Western Banks v Islamic Banks: Differences in the Governance, Efficiency and Capitalization - Research Proposal Example

Research Proposal Western Banks v. Islamic banks: Differences in the governance, efficiency and capitalization needs and policies Summary The development of business activities worldwide has been traditionally based on the following two criteria: the demands of the customers and the characteristics/ prospects of the targeted market. However, differences may exist in the strategic priorities of firms around the world; in this context, firms that want to expand their activities – or just secure their position in the market – need to identify the measures that are expected to be most aligned with the business objectives. Current study focuses on the examination of the differences between Islamic banks and Western banks especially with reference to their capitalization requirements, their efficiency and their governance. Research has been made on the financial data of 6 Conventional and 6 Islamic banks; Capitalization, efficiency and governance are differentiated between Conventional and Islamic banks; this difference is mainly based on a specific principle of Islamic banks: their capital is related to the nature of the sources of that money. Under these terms, the study will examine (see Figure 1, Appendix) the efficiency of banks, determined by monitoring of the banks’ financial data; it is assumed that equity is reducing the risk undertaking by the depositors. 1. Research Problem The performance of banks in the global market is usually measured using the following two criteria: a) their equity – i.e. the ownership interest but also the assets and b) the deposits; the role of these two elements on the performance of banks can be differentiated across banks of different structure; a classic example is the case of Western and Islamic banks. The risk in banking industry can be also different; under the influence of current recession regulators worldwide have decided that common rules should be developed within the banking industry; Basel principles have been regarded as an effective tool for achieving a high level of protection in the particular industry; the use of these principles would also support the equality in competition – referring specifically to Western and Islamic banks; however, because of their structural characteristics Islamic banks can be characterized as being safer compared to the Western banks – the rules on which Islamic contracts are based ensure the increased safety in the activities of Islamic banks. At this point, an important issue appears: could the equality in competition in the banking industry be promoted if capital ratios were imposed on both Western and Islamic banks or such a scheme would not have many chances to succeed – as not being adequately tested up to now. 2. Aims and objectives of the research This study is expected to help towards the identification and the evaluation of specific issues related with the activities of Western and Islamic banks. In this context, the aims and objectives of this study can be developed as follows: a) to identify the governance, efficiency and capitalization characteristics and needs of banks, b) to examine whether the governance, efficiency and capitalization characteristics and needs of Islamic banks are different compared to those of the Western banks, c) to check whether capital ratios have to be imposed on both the Western and the Islamic banks – supporting the equality in competition within the banking industry, d) to identify the aspects of the relationship between deposits and equity in both the Western and the Islamic banks, e) to examine and evaluate the role of stakeholders in the development of governance, efficiency and capitalization practices of banks – especially the Islamic and Western ones, and f) to identify the availability of policies that would respond to the governance, efficiency and capitalization needs of Western and Islamic banks. 3. Justification of the Research Banks have a crucial role in the development of markets worldwide supporting the activities of individuals and organizations in both the private and the public sector. The criteria for the establishment of banks are quite strict aiming to protect the interests of the public; however, the efficiency of banks is often doubted. On the other hand, risk in the banking industry cannot be eliminated; in fact, it has been proved that risk in the specific industry can be related with the operational structure of the bank – Western banks and Islamic banks represent two different types of banking institutions; Islamic banks – governed by the Shariah law – have specific capitalization requirements and a unique style of governance; these differences affect rather negatively the efficiency of Islamic banks – towards their Western rivals – however it seems that through rules of capitalization that are applied on the Islamic banks the risk for their depositors is reduced – compared to the Western banks. At this point the examination and the analysis of the relationship between equity and deposits in Western and Islamic banks will help to understand their advantages and weaknesses especially in regard to the risk undertaken by the investors and the stakeholders of the above organizations. 4. Literature Review 4a. Western banks – governance, capitalization requirements and efficiency The structure of Conventional banks is common with that of most private firms in the Western markets; like all financial institutions, conventional banks are set under the continuous control of specific authorities – for example the Financial Services Authority in UK – while their operations are regulated by the state with specific legal rules. The complexity of the banks’ activities and the continuous increase of risk related with financial transactions led to the establishment of the Basel Committee; the members of the Committee ‘are representatives of the central banks and other regulatory organizations of the Group of Ten (G-10) countries’ (Gallati, 2003, 125-126). The recommendations of Basel Committee focus on the regulation of Western banks activities – Islamic banks do not follow these rules but they are governed by the Shariah law. Under the – modified – recommendations of the Basel Committee of 1995 Conventional banks need ‘to measure and apply capital charges to their market risks in addition to their credit risks’ (Gallati, 2003, 