Islamic Banking and Profitability in Saudi Arabia - Thesis Proposal Example

Dissertation Proposal: Islamic Banking and Profitability in Saudi Arabia Name of University Submitted by Names: Tutor: Date Dissertation Proposal: Islamic Banking and Profitability in Saudi Arabia Islamic banking is banking activity, which is consistent with principles of Islamic Shariah, and their practical application that are meant to develop the whole scope of Islamic economics. Specifically, some banking institutions call it Shariah Compliant Finance (Nzibo 2014). Since the Shariah, principles prohibit floating or fixed payments or acceptance of any fees or interests (usury or riba) on any loanable finance, the banks participates in sharing of losses or profits with the borrower. It is important to note that although Islamic principles have been applied by various historical Islamic economies at varying degrees, it is only in the twentieth century that their usages have become widely applicable in Islamic community (Sailan Muslim 2009; Iqbal and Molyneux 2006). According to Ernst & Young report, the Islamic banking is rising rapidly continuously gaining a lot of popularity in both Muslim and non-Muslim communities. Saudi Arabia, which is one of the largest hubs of Islamic Banking, has accounted a total asset value of $ 1.6 trillion (Ghafoour 2013). Therefore, this proposal seeks to lay out the framework of the study that will investigate to establish relationship between Islamic Banking and profitability in the Kingdom of Saudi Arabia. Research Questions What are the general characteristics of Islamic Banking? Identify contrasting elements of conventional banking and Islamic banking towards profitability Identify common Shariah compliant instruments in Saudi Arabia. What are the internal determinants of profitability in the banking sector? What are the macroeconomic interactions/ external determinants that affect profitability in Islamic Banking? How can profitability in Islamic Banking be measured? Objectives of this Study To describe the general characteristics of Islamic Banking Identify and discuss the most contrasting elements between the conventional and Shariah compliant banks. To discuss the Shariah compliant instruments that banks in Saudi Arabia apply. To identify and discuss the internal determinants of profitability to banks in Saudi Arabia To realize the macroeconomic/external determinants interaction that favors/ hinders the growth of profitability in Islamic Banking in Saudi Arabia. To propose how profitability in the banking sector can be measured Literature Review Islamic banking is a banking system that is based on Islamic Shariah principles in the whole guidance of Islamic Economics. It is found on two basic principles: prohibition of Interest collection and sharing of loss and profits between the bank and the customer. Generally, Islamic banking espouses certain features that normally distinguish it from conventional banking. The first characteristic of Islamic baking is to avoid riba (interest) (Lewis 2013). Riba is perceived to be an increase in money form without an increase in the assets themselves. Therefore, this increase, which represents nothing, when charged, is forbidden according to Islamic jurisprudence. Secondly, Islamic banking ensures that the bank shares profit and loss with the borrower. This acts like partnership venture that is backed with real assets in the process of financing. By eliminating perils of uncertainties (gharar) and interest (riba), they promote the real economic activities and thus the economy may not plunge into effects of recession (IBNI 2014). Since the banks do not charge interest to avert its risks, it ensures that there is a very careful evaluation of risks on any investment demand they undertake with the customers. The banks are normally conceived to be multi-purpose but not purely commercial. They are actually crossbreeds of investment management institutions and investment trusts, investment and commercial banks and therefore offer a variety of services to its customers. Being equity oriented institutions, they cannot permit their management to borrow for short term and lend for long term (Bashir 2000). The banks operate primarily on the principles of Shariah unlike the conventional commercial banks, which do so on manmade basis (Beck, Demirguc and Merrouche 2010). The Islamic banks promote risk sharing between the customer and themselves, unlike the case in commercial banks where investor is assured of the prefixed interest. Islamic banking collects zakat, which is not applicable in conventional commercial banks. Moreover, the Islamic banks functions on partnership with the borrower unlike the conventional commercial banks which are just determined to get bank full interest and principal. Although the conventional banks may charge extra money on defaulters, Islamic banks are not mandated to do so. The Islamic banks will always participate in ensuring that equity grows, which is not the case in the conventional banks. Therefore, the Shariah compliant banks pay greater attention to appraising and evaluating any development projects. As the conventional commercial bank gives a lot of emphasis on credit worthiness of the customer, Islamic banking is much concerned with the viability of the project. Therefore, the relation of a client in an Islamic bank is that of partners, which is different from that of commercial bank that is characterized with the creditor –borrower (Beck, Demirguc and Merrouche 2010). Shariah Compliant Instruments and Generation of Profits For equity structure instruments, the Islamic banking system has instituted Musharaka to refer to partnership. In this case, the borrower agrees with the lender bank to start and run the business venture but return to him the agreed share of profit/loss and the principle (Faizulayev 2011). On the debt structure, Murabaha is a markup/ cost