezan Bank Limited (MBL) - in Pakistan has been chosen as a case study, reason being that it is the first Islamic bank in Pakistan. This bank will be compared with traditional banks in the country by evaluating its performance in terms of liquidity, profitability, efficiency and risk for a period of five years from 2003. Essay structure and presentation This essay has, first and foremost, defined the research problem in the foregoing section before laying out the structure, presentation and depth of the essay in the present section. A comprehensive review of current literature on traditional banking compared to Islamic banking is carried out in the forthcoming Section 4. Section 5 explicitly outlines the major differences between traditional and Islamic banking, giving way to a case study in Section 6 of this essay. The fact that data about this bank is readily available and that it is a domestic and private Islamic bank forms the main reason for selecting it for the case study. To conform to the nature of this bank, the four banks that are used in comparison with it are also private banks in Pakistan. Furthermore, this essay does not use foreign banks, whether traditional or Islamic, so as to restrict the comparison analysis only on domestic banks. This essay selected MBL for the case study since there are numerous commercial banks – including six Islamic banks – in Pakistan, and as mentioned elsewhere, has operated for more than five years. For this reason, the bank is relatively large and is experienced in banking business (Muhammad, 2008). Moreover, a set of only four banks have been selected to contrast with MBL because of limited space for this essay and lack of data availability for majority of other banks. Literature review Islamic banking was started in a town in Egypt in 1963 on experimental basis. The good results from this experiment opened a market for Islamic banking and finance that culminated in full-fledged banking services in 1970, subsequently starting to operate on moderately medium scale in Asian and Arabic countries. According to Fadzlan (2007), this mode of banking operates in slightly more than 60 Islamic countries with total assets amounting to roughly $165 billion and an annual growth rate of 12.5% on average. Presently, the credit market share of Islamic banks in Muslim countries is approximately 16%. These figures and facts indicate that Islamic banking can be as efficient and viable as the traditional banking. The main goals and the distinguishing features of Islamic banking are to follow and adhere to the teachings of Shari’ah law (i.e. Islamic law) by avoiding the following: Gharar, receiving and/or paying Riba, investing in profit-making ventures, investing in impermissible and/or unethical business ventures (Rosly, 2006); but to invest in socially responsible ventures. While Islamic banking has been regarded as a fast growing banking sector, it nonetheless encounters problems, issues and challenges like traditional banking institutions. Several studies have been carried out since the beginning of modern form of Islamic banking and finance as outlined by Saleh and Rami (2006). For instance, conceptual issues touching on financial institutions that are interest-free have been the major focus for these studies according to Van Horne and Wachowicz (2005). At the same time, Juan (2007) assert that literature on the viability of these banks is hardly available, not to mention their ability to facilitate transactions that drum-up savings or manage risks. However, Ahmed (2007) and Hilary and Sait (2006) indicate availability of limited literature focusing on the elimination of interest payment in these banks. Furthermore, Memon (2007) and Michael (2009) maintain that research that focuses on the efficiency of Islamic banks is still minimal. Indeed, much research on Islamic banking focuses on evaluating and/or analysing the performance of these banks regarding their profitability and comparing them to traditional banks. Good examples include studies carried out by Ross and colleagues (2005) that make use of banking data to perform regression analysis in order to determine the basic determinants of Islamic banking. Other researchers like Fadzlan (2007) employ financial ratios to assess and analyze the performance of the Malaysian Islamic banks, for instance. Another study carried out by Esse and associates (2012) assesses the performance of Islamic banks by looking at factors such as the banks’ risk, profitability, solvency, liquidity, and community involvement over a period of time in comparison to traditional banks. These researchers show that when financial ratios coupled with F-test and T-test are carried on Islamic banks register significant improvement on profits in the study period although the same profits lag behind in traditional banks. However, as mentioned elsewhere in this paper, Islamic banks are relatively less risky but more solvent than traditional banks. Furthermore, the performance analysis for these banks show a higher liquidity compared to traditional banks. What is more, Abdussalam (2009) compared the performance of interest-based traditional banks and interest-free Islamic banks in Bahrain in the period from 1991 to 2001 using financial ratios to measure the banks’ performances in respect to: (i) liquidity, (ii) profitability and (ii) credit risk, before applying T-test to these financial ratios. The study concludes that while there is