The Financial Stability of Islamic Banking - Dissertation Example

?Provisional An investigation of the financial stability of Islamic banking versus conventional banks in the perspective of global credit crunch in countries where Islamic and conventional banks are both significant such as the Kingdom of Saudi Arabia. Brief Background The global financial market is one of the highly affected areas of financial stability during the emergence of financial crisis which also delayed economic developments. It has been reported that Islamic banks are not greatly affected by global financial crisis unlike the tremendous losses incurred by conventional banks in a cross-country examination. Islamic banking and finance is the new representation of financial institutions and it is also said to be the answer in looking for a better and fairer way of managing money and in underpinning the real financing activities. Since its origin, just over thirty years ago Islamic banking has been the fastest growing industry in the financial system and financial markets of several countries. It has “concentrated in the Middle East and Southeast Asia, but they are also present as niche players in Europe and the United States” (Cihak & Hesse, 2008, p.3). For instance, Islamic banking in the Kingdom of Saudi Arabia is more lucrative compared to conventional or commercial banks of the country (Parker, 2010). Aside from profitability, Islamic banks also are strong in asset growth despite of the abrupt decline of credit ratio compared to the average banking sectors in many countries. However, when global financial crisis had entered the real economy, Islamic banks started to incur more and more lucrative losses than their conventional counterparts, because Islamic investments are more prone to risk. The aim of this paper is to investigate the financial stability of Islamic banks versus conventional banks in the perspective of the global credit crunch. To investigate financial stability, the data needed will involve efficiency, asset quality, and different business model of conventional and Islamic banks. The investigation will be utilizing secondary research data from countries where Islamic and conventional banks are both significant such as the Kingdom of Saudi Arabia. An Initial and Brief Literature Review Most of the relevant literatures suggested that Islamic and conventional banks vary in many ways particularly in taking risks and liquidity. The growing literature mostly contained issues of comparison between the role of Islamic and conventional banking in the global credit crunch. When it comes to empirical analysis of financial stability the argument would always be about risk whereas when it comes to empirical papers, most of the arguments are discussing the efficiency of handling risks (Cihak & Hesse, 2008, p.3). The severe deficiency of money or credit which is also known as credit crunch has created a big impact on banking operations and practices around the world. Global credit crunch is a higher form of risk that distinguishes the differences executed by Islamic banks from those executed by conventional banks. Several institutions in various countries are now offering Islamic financial services like Murababa, Ijara, and Musharaka, wherein Muslims and non-Muslims can lend money without interest and no trading debt (Ahmad, 2010, p.38). According to the International Monetary Fund (IMF), the success of Islamic banks is present in almost all Middle East countries except Bahrain, Qatar, and the UAE. Based on the study of Hassan and Bahshir (2005), Islamic banks are said to be efficient when it comes to resources allocation, profitability, liquidity, development of assets, and many more. However, according to Schoon (2009, p.187), Islamic banks are settled in a less efficient and cost effective market as long as the average rate of return is elevated. He said further that Islamic banks are not efficient in terms of liquidity ratios because of an absence of liquid assets and accepted primary liquidity instruments such as cash, bank balances, negotiable instruments, etc. It also contained a higher form of risks subject to an interest rate risk different from those in conventional banks. Based on the empirical analysis of Yudistira (2004), Islamic banks are less inefficient compared to their conventional peers because the former are greatly affected by global financial crisis in the real economy. This argument has been seconded by Abdul-Majid, et al. (2010) based on his research. Islamic Banking versus Conventional Banking in the Kingdom of Saudi Arabia The rule of Islamic finance is under Muslim’s law (Shari’ah) which is derived from the Holy Qur’an and Sunnah (Strom, et al., 2007). According to the International Monetary Fund (2010), “the size of the Islamic banking industry at the global level was close to $820 billion at end-2008...the largest Islamic banks are located in the countries of Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE). The Kingdom of Saudi Arabia is one of the biggest centers for Islamic finance and in the growing Shari’ah-compliant banking assets. It is also one of the most active countries that support the capitalism and development of Islamic banks when it is introduced during the prosperity of oil prices (Saeed, 1999, p.11). The country is very much dedicated to the teaching of Islamic banking; however, the Saudi Arabian Monetary Fund has decided to let the Islamic banking remained unregulated to provide fairness with its conventional counterparts. Definitely, Islamic and conventional banks have the same purpose and they are playing the same roles, this is to serve their customers in undertaking trading activities, investment, savings, etc. The main difference between the two is the application of rules and banking principles. All financial operations and practices by Islamic banking are based on Shari’ah principles which is to promote profit-and-loss sharing schemes (PLS) in line with the prohibition of riba (prohibits the paying and receiving of interest), and financing techniques based on the deferred payments in trade (Billah, 2007, p.402). The charging of interests in receipts and payments are in conflict with the teachings of the Islamic religious practices and law particularly the Shari’ah-compliant banking practices. Simply, the lenders as well as the borrowers are only expected to return the lending investment in full amount without requiring or obtaining any interests. On the other hand, conventional banks are based on collateral and interest rate imposed on a certain assets or investment. The creditor or commercial bank has the right to charge and receive interest because this is how they conduct business (Saeed, 1999, p.12). This interest rate is predetermined and is set contractually that depends upon the bank’s investment decisions. This is very much particular in making profits unlike Islamic banking who viewed money as no intrinsic value. Another significant