plus, which involves purchasing of a tangible asset from a third party and selling it to the client at an agreed price on installments where profit margins are added (Islamic Development Bank 2014) . This is not the case in commercial bank, the markup should not be so high, and it is mandatory that the buyer is aware. On Ijara, the Islamic bank will acquire assets on behalf of customers leasing them to willing clients over a specific period and although getting profit, it avoids charging interest rate. In Istisna, an Islamic bank will finance the construction of an engine, ship or other assets so that payment can be made later to it. Qard Hassan is an interest free loan that is only acceptable in Islam. In Wadia, a customer will deposit money in the bank, earning nothing as the bank use the money as it desires. However, his funds must be secured (Faizulayev 2011). Internal Determinants of Profitability in Islamic Banking For internal sources that determine profitability, analysts list fund use management, fund source management, and liquidity and capital ratios that determine the internal profitability of the Islamic banks. In this case, it is noted that profitable banks are normally well capitalized or enjoy cheaper sources of capital for any subsequent improvement of its structures. Profitability was also seen to be very much dependent on the ratio between bank loans to the total assets. Since the Islamic banks normally do not depend on interests on loans to earn profits, during difficult times of businesses, their profitability can be under stress. The reverse, however, may be true. The type of ownership are also likely to affect the profitability of the firm indicating that depending on domestic ownership, banks may benefit from tax breaks among other preferential treatments. Other important determinants are asset quality, capital size, and managerial operations size (Wasiuzzaman and Tarmizi 2010). External Determinants of Profitability in Islamic Banking External determinants on an Islamic Bank’s profitability are those that cannot be controlled by its management. Among the widely known and discussed external determinants are the market share, competition variables, concentration, regulation, inflation, and money supply, scarcity of capital and size of the industry. On Competition, there is no resolved opinion whether competition affects profitability or not. Most researchers would like however to incorporate it in market structure in the scope of regulations. Concentration, which is defined as the size and number of firms in the market, has had positive impact on profitability (Haron and Azmi 2004). When the firm has a bigger market share, it is evident that it will increase in efficiency and hence profitability. The scarcity of capital as determined by high interest rate on it may hinder the profitability of firms in the market. Most researchers nevertheless agree that expansion in money supply would increase profitability in banking sectors. On inflation, it was also found that it had positive relationship with profitability of the banks (Wasiuzzaman and Tarmizi 2010). Measuring Profitability in Islamic Banking by Derivations from Internal Determinants To measure the return on the above instruments of Shariah compliant banks, banking firms are employing measures such as Return on Assets (ROA), Rate of return on investment deposits (ROD), Return on assets (ROA) and Return on investment Deposits (ROD) (Haron and Azmi 2004).. Others are Net Interest margin, but in the case of Islamic banking, it will be used to refer to profit on costless assets to match with conventional banking. The other measure consists of liquidity ratio, which will be shown by Loans to Asset ratio. It should be understood that when things are constant, deposits are transformed into loans, which may result in the bank having higher profits. However if the banks have to fund the high loan portfolios it is evident that they will reduce their profitability (Wasiuzzaman and Tarmizi 2010; Bashir 1999). Methodology In this review, the study will be using Primary data: data generated from an original source such as tour own experiments, surveys, interviews or focus groups and Secondary data that are data collected from an existing source, such as database, internal records and publications. (Abramson et al. 2009). Qualitative Research Qualitative data are data in a nominal form. Qualitative research seeks to investigate how individuals interpret, view, understand and/or create social reality. From the researcher’s perspective, the purpose of qualitative research is to “increase understanding of a particular issue”. Qualitative research questions tend to ask ‘how’ and ‘why’ in order to understand individuals’ motivations, whilst quantitative research questions is more likely to be closed. In this regard, the managers of Islamic banking and other financial analysts will be asked to determine why Islamic banking is better than conventional banking. There will also be themes of how they feel pressured on competing against the conventional banks so that they are at par or overwhelm them. Therefore, on this particular approach, it will seek open answers on factors that influence their interest and repercussions in the Islamic banking instruments (Patton and Cochran2002). Quantitative Research Quantitative research, on the other hand, focuses on numerical values and seeks to test pre-established theories and/or hypotheses. Specifically, “Quantitative research is a means for testing objective theories by examining the relationship among variables that can be measured, typically on instruments, so that numbered data can be analyzed using statistical procedures”. In this regard, the researchers will have to seek from sources of 20 selected banks in Saudi Arabia to get measures of profitability to be undertaken under various statistical treatments. They will also be have to access