Differences between Islamic Banking and Conventional Banking - Research Proposal Example

Student’s Name: Instructor’s Name: Course Code & Name: Date of Submission: TABLE OF CONTENTS 1.0INTRODUCTION 1 1.1 Statement of problem 2 1.2 Research questions 3 1.3 Significance of the study 3 1.4 Definition of terms 3 1.5 Limitations 4 1.6 Organization of the study 4 2.0 LITERATURE REVIEW 5 2.1 Reasons for banks existence in economy 5 2.1.1 Theories on banks existence 5 2.2 Conventional bank 8 2.3 Islamic banking system 8 2.3.1 Sharia model in Islamic banking 9 2.3.2 Islamic view on interest rate and its rationale 10 2.4 Impact of financial crisis on Islamic and conventional banks 12 2.4.1 Profit and loss sharing principle 13 2.4.2 Growth of financial derivatives products 13 2.4.3 Islamic banks performance during financial crisis 14 3.0 METHODOLOGY 14 3.1 Review of the Research Methods 14 3.2 Population and Sample size 15 3.3 Instrumentation 15 3.4 Data collection 16 3.5 Data Analysis 16 Reference 17 Appendices 20 Appendix 1: Conventional banking system 20 Appendix 2: Islamic banking system 21 Appendix 3: Mudaraba profit sharing (equity participation) 22 Appendix 4: Musharaka profit and loss sharing 23 LIST OF FIGURES Fig1: Conventional banking system............................................................................................................20 Fig 2: Islamic banking system......................................................................................................................21 Fig 3: Mudaraba profit sharing (equity participation ................................................................................22 Fig 4: Musharaka profit and loss sharing....................................................................................................22 CHAPTER ONE 1.0 INTRODUCTION The global financial system has recorded drastic growth and played a major role in the world's economy by facilitating the global transaction. According to Chapra (2008), the growth of the global economy has been majorly attributed to the major developments taking place in the global financial system where Islamic banking and conventional banking are major contributors. Despite the challenges faced in the global financial market, the global banking industry has experienced growth and maturity in the provision of financial services. According to Stiglitz (2003), the global financial system had experienced numerous financial crises in the past. These crises were experienced globally where it affected financial markets of several countries negatively. Therefore, 2008 financial crises was not a new experience in the global financial market. The 2008 crises started in United States financial market and later spread to other countries. It was evident in Europe financial market since there had been increased vulnerability of the government debt in the foreign financial market (Eurobond market). According to International Monetary Fund report (2010), Greece's difficulty in raising sovereign debt was attributed to fiscal and growth challenges in the Eurobond market. According to Jickling (2010), the financial crisis was attributed to the lack of discipline and insufficient regulatory framework in the financial markets thus causing financial imprudence and excessive lending by banks. The major finding on the causes of finacical crisis includes; lack of prudence in lending, inadequate information from rating agencies, market-to-market accounting, inadequate financial disclosure, deregulation of financial market, housing bubble, shadow banking system, lack of financial balance globally, short-term incentives and excessive lending (Jickling 2010). There is an argument between conventional banks and Islamic banks on the strategies that will help reduce or eliminate recurrence of the financial crisis. Islamic banks hold that the move by conventional banks to increase financial prudence and regulatory framework will not be an ultimate solution to stop the recurrence of similar financial crisis (Chapra 2008). The move taken by conventional banks was an introduction of Basel III regulation that majorly touched on the regulatory framework and financial prudence in lending. The Islamic banks argue out that the use of collateral in securing debt is not going to bring much impact or protect the banks since collateral are affected by the crises (Chapra 2008). The Islamic banks do not experience much financial impact in case of occurrence of crisis thus giving them a better position in arguing out their techniques of reducing financial crisis. They insist on the use of profit and loss sharing system and "too-big to fail" concept in their operation to protect the defaults to the banks. Though Islamic banking is an infant in the global financial system, it has grown at a higher rate. Its growth is estimated to be between 15 to 20 percent (http://www.ifsb.org). Its growth has attracted conventional banks to use Islamic Windows for example Barclays Bank. Therefore, there is a wide area of study on the relationship between conventional banks and Islamic banks and their contribution to the financial crisis. 