distinction between the Islamic and conventional bank is on the handling of risks involved. Islamic banks choose to manage high-leveraged risks to a certain limit because they are more direct and active in the activities of real economy. According to Ariff (1988, p.3), “it is quite obvious that Islamic banking is a risky business, but it is this risk-sharing that justifies profit-sharing and hence the return to capital in an Islamic system. From another point of view, conventional banks are not risk tolerance instead it prefers to eliminate or transfer risks. Methodology This study intends to investigate Islamic and conventional banks in the perspective of the global credit crunch. Thus, this study will determine the contribution of Islamic and conventional banks to financial stability during the financial crisis. For this study, descriptive type of research will be utilized that deals particularly with the present existing condition. This method will also include quantitative elements as to the surveys conducted by individual researchers and qualitative elements that measure those within the business domain. Most of the common research proposals about the issue are being mentioned in the literature overview, and this will be helpful details in understanding the process. The data that will be reviewed are mostly gathered from surveys of previous researches and followed by situational analysis. Data Analysis Based on the survey conducted by the International Monetary Fund (2010), Islamic and conventional banks are having different performances during the recent financial crisis - when money or credit is in shortage. The result showed that Islamic banks during the financial crisis are more flexible compared to conventional banks; however, in terms of recession Islamic banks suffered great losses because of their direct and active involvement in the real economy. The survey has three stages: before crisis, early stages crisis, and post crisis (real economy). In the first stage (before crisis), the impacts of crisis to Islamic and conventional banks are still under control considering that there is an increase both in average assets and equity ratio of the two banks (see Chart 1). However, it is very obvious that Islamic banks are more profitable compared to conventional banks in terms of assets and equity ratio. On the early stages of crisis, profitability for both banks are declining but it has only a minor impact on Islamic banks than on conventional banks (see Chart 2). Despite of the stability of credit and assets ratio, the declining percentage of conventional banks are fared differently compared to decreasing percentage of profitability for Islamic banks. However, when the crisis had entered the real economy, Islamic banks started to suffer from great losses compared to conventional banks (see Chart 3). This is a sign that Islamic banks need to strengthen their liquidity and risks management system in order to remain profitable as part of global improvement (El Tiby, 2011, p.186). Good thing that credit and assets ratio remained to be high compared to the ratios of conventional banks. Likewise, the result of the study of Demirguc-Kunt (2010) showed that “Islamic banks yield lower returns for their investors in general, this pattern reversed during the crisis period - the result of higher liquidity and capitalization” (see Fig. 1). Overall, the surveys suggest that “Islamic banks contributed to financial and economic stability during the crisis, given that their credit and asset growth was at least twice as high as that of conventional banks” (International Monetary Fund, 2010). However, because Islamic banks had steep decline in profitability particularly when crisis had moved to the real economy, then it is not likely to be the solution to financial crises. Recognition of Problems and Opportunities The sharp decline of profitability in the midst of real economy crisis is one of the problems of Islamic banks. Declining profitability is not the only problem for conventional banks but also the reduction of credit and assets ratio which means that their growth is largely affected by crisis. More or less, Islamic banks are favourable than that of conventional banks in terms of efficiency, cost reduction, profitability, assets allocation, and many more. To address these challenges, Islamic banks need to prioritize the increased of their liquidity management and strengthen their risks management capabilities. The global crisis particularly in the real economy has given Islamic banks an opportunity to attest their resiliency. Another opportunity is the continuing growth of demand for Islamic banking because of the transformation in the global investment climate such as innovation (Foster, 2008). Because of these growing opportunities, Islamic banks need to strengthen their credit risk management practices to institutional standards. They also need to have a financial management upgrading in line with more complex services to gain goodwill and loyalty from investors. Conclusion In summary, Islamic and conventional banks are highly different from each other. Both of them are playing significant roles in the financial and economic stability. However, based on several studies, Islamic is more favourable than conventional banks particularly in assets and credit ratio, profitability, cost efficiency, liquidity, and in managing of risks. The growing demand of Islamic financial services also served as an opportunity for Islamic banks to improve and upgrade their services especially the liquidity and risks management capabilities. Thus, Islamic banks are financially stable in the perspective of the global credit crunch; however, it is not the only solution to financial crises. Chart Source: International Monetary Fund, 2010 Source: International Monetary Fund, 2010 Source: International Monetary Fund, 2010 Source: Demirguc-Kunt, 2010 References Abdul-Majid, M., Saal, D.S., & Battisti, G., 2010. Efficiency in Islamic and conventional banking: an international comparison. Journal of Productivity Analysis, [Online] 34, pp. 25-43. Abstract only. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1668966 [Accessed 24 January 2011]. Ahmad, A. U. F., 2010. Theory and practice of modern Islamic finance: the case analysis from Australia. USA: Brown Walker Press. Ariff, M. ed., 1988. Islamic banking in Southeast Asia: Islam and the economic development of Southeast Asia. Singapore: Institute of Southeast Asian Studies. Billah, M.M., 2007. Islamic banking and the growth of takaful. In: M.K. Hassan & M.K. Lewis, eds. 2007. Handbook of Islamic banking. UK: Edgar Elgar Publishing Ltd, pp.401-418. Cihak, M. & Hesse, H., 2008. 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Available at: http://www.irti.org/irj/go/km/docs/documents/IDBDevelopments/Internet/English/IRTI/CM/downloads/IES_Articles/Vol%2012-1..Donsyah%20Yudistira..Efficiency%20in%20Isl%20Banking..pdf [Accessed 24 January 2011]. Read More