external determinants on profitability on any banking sector, by consulting records from organizations such as World Bank, IMF, International Financial Statistics among others. The quantitative method will enable researchers to confirm the levels profitability in various individual Islamic banks and the whole industry (Sage Pub 2010). Data Collection and Manipulation Qualitative part will be handled by sending mail questionnaire to senior executives of banks and other key players in the industry. In quantitative analysis, Internal determinants of profitability such as Rate of return on Assets, liquidity, asset quality, capital size, managerial operations size and capital of banks will be obtained from the selected 20 banks in Saudi Arabia. Their statistics will have to be verified from other bank databases for window period of 10 years, from 2003-2013. After all the information has been collected, the data will be pulled together for statistical treatments. External determinants will be obtained from International Financial Statistics (IFS) and IMF database. Using the linear regression model, the study will have to test relationship between specific determinant and profitability. However, the overall equation will have to include all the internal determinants and external (macroeconomic) determinants, so that the linear progression model will be as below: Pqt = C +Σαi Bqjt +Σ βiXkt + Uit In this case, Pqt= Profit made by the selected banks as dependent variable Bqj = Internal determinant/ derivations characteristics of bank q at time t Xkt = K –th external determinants/ macroeconomic variables at time t Uit = Error terms Given that all assumptions have been, met Ordinary Least Square method has been chosen so that to give the best fit coefficients for the better future predictions. Ethical Considerations Taking into account the importance of ethics in any research, the researchers, will institute the ethical principles that are acceptable in current modern scientific research. Therefore, basic policies and procedures will be designed to ensure that the research subjects are safe and that sloppy or irresponsible behaviors are prevented. Owing to the fact that ignorance is not the defense here, the researchers will have the duty to seek out and understand the theories and policies that are designed to bring upstanding research practices. These would then enhance the trustworthiness, and considerations that the researchers will be socially responsible to provide valuable results. It is important to note that this will involve submitting them for peer review to be considered ethically and socially accepted. As widely noted, just when one part of the project is unethical the entire project may be considered to be in a sham (Centre for Bioethics 2003). As regards the authorship of the project, the researcher will take a lot of considerations regarding the responsible authorship practices. (Centre for Bioethics 2003).Taking into account that this study will involve human subjects from diverse backgrounds, the researcher will have to be careful with topics ranging from fair selection, voluntary participation and human justice (Centre for Bioethics 2003). Limitations of the Study The study will be hampered by the fact that Islamic banks are very much long run focused which may make it difficult to adjust on short-term measures and therefore they would not be measured on such deviations. It will also need to have another analysis on conventional banks so that more elaborate evaluation and conclusion can be made. Since the Islamic Banking may be operating in an economic system (for instance some of economic data used were from IMF) which is not Islamic, the application of the results may be compromised at some degree. The last but not least is that the number of participating banks will be not inclusive of all banks and therefore some interesting questions may not be answered. List of Reference Abramson, MJ et al. 2009, Mobile Telephone Use Is Associated with Changes in Cognitive Function in Young Adolescents, PubMed, viewed 16 January 2014 Bashir, A M 2000, Determinants of Profitability and Rate of Return Margins in Islamic Banks: Some Evidence from the Middle East, ERF Seventh Annual Conference, Amman. Bashir, A M 1999, Risk and Profitability Measures In Islamic Banks:The Case of Two Sudanese Banks, Islamic Economic Studies, 6(2). Beck, T, Demirguc, A, Merrouche, O 2010, Islamic vs Conventional Banking, The World Bank Development Research Group. Centre for Bioethics, 2003, A Guide to Research Ethics, University of Minnesota. Faizulayev, A 2011, Comparative Analysis between Islamic Banking and Conventional Banking Firms in terms of Profitability, 2006-2009, Eastern Mediterranean University, Gazimagusa, North Cyprus. Ghafoour, PKA 2013, Islamic banking: Value of KSA share exceeds $207bn, Arab News, viewed 16 January 2014 Haron, S and Azmi, WNW 2004, Profitability Determinants of Islamic Banks: A Co-Integration Approach, Islamic Banking Conference. Union Arab Bank. IBNI, 2014, Islamic Banking & Finance: Our Values, viewed 16 January 2014 Iqbal, M and Molyneux, P 2006, Thirty Years of Islamic Banking: History, Performance and Prospects, J.KAU: Islamic Econ, 19(1). Islamic Development Bank, 2014, Financing Instruments, viewed 16 January 2014 Lewis, KM 2013, In What Ways Does Islamic Banking Differ from Conventional Finance, Journal of Islamic Economics, Banking and Finance. Nzibo, YA 2014, Islamic Banking: General Overview, viewed 16 January 2014 Patton,Q M, and Cochran M 2002, A Guide to Using Qualitative Research Methodology, Medecins San Frontieres. Sage Pub, 2010, Introduction to Quantitative Research. Sailan Muslim, 2009, Origin and History of Islamic Banking, viewed 16 January 2014 Wasiuzzaman, S and Tarmizi, HBA 2010, Profitability of Islamic Banks in Malaysia: An Empirical Analysis, Journal of Islamic Economics, Banking and Finance, 6(4). Read More