60); additional capital charges like the ‘capital charges for foreign exchange risk and for commodities risk’ (Gallati, 2003, 60) are also included in the provisions of the 1995 Basel Committee recommendations. The provisions of the Basel Committee referring to the capital structure of banks (Western banks) are important for understanding the framework in which the capitalization needs of banks are developed. At the next level, the concept of efficiency is valuable and is used as the basis for the design and the development of banks’ strategic plans. Efficiency has been graphically represented in the study of Bikker (2008, 11) – see also Figure 2 in the Appendix section; the above study refers to the concept of efficiency as part of the strategic planning in the conventional banks. In the study of Bikker et al. (2008) efficiency is defined as ‘the difference between observed and optimal input/ output mixes’ (Bikker et al., 2008, 11). The role of efficiency – as described above – in the identification of capitalization requirements and the governance needs of conventional banks is quite important. Under the pressure of global financial crisis conventional banks – that have invested a lot on risky financial products – would need to review their capitalization requirements; it is noted that ‘tightening these requirements may limit banks’ profitability and reduce the operating efficiency but it could encourage banks to seek for new ways to invest expanding the production-possibilities frontier’ (Grigorian et al., 2002, 4); Conventional banks worldwide have understood the chances of Islamic markets and for this reason they have developed branches offering ‘financial products that are aligned with the Shariah law’ (Van Greuning et al., 2008,13-14); these financial products are commonly known as ‘Islamic Windows’; American Express Bank, BNP-Paribas and Citicorp group are among the banks that have introduced the above products (Van Greuning et al., 2008, 14). The specific initiative of the above organizations – introduction of the ‘Islamic Windows’ scheme can be regarded as an effort to expand their activities globally and improve their competitiveness in the banking industry (Vishwanath, 2007, 690). 4b. Islamic banks - governance, capitalization requirements and efficiency One of the most important characteristics of Islamic banks is that these organizations are interest – free, i.e. customers of Islamic banks do not have to pay interest for the money borrowed; in the study of Hassan et al. (2007) the characteristics of the Islamic banking system are described as follows: the Islamic banking system is based on the Shariah law; furthermore, the receiving and paying of interest is prohibited in Islamic banks’ (Hassan et al., 2007, 401); it has to be noted that the prohibition of interest in all operational activities of the Islamic banks cannot lead to the assumption that Islamic banks are ‘charitable concerns’ (Usmani, 2003, 134). The Islamic banking system was first established in 1974 through the Islamic Development Bank (Hassan et al., 2007, 401). Suflan et al. (2009) examined the efficiency of the Islamic banking system; their study was based on the data development analysis of data related with the banks of 16 Islamic countries; it was revealed that ‘a positive relationship exists between bank efficiency and loans intensity, size, capitalization, and profitability’ (Suflan et al., 2009, 120); it was also found that ‘technically more efficient banks are those that have smaller market share and low non-performing loans ratio’ (Suflan et al., 2009, 120). At the next level, the involvement of the Islamic banks on short term projects – rather than long term projects that may are more risky – can explain the low level of risk involved in the activities of Islamic banks (Siddiqui, 2008, 680). From a different point of view, Khan et al. (2008, 708) noted that the development of Islamic banks could be regarded as the result of the increase of profits from oil, the promotion of innovation, the support of regulators and the improvement of technology used in all sectors of the specific organizations. In accordance with this view, the capitalization requirements and the governance of these institutes are depended on the level of innovation – including the IT systems – and the development of the Shariah law – under the influence of the local ethics and the market trends. 5. Research strategy and methods 5a. Selection of research strategy – criteria, justification and analysis The research strategy used in this study is based on the study’s aims and objectives. More specifically, in order for the issues of capitalization, governance and efficiency of banks to be examined it is necessary to retrieve data related with the specific organizations – Western and Islamic banks. These data – referring to the period from 1998 to 2005 - will have to be analyzed and evaluated in order to identify the various aspects of the research problem. The efficiency frontier techniques have been identified as the most effective research tool for achieving the above target. RBA Statistics Database and IBIS (Islamic Banks and Financial Institutions Information) will be used as the source of data used in the research; this part of the research is the quantitative one. However, the qualitative research will be also involved in this study; qualitative research will be based on the review of the literature published in relation with the study’s subject. Only studies published 2000 onwards will be used in the literature review part of this study. The comparative analysis of the findings of the empirical research – as described above – and those of the qualitative research is expected to lead to the increase of the study’s credibility and validity. 5b. Explanation of sample The sample used in this study has been chosen as follows: The data used in the study have to refer to Islamic and Western banks. Two have been the major criteria for choosing the banks – sample in the research: their operational structure – referring especially to banks that have the Western or the Islamic operational structure; at the next level, the performance of these banks has been a decisive criterion for choosing the specific organizations; in this context, the most powerful banks – among those having the characteristics set above – have been chosen as sample for the needs of this study. No other criterion has been set for choosing the organizations – sample, the data of which will be used for the development of the study’s research methodology section. 