little difference in liquidity and profitability performances, there is however a huge difference in the credit performance between traditional and Islamic banks. Ghayad (2008) used bank data (such as balance sheets and income statements) to examine the performance of United Arab Emirates (UAE) Islamic banks. These researchers applied financial ratios to evaluate the performance of the banks using the parameters of liquidity, profitability, solvency, risk and efficiency. They found that compared to UAE traditional banks, Islamic banks are relatively less liquid, more profitable, more efficient, and less risky. Skully (2008) concluded by attributing two reasons to these findings. Firstly, the attributes of Islamic banking profit-and-loss sharing patterns are probably the major reason for the speedy growth of Islamic banking in this country. Secondly, the practice of corporate governance for UAE Islamic banks relating to regulation and supervision of these banks is different from the practice applied to UAE traditional banks. Elsewhere, another study conducted by Zurbruegg and Rammal (2007) with the aim of evaluating the performance of Islamic banks in Jordan, and of examining and analyzing the practical experience with Islamic banking confirmed earlier findings. They used data relating to and from the first and second Islamic banks in Jordan, i.e. “Jordan Islamic Bank for Finance and Investment” (JIBFI), and “Islamic International Arab Bank” (IIAB). The same study also highlighted the domestic and global challenges faced by Islamic banking and finance sector. The research applied a performance evaluation methodology by conducting liquid tests and looking at profit maximization and capital structure, with the following results: in the first place, the ability and efficiency of the corporate management for both banks sharpened while at the same time both banks expanded their banking activities and investment. In the second place, both banks played significant roles in financing development projects in Jordan. Thirdly, these banks focused on the short-term investments only. Fourthly, study discovered that the Bank for Finance and Investment (JIBFI) had been getting high profits over a period of time. Consequently, the researchers concluded that Islamic banks have had high growth rate in terms of profitability and credit facilities. A probably large study was conducted by Michael (2009) to examine the performance of Islamic banks’ performance operating in eight Middle Eastern states between the years 1993 and 1998. The study applied inter-country bank-level data on balance sheets and income statements for fourteen Islamic banks. The study aimed at establishing and examining the relationships (if any) between Islamic banking characteristics and profitability. The study came up with very interesting results highlighted below. First, the profit margins for majority of the Islamic banks increased proportionally with an increase in capital expenditure and loan ratios, a finding which is consistent with other researches. Second, the study underscored the critical role played by loan portfolios and adequate capital ratios in determining the performance of not only Islamic banks but also traditional banks. Third, the results point to the fact that non-interest earning assets, short-term funding and customer base, and overhead are important factors for upholding a (traditional or Islamic) bank’s profits. Fourth, the results also reveal the fact that foreign-owned banks tend to be more profitable than domestic banks probably due to differences in corporate governance styles (Abdussalam, 2009). The difference between traditional banking and Islamic banking Like a traditional bank, an Islamic bank is a trustee and a go-between of money for other people. However, the former bank shares profit and/or loss with its customers or depositors. This difference introduces the aspect of mutuality in Islamic banking by making depositors as customers with ownership of right in the bank (Ahmed, 2007). Islamic banking differ from traditional banking in that while the latter follows the conventional principle of interest-based, the former is based on the principle of non-interest and the principle of sharing profit-and-loss in their day-to-day businesses (Kuran, 2005). The raison d'être behind the principles of non-interest and profit-and-loss sharing in Islamic is to create a relationship of partnership and financial trust between lender, borrower, and intermediaries (Ross et al, 2005). Furthermore, Islamic finance is a kind of financial system that aims at fulfilling the teachings of Holy Qur’an instead of maximising returns on financial assets. Thus, the main concern for Islamic financial system is conformity to the norms of Islamic ethics. The core of these Islamic ethics is a form of corporate governance as enunciated by the Shari’ah to govern and guide all financial transactions in an Islamic financial system. On a moral level, this system is described as “Fair” and “Free” where “Fairness” is the primary goal (Van Horne and Wachowicz, 2005). However, this system limits the “freedom” of the customers in that they may be free to enter into financial transactions although this freedom is constrained by several other norms like the prohibition of Gharar and Riba (Michael, 2009). According to Memon (2007), an Islamic bank is primarily a partner with depositors when it applies the depositors’ funds in productive