1.1 Statement of problem The study will examine the difference between Islamic banking and conventional banking and the effect of the recent financial crisis on the growth of Islamic Banks. 1.2 Research questions The research will be carried out basing on research questions below. What is the difference between conventional banks and Islamic banks? How do financial crisis impact conventional banks in comparison to Islamic banks? How do interest-free rate banking system in Islamic banking works? How do interest rate banking system in conventional banks works? What is the relationship between interest-free and interest-based banking and contribution to the financial crisis? How does the corporate governance of conventional banks differ from Islamic banks? What is the impact of the combination of Islamic and conventional model in the banking system? What is the impact of the emergence of Islamic banking in the global financial system? 1.3 Significance of the study The study will be resourceful for the policy makers in determining the best model to use in the banking industry. It can help also in a combination of conventional and Islamic banking models in order to avoid or reduce the recurrence of the global financial crisis. 1.4 Definition of terms The following are meaning of words not widely used and acronyms in the proposal; Sharia- Set of regulation, rules, values and regulations that govern Muslims. USA- United States of America Allah-God Sunna- Ideal human conduct Hadith- records of actions and sayings of prophets Ijm'la- Consensus of Islamic scholars Ijtihad- This is doctrine based on science and adaptation Mudarabaha-Trustee financing Wakalah- agent 1.5 Limitations The most likely limitation in the research will be cost to carry out interviews with several banks since Islamic banks are few and scattered. Secondly, translation and obtaining precise meaning of some Islamic terms used might be a challenge too. Lastly, willingness and accuracy of information provided by a respondent might limit the study but it will be minimized by application of research ethics. 1.6 Organization of the study The research will be divided into three chapters. Chapter one entails background information, statement of the problem, research questions, the definition of terms and limitation of the study. Chapter two entails literature review of the conventional and Islamic banking from published books, journals, thesis, and agencies reports. Lastly, chapter three will entail methodology to be used in the research that is a review of research methods, population and sample size, instrumentation, data collection and data analysis. CHAPTER TWO 2.0 LITERATURE REVIEW This chapter will elaborate the reason for the existence of banks in an economy and difference between conventional and Islamic banks. Various theories on banking will be discussed and how these banks operate and governed. It will be based on published books and journals, respective agency websites, and thesis. 2.1 Reasons for banks existence in economy Banks are major players in any economy since they act as intermediaries between surplus and deficit units of production in any economy. Banks always mobilize funds from surplus (savers) sector of economy and pool them for deficit (borrowers) sector of the economy to borrow and finance their operations (Zineldin 1990). Therefore, without banks in an economy affects resource utilization in deficit sector and loose of money value in the surplus sector. 2.1.1 Theories on banks existence According to Casu, Girdardone & Molyneux (2006), there are five theories that explain the existence of banks in an economy. These theories base their arguments on different perspective, but the ideas are the same. These theories include information production, consumption smoothing, liquidity transformation, delegated monitoring, and commitment mechanism (Casu, Girdardone & Molyneux 2006). These theories are elaborated below; According to information production, banks holds that every investor is supposed to seek for information before making any investment, and if he/she seeks information directly from borrowers, it will be more costly. Therefore according to banks, information for investors and borrowers is valuable and as a result, they act as intermediary by conveying information between investors and borrowers thus reducing cost of information and information asymmetry in the economy (Casu, Girdardone & Molyneux 2006). Secondly, consumption smoothing theory it holds that people are always trying to find balance between spending and savings in order to ensure their future is protected when they will be less productive (Casu, Girdardone & Molyneux 2006). Therefore, banks act as agents by providing illiquid assets that act as security in future. These assets include fixed accounts and insurance products due to the consolidation of banking and insurance industry (bancassurance). According to Casu, Girdardone & Molyneux 2006, liquidity transformation is transformation of deposit from highly liquid to illiquid loans where risk on loan is charged against