The Performance Of Islamic Banks and That of the Conventional Banks - Research Paper Example

Compare performance of Islamic Banks with that of conventional banks Name: Tutor: Course: Date: Table of Contents Table of Contents 2 The Financial Performance of Conventional vs. Islamic Banks: Empirical study of MENA and GCC region. 3 1.0 Introduction 3 2.0 Literature review 4 2.1 Research objectives 5 2.2 Research Hypotheses 6 3.0 Research Methodology 6 4.0 Data analysis 6 5.0 Conclusion 8 Reference list 9 Appendices 12 Appendix I: Descriptive statistics of CB and IB comparison 12 Appendix III: Regression models moderated by bank type 15 The Financial Performance of Conventional vs. Islamic Banks: Empirical study of MENA and GCC region. By (Al-Gazzar, M. M. 2014) Retrieved from: http://www.bue.edu.eg/pdfs/BAEPS/Manar%20Mahmood%20Al-Gazzar.pdf 1.0 Introduction The stability of the banking sector in a country to a larger extent affects the growth and stability of its economy. Banks facilitate funds and act as intermediaries for deficit and surplus units sparking economic development. Islamic system of banking has emerged as a feasible alternative to the conventional banking system. The first bank that follows Sharia law was introduced in Egypt in 1963 and since then it has increased to more than 600 banks in 75 countries globally (Al-Mazari, 2014; Rashwan, 2012). Young (2012) noted that assets of Islamic banks in the commercial banking system had grown by 19 percent to $1.3 trillion. In a past study by Hassan and Dridi (2010) and Khamis and Senhadji (2010), Conventional banks (CBs) and Islamic banks (IBs) found that Islamic banks in the economic recession of 2008 were efficient and compliant to speculation and negative profitability. To restore investor confidence, Jusufovic (2009), notes that it was important to stabilize the financial system. Moreover, Sayed and Hayes (2012) agreed that it was essential to conduct continuous assessment of the banking operations to protect against poor or risk management that threatens a country’s financial system. A CAMEL model was proposed by the Basel Committee on Banking Supervision to assess financial management hence ranking the banks based on performance. This study compares the performance of Islamic banks with conventional banks in terms of performance indicators, effectiveness and efficiency and other indicators derived from Balance sheet and Income statements. The study is important in highlighting the competitive position of Islamic banks compared with conventional banks in terms of liquidity and earnings quality, management quality, asset quality and capital adequacy. 2.0 Literature review Islam comprises three broad concepts; Aqidah (faith and belief), Sharia (practical actions by Muslims) and Akhlag (attitudes, work ethics and behavior). Inception of Islamic banking is based on Riba or interest (Geelani, 2005) and Gharar or uncertainty and speculation (Kahf & Khan, 2007). According to Kettel (2011), Islamic banks promote, between fund providers, risk sharing and proper use of entrepreneur funds. Moreover, Al-Janabi (2012) asserted that money in Islam is only meant as a medium of exchange and any value of money should be asset based. The instruments of Islamic banking comprises leasing (Ijarah), forward sales (Salam), cost-plus (murahaba), sale of non-existent assets (Istina’a), system of insurance (Takaful) and profit sharing principle (Mudarabah). However, Islamic banks also face challenges such as absence of standardized regulatory frameworks, unsatisfactory record for innovation, risk management challenges, and deficient human resources and Sharia experts (Khamis and Senhadji, 2010; Siddiqi, 2012; and Khalid and Amjad, 2012). The comparison in performance and efficiency between conventional and Islamic banks is evaluated throughout the world and specifically the gulf countries. Srairi (2009) used stochastic frontier analysis of 71 commercial banks to evaluate the profit and cost efficiency of Gulf Cooperation Council (GCC) countries from the year 1999 to 2007. The author found from although computed results on the efficiency of banks in Gulf countries was more convincing to the world, conventional banks were more efficient than Islamic banks. This implies that Islamic banking is not merely a copy of conventional banking but differs based on the boundaries of Islamic Law such as interest, avoidance of economic activities, introduction of Islamic tax and production of goods and services prohibited by Islam. This meant that despite Islamic banking system running their operation on interest free principles, they are also victim of interest rates. Akhtar et al. (2011) in a comparative analysis of conventional and Islamic banks emphasized the significance of return on asset with liquidity risk management, capital adequacy, return on equity, networking capital and the importance of size of the firm. The results show that networking capital and size of the banks to net assets have insignificant but positive relationship with liquidity risk. Return on asset in Islamic banks and capital adequacy in conventional banks have a significant and positive relationship with liquidity risk. On previous studies, Jaffar and Manarvi (2011) performed a CAMEL test of conventional and Islamic banks and found that Islamic