investment in contrast to a traditional bank which is essentially a lender and borrower of funds. A further difference between traditional and Islamic banking and financial systems lies in the form of corporate governance. For instance Islamic banks must obey and adhere to a different set of banking rules – as enshrined in the Holy Qur’an – in order to meet the expectations of the Muslim community. However, the two banking systems are similar because they both offer similar financial services and play an important role in the economic development of their countries. Case study: Islamic banking in Pakistan In July, 1948 during the official opening of “The State Bank of Pakistan”, Quaid-e-Azam Muhammad Ali Jinnah, the founder of Pakistan is quoted on Islamic banking as saying: “We must work our destiny in our own way and present to the world an economic system based on true Islamic concept of equality of manhood and social justice. We will thereby be fulfilling our mission as Muslims and giving to humanity the message of peace which alone can save it and secure the welfare, happiness and prosperity of mankind” (Muhammad, 2008). Sometimes in the financial year of 1977/78, Islamic banking was born in Pakistan when charging of interest was eliminated from the operations of commercial banks and other specialised financial institutions. Two years later, the corporate and financial system was amended so that corporate financing would allow the issuance of a new interest-free instrument, “Participation Term Certificate” (PTC), to financial institutions (Muhammad, 2008). And at the same time, Ordinance was introduced with the intention of establishing Mudaraba firms and floating Mudaraba Certificates. Sometimes in July 1985, all commercial banks in the region of Pak Rupee were mandated to operate as interest-free, and sometimes in November 1991; Federal Shariat Court (FSC) declared this as un-Islamic (Muhammad, 2008). Meezan Bank Limited (MBL) Islamic banking came under the regulation of Islamic Banking Department of The State Bank of Pakistan (SBP) sometimes in September 2003. The department was mandated to regulate and promote Islamic banking in accordance with best international practices by making sure that Shari’ah Compliance is adhered to and by ensuring transparency in the operations of Islamic banks. In addition, this department had to ensure that Islamic banking is the first choice for both users and providers of financial services as indicated in the Meezen Bank Annual Report of 2007 (Cited in Muhammad, 2008). Indeed, the foremost mandate for the department was to develop and promote Shari’ah Compliant Islamic Banking in the country. The department is composed of three divisions including Shari’ah Compliance, Policy and Business Support. To this effect, the department established a Shari’ah Board that is made up of experts to guide Islamic banking industry within SBP. This board will also handle Corporate Governance, Risk Management, Accounting & Shari’ah Standards, Prudential Regulations, etc., as the other key areas within SBP in the process of supervising and regulating the Islamic Banking sector. Currently, Islamic Banking Sector is operating under the existing laws & regulations for conventional banks (The State Bank of Pakistan cited in Muhammad, 2008). To this effect and in accordance with the guidance of the SBP department mentioned above, MBL, a publicly listed institution incorporated in January 1997 to operate as an investment bank, was granted the first Islamic Banking License in January 2002 to operate as an Islamic commercial bank. Within a short period of time, MBL established itself throughout Pakistan with branches in all major cities and thus becoming the largest Islamic Bank in the country. In its first five years of operation as a full-fledged Islamic commercial bank, MBL has recorded the fastest growing bank status in the history of banking sector. For instance, deposits grew at an average rate of 60% p.a. in this period while the bank’s branches grew from 4 to 100 (Muhammad, 2008). Furthermore, the bank established a credible and very strong corporate governance team consisting of experienced professionals, who steered the bank to achieve a strong balance sheet in addition to excellent profitability and strong banking ratios that placed the bank at the summit of the banking industry in the country. Perhaps the sterling achievement highlighted above can be attributed to a think-tank of leading financial experts and institutions who are the main shareholders, namely, “Noor Financial Investment Company of Kuwait, Pak-Kuwait Investment Company in Pakistan, the Islamic Development Bank of Jeddah, and Shamil Bank of Bahrain–a leading Islamic Bank in Bahrain (Rosly, 2006). The established position, reputation, strength and stability, of these institutions add significant value to the Bank through Board representation, corporate governance and applied synergies” (Meezan Bank Limited cited in Muhammad, 2008). The same source further intimates that: “The Bank has an internationally renowned, very high caliber and pro-active Shari’ah Supervisory Board (read corporate governance) Chaired by Justice (Rtd.) Maulana Muhammad Taqi Usmani, an internationally renowned figure in the field of Shari’ah, particularly Islamic Finance (Muhammad, 2008). He holds the position of Deputy Chairman at the Islamic Fiqh Academy, Jeddah and in his long and illustrious career has also served