bank balance sheet since deposits are more of contract between depositor and bank. Therefore, banks transform highly liquid, and fewer risk assets to illiquid and highly risk assets in an economy. Delegated monitor theory on the hand brings out the existence of the bank as a monitor for lending. The banks have economies of scale in searching for information, specialized staff and evaluated information on investment riskiness than an individual investor (Casu, Girdardone & Molyneux 2006). Therefore, surplus individuals in economy entrust their cash to banks which monitors how the surplus will be advanced to deficit individuals or units of production with good credit ratings. Banks also act as commitment mechanism where banks convert liquid assets into illiquid assets and be ready to reconvert them on demand by the depositor of the liquid assets. Depositors can demand their cash anytime their need for liquid assets arises. Unpredictable demand by depositors makes it a challenge to match between demand and supply of cash. The above challenge; therefore, forces banks to carry out their operation prudently by ensuring they have sufficient liquidity and capital to meet unexpected demand or supply (Casu, Girdardone & Molyneux 2006). According to Basel II and III, banks are required to maintain certain minimum reserve and liquidity level. Adherence to this regulatory framework is monitored by respective banks regulatory bodies in each country. According to Casu, Girdardone & Molyneux 2006, banks plays three intermediation roles. These roles are maturity, size and risk transformation between depositor and borrower in the economy. Investor's and borrower's needs are not the same therefore it is the role of the bank to intermediate and transform financial assets in order to meet individual needs of their clients for example, depositors are willing to lend little quantity of cash while borrowers want huge quantity of loans thus banks pools deposits in order to provide huge loans to borrowers. According to maturity, depositors need short-term lending while borrowers need medium and long term borrowing thus banks transforms short-term deposits to meet borrowers' needs. Lastly, risk transformation is majorly done for the benefit of depositors since they have highly liquid and low risk assets and they need to transform them into illiquid and high risk assets at a higher return with lower credit risk. Lenders always transfer the risk to bank balance sheet other than bearing it. 2.2 Conventional bank Conventional banks are financial intermediaries that assist in selling and purchasing financial assets from lenders and borrowers in the economy (Casu, Girdardone & Molyneux 2006). The major products and services transacted in conventional banks loans, deposits, investor information dissemination on investment, payment and cash receipt and foreign exchange services. The major sources of income for conventional banks are interest charged on loans by buying deposit at a lower cost and selling them at a higher price, charges on opening and operation of account with the bank. Banks also earns revenue from foreign exchange spread on bid and ask price in the conversion of one currency to another. The intermediation structure of the conventional bank entails financial markets, borrowers, depositors, asset securitization and financial intermediation (banks). The relationship of the above components of conventional banking is as shown below (Appendix 1). 2.3 Islamic banking system Islamic banks are similar to conventional banks since they carry out the same activities such as deposits, dissemination of investor information and foreign exchange conversion. The only difference comes in on deposits and loans on the issue of interest rate. They also reduce information asymmetry in the financial markets and transaction cost by availing required investment information to the investors in the market. Mudarabaha and Wakalah contract is the major basis in which Islamic banks pools financial resources from the surplus unit. The demand deposits mobilized are interest-free while loans are advanced to borrowers by use of profit sharing principle according to Islamic Sharia (Zineldin 1990). The Bank only acts as safe depository for depositor on demand deposit and only guarantees safety. While the time deposits are invested, and income earned from the investment are shared between the bank and investor upon its maturity. It can be noted therefore that Islamic banks majorly acts as investment banks providing and advising investors on various investments such as debentures and equity financial instruments (Zineldin 1990). The Islamic banking system is according to Zineldin (1990) is illustrated in Appendix 2. 