banks had high liquidity and better performance compared to conventional banks. Nonetheless, conventional banks have good earning ability and pioneer in the management. Continuous assessment of bank performance according to Rozzani and Rahman (2013) is fundamental protecting the banking operations against its poor management or inherent risks that threatens the whole financial system of a nation. Jamali et al. (2012) pointed out that bank performance is a crucial subject to all stakeholders of the bank such as general public, customers, and investors. Consequently, a number of studies on financial institutions have not only compared Islamic and conventional banking but also discovered their determinants of successful bank performance as well as their efficiency of economic growth impact. 2.1 Research objectives 1. To compare empirically the performance of conventional banks and Islamic banks in the GCC using various indicators 2. To test the differences in performance between conventional and Islamic banks based on known indicators 3. To examine critically the various profitability determinants in conventional and Islamic banks based on macroeconomic and bank-specific variables 2.2 Research Hypotheses 1. Capital Adequacy is better in IBs compared to CBs 2. IBs have better asset quality compared to CBs 3. IBs are preferable to CBs in terms of management quality 4. IBs have higher earnings compared to CBs 5. IBs can manage liquidity in an efficient manner compared to CBs 3.0 Research Methodology This study was based on historical data or secondary sources of Islamic and conventional bank information in the MENA (Middle East and North Africa) and GCC (Gulf Cooperation Council) countries. The sample comprised 35 conventional banks and 10 full-fledged Islamic banks. The selected banks are from various GCC countries namely; Egypt, Lebanon, Israel, Jordan, Qatar, Oman, Bahrain, Kuwait, United Arab Emirates and Saudi Arabia (see Appendix I for the full list of banks). A total of 224 observations were made of which 49 were for Islamic Banks and 175 for conventional banks. The criteria for selection of the banks was based on total assets exceeding $5billion, bank is listed on stock market and its market capitalization exceeding $2billion. The bank should also have a complete data set from 2009-2013. The selected banks were those listed by the Gulf Business Report as the top 50 banks in the GCC. To analyze the data, descriptive statistics, One-way ANOVA and Multiple regression models were used. The dependent variables were Return on Assets (ROA), Return on Equity (ROE) and Net Interest Margin (NIM). Independent variables were Capital Adequacy, Asset Quality, Management Quality, Earnings Quality, Liquidity and Gross Domestic Product. 4.0 Data analysis Descriptive statistics were computed to compare the differences between conventional and Islamic banks. From the results, ROA of Islamic Banks was 1.58 percent compared to 1.51 percent for conventional banks. This shows that the marginal efficiency of Islamic banks is higher than conventional banks. These findings were not consistent with Momeneen et al (2012) who showed that Islamic banks were less profitable than conventional banks. On ROE, Islamic banks (9.51 percent) were lower than conventional banks (12.78 percent). This shows that conventional banks are efficient in profit generation for every equity capital of the shareholder. NIM for Islamic banks (2.85 percent) was higher than conventional banks (1.91 percent). This agrees with Shaista and Umadevi (2013) who intimated that Islamic banks are more profitable in effective loan decisions and least costly funding options. Islamic banks dominates Capital Adequacy (18 percent) compared to conventional banks (13 percent) in terms of Equity to Assets. This shows that Islamic banks can cushion against unforeseen events and unexpected losses. These findings are consistent with Said (2013) that Islamic banks respond strongly to balance sheet shocks like credit risks and liabilities payments. On Asset Quality, Islamic banks have lower Loan Loss Reserves (3.10 percent) compared to conventional banks (3.99 percent). This shows that Islamic banks have superior and credible asset quality as opposed to conventional banks. Again, the findings are consistent with that of Momeneen et al (2012) who found that bad loan signify bleak future for banks. Islamic banks on Management Quality in terms of Loans to Deposits (127.6 percent) were higher compared to 80.2 percent for conventional banks. This shows that Islamic banks were trusted by customers for their deposits. These findings were consistent with Faizulayev (2011) that Islamic banks had superior LDR. Islamic banks were also dominant on Earnings Quality (41.5 percent) compared to conventional banks (52.7 percent) hence lower costs of generating a dollar of income and controlling costs as depicted by Momeneen et al (2012). On Liquidity, conventional banks had lower Net Loans to Total Assets (59.5 percent) compared to 58.5 percent indicating fewer assets to engage loans. These findings were inconsistent with those of Shaista and Umadevi (2013) and Momeneen et al (2011). On One-way ANOVA (See Appendix II), Equity to Assets and Net Interest Margin were significant (0.000) and Loans to Deposits (0.003) at p Read More