as a Judge in the Shariat Appellate Bench, Supreme Court of Pakistan. The Board also includes Sheikh Essam M. Ishaq (Bahrain), Dr. Abdul Sattar Abu Ghuddah (Saudi Arabia) and Dr. Imran Usmani who is also the resident Shari’ah advisor of the Bank. Dr. Imran is assisted by a team of professionals (otherwise referred to as the Product Development and who strictly monitors the regular transactions of the Bank”. Maulana Muhammad Taqi Usmani adds by saying: “At Meezan Bank, we strive to find commonalties with the conventional banking system with absolutely no compromise on Shari’ah rulings. The bank has developed an extraordinary research and development capability by combining investment bankers, commercial bankers, Shari’ah scholars and legal experts to develop innovative, viable, and competitive value propositions that not only meet the requirements of today’s complex financial world, but do so with the world-class service excellence which our customers demand, all within the bounds of Shari’ah”. A further point worth mentioning is the use of Information and communications technology at the Bank by employing customer knowledge-based systems that focus on the use of the current state-of-the-art systems and technology. The mission of the bank is highlighted by the source mentioned above, thus “The Bank’s Corporate and Investment Banking business unit is geared towards nurturing and developing a long term relationship with clients by understanding their unique financing requirements and by providing Shari’ah compliant financing solutions through corporate banking and structured finance” (Muhammad, 2008). Conclusion This essay has clearly demonstrated that while conventional and Islamic banking have a lot of differences especially in their mode of corporate governance, they also share similarities in the fact that they both offer similar financial services to their clientele. They also play a pivotal role in the economic development of their respective countries. Furthermore, and based on the current literature reviewed in this essay, together with the case study used herein, a trend emerged to the effect that most of Islamic banks tend to be more solvent (i.e. less risky) although less profitable and less efficient in corporate management compared to the traditional banks. Notwithstanding this fact, the liquidity for the two sets of banks is significantly the same. This is attributable to the facts that traditional banks in this country have been in existence long before Islamic banks and are therefore more experienced in banking business so that they (traditional banks) dominate the financial sector since they have a larger share in the financial assets in this country. References Abdussalam, M (2009) Corporate governance from the Islamic perspective: A comparative analysis with OECD principles. Critical Perspectives on Accounting 20: pp556–567 Ahmed, K (2007). The Business of Culture: Morality and Practice in Islamic Finance. Ansari, S (2005). Interest-based Conventional and Non-Interest Modern Banking Investment and Marketing. Karachi Issue No. 08 pp6-9. Banaji, J (2007) “Islam, the Mediterranean and the rise of capitalism”, Historical Materialism 15 (1), pp. 47–74, Brill Publishers Esse, A., Bruno, Z., Miaoli, Du., Yongqiang, Li and Hassan, A (2012) The Impact Of Investor Protection On Financial Performance Of Islamic Banks: An Empirical Analysis. Corporate Ownership & Control / Volume 9, Issue 4 Fadzlan, S (2007), “The efficiency of Islamic banking industry in Malaysia: Foreign vs Domestic banks.” Humanomics, Volume 23, no. 3, pp. 174-192. Ghayad, R (2008) Corporate governance and the global performance of Islamic banks. Journal of Humanomics Volume: 24 Number: 3 pp: 207-216 Hilary, L and Sait, S (2006) Land, Law and Islam. New York: UN-HABITAT. p. 175 Imam, P and Kangni, K (2010) Islamic Banking: How has it Diffused? IMF Working Paper, African Department Juan, S (2007) ISLAMIC FINANCE: Islamic Banking Makes Headway. IMF Monetary and Capital Markets Department Kuran, T (2005) “The Absence of the Corporation in Islamic Law: Origins and Persistence”, American Journal of Comparative Law 53, pp. 785–834 [798–9]. Memon, N. A (2007) Islamic Banking: Present and Future Challenges. Journal of Management and Social Sciences Vol. 3, No. 1, Department of Economics, Institute of Business & Technology (BIZTEK) Michael, M (2009) Islamic Capital Markets and Risk Management London: Risk Books. Muhammad, S. M (2008) Performance of Islamic Banking and Conventional Banking in Pakistan: A Comparative Study. Master Degree Project in Finance Rosly, S. (2006) Critical Issues on Islamic Banking and Financial Markets: Islamic Economics, Banking and Finance, Investments, Takaful and Financial Planning. AuthorHouse Ross, S. A., Westerfield, R. W and Jaffe, J. (2005) “Corporate Finance.” 7th Edition. McGraw-Hill Inc. Saleh, A. and Rami, Z (2006), “Islamic Banking Performance in the Middle East: A Case Study of Jordan.” Working Paper 06-21, Department of Economics, University of Wollongong Skully, M (2008) “Corporate Governance and Islamic banks”, Islamic Banking and Finance Symposium at the Asia Institute in Melbourne University Van Horne, J and Wachowicz, J (2005) “Fundamentals of Financial Management”, 12th Ed. Pearson Education Limited Zurbruegg, R and Rammal, H (2007) Awareness of Islamic Banking Products Among Muslims: The Case of Australia. Journal of Financial Services Marketing, 12(1), 65-74. Read More