2.3.1 Sharia model in Islamic banking According to Zineldin (1990) Sharia entails rules, regulation, values and teachings that direct individuals' behavior in the society. Sharia are derived from five sources which include Koran, which is believed to be communication to Muslims from Allah through angel his prophet (Muhammad). The Second source is sunna that entails prophet Muhammad actions or things that he implied. Hadith another source, it entails historical records of Muhammad teachings and action documented by his followers or witnesses. The Fourth source is Ijtihad, entailing science, adaptation and interpretation of the existing doctrines basing on the changing social, political and economic environment (Zineldin 1990). Ijm'a is the last source; it entails agreement on Islamic laws concerning banking by Muslim intellectuals. The major sources are Koran and Hadith from which it provided guidance to the development of Sunna and required human conduct in the society. According to Zineldin (1990), Islamic economy differ western economy on various points of views. For example accumulation of wealth in western country is not governed by any rules as long as one followed the right procedures according to government rules and regulation while for Islamic economy, one is allowed only to accumulate wealth or own property if it is lawfully carried out. Lawful accumulation of wealth in Islamic economy does not necessarily mean state's rule and regulation adherence but adherence to the Sharia where it prohibits any wealth received from what he/she has not put effort, "man hath only that for which he make the effort" (Qur'an, 53:39). It is therefore, noted that in western economy social fabric is built on capitalism where one is allowed to own property or accumulate wealth for the betterment of his/her own status (Zineldin 1990). On the other hand, Islamic economy uses a socialist structure that it prohibits the accumulation of wealth through deprivation of the rights or well-being of other citizens in the society such as selling of harmful drugs or Gambling. 2.3.2 Islamic view on interest rate and its rationale Interest is anything charged above the principal advanced to the borrower by the lender. Interest is referred to riba in the Islamic religion. Allah prohibits interest rate since according to Koran, which is believed to be a world of Allah spoken by the angel to Muhammad. According to Koran (2:275), it reads "Allah has permitted trade and has forbidden interest". The second verse sampled from the twelve instances from which it is mentioned is where Allah spoke to Muhammad in a commanding voice that "O you, who believe fear Allah and give up what remains of your demand for interest, if you are indeed believers. If you do not, take notice of war from Allah and His Messenger: but if you repent you shall have your capital sums; deal not unjustly and ye shall not be dealt with unjustly" (Baqara, 2:278-279). The above condemnation is believed and strongly adhered to by Islamic banking system as guidance from Allah. Judaic and Christian religious books also prohibit interest rate as unjust, but it is not actively followed than how the Muslims follow the teachings of Koran on the interest rate. According to Lewis (2009), Muslim academicians prohibits interest rate citing five reasons that includes the fact that, interest is against prophet saying that a man's property is unlawful to the other as his blood and thus prohibition of interest rate since it is demanding for another person wealth without adding any value (Lewis 2009). Secondly, riba is forbidden because it interferes with the relationship between individuals in the society. It is also termed as unjust and against equity since it enables the rich to take more than what they gave. Loan advancement enables the lender to earn without working that is against sharia since it makes one lazy. Lastly, scholars forbid interest because it is forbidden by Koran, and it needs no explanation because the world of Allah shall not be altered and should be accepted without any reason (Lewis 2009). The major area of argument between Islamic banking and conventional banking is on the interest rate on having fixed interest rate and fixed maturity period. Muslim scholars believe that fixing interest rate is unacceptable since it is not obvious that the borrower will earn profits in future since business is highly unpredictable. According to Chapra (2008), fixing maturity period is prohibited since it is not guarantee that the borrower will have recovered the amount and interest within that period. According to conventional banking, the loan has fixed interest rate and maturity period that it should be recovered without any consideration that the business might fail or earn a profit. According to Mehboob (2005), lender is justifiable to get a share of profit from borrowers if only he/she is willing to share loss incurred in the course of business, the principle is derived from sharia. Islamic teaching also does not allow anyone to earn what he/she has not to physical effort or risk which means that it contravenes conventional banking principle on interest rate that it is termed as the reward for the savings by depositor. Islamic banks therefore, disregard fixed interest rate and fixed maturity period because it is more based on the money advanced to the borrower rather than fixing them on the capital productivity of the money taking care of the business performance of both profits and loss (Mehboob 2005). The Islamic bank uses Mudaraba profit sharing illustrated in Appendix 3. The interest also acts as a source of injustice and inequality since the lender wants to earn more than the principle irrespective of the situation of the borrower who might have borrowed to satisfy his/her needs. Therefore, charging fixed interest on a fixed period of time is a social injustice that results to poor get poorer while rich becomes richer (Mehboob 2005). Injustice and inequality are strongly condemned by Koran and Hadith. The basic technique used in the form of Mortgage in place of conventional banks is the use of equity participation or Musharaka where bank and client contribute capital in a certain proportion. The property is managed jointly until the client has 100% ownership while rent earned is shared according to the proportion of contribution (Zineldin 1990). Musharaka technique is as shown in the figure below (Appendix 4). 2.4 Impact of financial crisis on Islamic and conventional banks The global financial crisis started from USA due to excessive and imprudent lending by banks. The major reason was due poor performance of mortgage loans that took a better part of the various banks portfolio. According to Jickling (2009), financial crises was attributed to greed or emphasis of short-term gains by managers, credit rating agencies, brokers and individuals thus failing to take due care in the evaluation of investment properly. The illusion of short-term gains prevented major players to predict and devising strategies to avoid the risk in long run thus being trapped in the financial crisis of 2007 and 2008 caused by housing bubble burst (Chapra 2008). Corporate governance of the USA banks also failed to some extent due to failure to provide accountability, transparency and good administrative skills since they allowed managers to act imprudently without considering its consequence to other stakeholders (Simon & Rifaat 2009). The Islamic banks were less affected by the financial crisis because of their practices of lending and borrowing than its counterparts. The reasons for the difference in impact experienced between the two are explained below. 2.4.1 Profit and loss sharing principle As mentioned earlier, borrower and lender are supposed to share profit and loss in order to uphold Islamic rules brought out by Sharia. The above technique ensures discipline by banks since they carry out intensive research on the investment in order to check more on production capacity before lending depositors savings in order to minimize the likelihood of incurring losses which is shared. The principle also reduces the attractiveness of incentives thus creating an environment for the managers to develop strategies to cope up with future challenges in the long run. Lack of the above practices in conventional banks led to huge losses due to excessive and imprudent lending caused by short-term illusion from housing performance to banks management. 2.4.2 Growth of financial derivatives products According to Chapra (2008), the shift of the western economy to use of the derivative instrument is another major cause of the differential impact of the financial crisis on conventional and Islamic banks. Derivative instruments are a financial asset that derives their values from other underlying assets, and its purpose is to hedge risk. Sharia prohibits the transfer of risk from one person to another thus derivatives are not traded in Islamic banks making management work prudently since they are aware that they will bear any financial loss incurred fully. The conventional banks, on the other hand, will act imprudently due to the presence of derivative instruments that enable them to transfer risk. Sharia that prohibits the transfer of risk makes the difference on less impact of a financial crisis caused by the housing bubble burst to Islamic banks than conventional banks that were adversely affected. 2.4.3 Islamic banks performance during financial crisis According Dridi (2010), global crisis affected few Islamic banks compared to conventional banks since the research he conducted on 120 Islamic banks and same number of conventional banks shows that three quarter of banks affected where conventional while Islamic only had a quarter of its banks affected by the crisis. According to the report carried out by International Monetary Fund (2010) on 80 Islamic banks globally, it is evident that the Islamic banks recorded slight decrease (10%) compared to the conventional banks that experienced drastic decrease of approximately 30%. In conclusion, Islamic banks have a better structure in its operation to absorb shocks from the economic crisis more than conventional banks. CHAPTER THREE 3.0 METHODOLOGY This chapter will be subdivided into five parts that will be composed of review of research methods, population and sample size, instrumentation, data collection and lastly data analysis. 3.1 Review of the Research Methods The research will be qualitative and descriptive nature due to the nature of the variables, recommendation needed and use of the research. The major reason for adoption of qualitative approach by researcher is the fact that it provides a platform of interacting with the natural setting of the variables and coming up with more accurate information necessary to arrive at conclusive research. The qualitative approach also enables the researcher to interact with the interviewee extensively and enable interviewees to explain themselves exhaustively since it uses an open-ended type of questions. The research will be based more on the establishment of difference in the Islamic and conventional banks thus making it appropriate to categorize research to be descriptive and explanatory research. The data will be collected from respective managers of conventional and Islamic banks, Journals, and major financial players' websites. 3.2 Population and Sample size The research will be carried out on 30 banks where 15 will be conventional banks, and the remaining will be Islamic banks. The banks to be analyzed will be selected from at least three countries in four continents. The study will require the participation of four personnel in each bank thus coming up with a population of 120 respondents. The respondent will entail senior management staff, top, and middle level staff. The banks selected should be more than ten years old in the banking industry in order to ensure accurate data is collected. The questionnaires from each will be randomly selected where one will be picked. The sample size, therefore, will comprise of 30 questionnaires, 15 from Islamic banks and the rest from conventional banks. The sample selected will be used for analysis. 3.3 Instrumentation The data will be collected by use of questionnaire due to the qualitative technique that will be adopted in the research. The nature of the research also dictates the instrument to be used since descriptive and explanatory research always requires the use of the open-ended questionnaire in order to increase the level of interaction and freedom of respondent. 3.4 Data collection The research will be carried out in 30 banks from at least three countries in more than four continents which will compose conventional and Islamic banking in equal proportions. The researcher will send emails and call respective persons from each bank in order to get consent to carry out research in the organization. After receiving consent, each bank will be emailed four open-ended questionnaires that will be filled by senior, top level and middle managers. The banks audited financial statements will also be requested in order to be used in the ascertainment of the facts provided by the respondent. The questionnaires will be complimented by direct interview via phone call or teleconferencing with selected individuals from randomly selected banks. The questionnaires will be emailed back after completion of banks financial statement. The data collected will then be arranged and recorded for analysis. 3.5 Data Analysis The gathered data will be analyzed by use of qualitative techniques. Qualitative analysis technique will be used since questionnaires will comprise of open-end questions. The Statistical Package SPSS and Ms Excel will be used in generating graphs from data that will be recorded after collection. Data analysis will entail the use of wide range of values in order to increase the accuracy of the research. SPSS will be majorly used in evaluation of the reliability and validity of the data by obtaining significance of the confidence level of the data before opting to use the data further since wrong information will lead affect the accuracy of the recommendation and conclusion of the research. The graphs and charts will be used in order to compare results visually and enable users to understand the research paper easily. Reference Abdul-Rahman, Y. (2010). The art of Islamic banking and finance. Hoboken, N.J.: Wiley. Abul, H. (2009). The Global Financial Crisis and Islamic Banking. Available at: http://www.iefpedia.com/english/wp-content/uploads/2009/10/The-Global-Financial-Crisis-and-Islamic-Banking.pdf [Accessed 6 Apr. 2015]. Ayub, M. (2007). Understanding Islamic Finance. Hoboken, NJ: John Wiley & Sons. Berlatsky, N. (2010). The global financial crisis. 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[Washington, D.C.]: International Monetary Fund, Monetary and Capital Markets Dept. Sun, W., Stewart, J. and Pollard, D. (2011). Corporate governance and the global financial crisis. Cambridge: Cambridge University Press. Usmani, A. (2002). A guide to Islamic banking: Daru - Ishaat Urdu Bazar Karachi-1 Pakistan Zineldin, M. (1990). The Economic of Money and Banking: Almqvist & Wiksell, Stockholm, Sweden Appendices Appendix 1: Conventional banking system Fig 1: Conventional banking system. Source: Casu, Girdardone & Molyneux (2006). Appendix 2: Islamic banking system Fig 2: Islamic banking system. Source: Zineldin (1990) Appendix 3: Mudaraba profit sharing (equity participation) Fig 3: Mudaraba profit sharing (equity participation). Source: Zineldin (1990) Appendix 4: Musharaka profit and loss sharing Fig 4: Musharaka profit and loss sharing. Source: Zineldin (1990) Read More