6. Data analysis – Selection of data analysis methods The method selected for the research required for this study is the stochastic frontier approach; this method has been already used successfully in similar studies (see the research of Fried et al., 1993, 386) and for this reason it is strongly suggested in the literature – when research on the issues discussed in this study is to be developed (Aigner et al., 1977, Meeusen et al., 1977 in Fried et al., 1993, 386). The selection of data analysis method has been based on the credibility of the specific method – as emphasized in the studies mentioned above – but also on the material available for the development of the research; more specifically, the existence of financial data referring to Western and Islamic banks makes the use of the above method feasible. 7. Research Plan – timescale The research will be developed gradually; each phase will be completed within a specific time period; however, additional period of time – about 10 days – has to be available in case of any unexpected problem during the development of the study. The schedule of the study has been designed in accordance with the study’s needs – the estimated time for the completion of the empirical research part has been important for deciding on the time spent on the development of each phase of the project. Under these terms, the schedule of the proposed study could be presented as follows: a. Research over the existing databases for the availability of data on the performance of banks – 3 days b. Research on the database(s) chosen and design of the procedure required for the data analysis – 10 days c. Development of the introductory section of the dissertation – 3 days d. The research on the literature, development of the literature review section – 6 days [material is required for the development of the literature section of the study, also by putting this phase at this point it is expected that there will be no time loss for waiting the completion and the return of the questionnaire by the participants] e. Development of the research methodology section – gathering of statistical data – 5 days f. Data analysis – 10 days [this phase, as explained above, will also include the development of the graphical representation of the results] g. Discussion on results – 7 days [this phase is expected to take longer from the other phases of the project mostly because it will include an overall discussion on the study’s subject using both the findings of the empirical research and the secondary data (e.g. views in the literature, statistics). h. Completion of the dissertation – 15 days [in this phase the writing of the Results and Conclusion section will be completed – the dissertation will be checked as of its structure and presentation]. In accordance with the schedule described above, the dissertation is expected to be completed within 39 days – another 6 days would be added in case of unexpected delays; this means that the proposed study can be completed within a time framework of 65 days. 8. Resources The resources used in the proposed study have been chosen in accordance with the following two criteria: their credibility and their accessibility. The term resources in this case is related not only to the material available – studies, reports, statistics – on the issue under discussion but also the facilities used for the development of the study’s various tasks. In this context, the following resources have been chosen as required for the completion of the proposed study: a) the University’s library – where books and academic journals on the study’s subject can be retrieved; it should be noted here that only academic resources that have been published after 2000 will be used in the specific study, b) the Internet will be used for the retrieval of additional material; where it is not possible to retrieve the relevant resource in the University’s library, for example the statistics of governmental/ non-governmental organizations. 9. Evaluation of research strategy – limitations The research strategy chosen for the proposed study can be characterized as quite effective; however, it is necessary that the terms set in current proposal need to be applied; any failure to follow the research plan – as proposed above – could lead to the limitation of the study’s credibility – delays in the development of the research are also expected to appear. On the other hand, limitations in the achievement of the study’s aims and objectives may be unavoidable – even if they would be limited. In this context, problems like non-availability of recent resources on specific issues – those related with the study’s subject – or co-existence of different views or contradicting information on the issue under examination may not be possible to be totally avoided when developing the proposed study. However, by following the study’s schedule and conditions – as closely as possible – it is expected that problems, delays and limitations that are a common phenomenon in research will be effectively controlled. References Bikker, J., Bos, J., 2008. Bank performance: a theoretical and empirical framework for the analysis of profitability, competition and efficiency. Taylor & Francis Gallati, R., 2003. Risk management and capital adequacy. McGraw-Hill Professional Gestel, V., Baesens, B., 2008. Basel II. Credit Risk Management. 192, pp. 344-535 Grigorian, D., Manole, V., 2002. Determinants of commercial bank performance in transition: an application of data envelopment analysis. International Monetary Fund Fried, H., Lovell, C., Schmidt, S., 1993. The measurement of productive efficiency: techniques and applications. Oxford University Press US Hassan, K., Lewis, M., 2007. Handbook of Islamic banking. Edward Elgar Publishing Hassan, M., Al-Sharkas, A., 2004. An empirical study of relative efficiency of the banking industry in bahrain. Studies in Economics and Finance, 22(2), pp. 40-69 Khan, M., Bhatti, M., 2008. Islamic banking and finance: on its way to globalization. Managerial Finance, 34(10), pp. 708-725 Lastra, R., 2004. Risk-based capital requirements and their impact upon the banking industry: Basel II and CAD III. Journal of Financial Regulation and Compliance, 12(3), pp. 225-239 Ling, C., Mathieu, R., 2007. Bank capitalization and lending behavior after the introduction of the Basel Accord. Review of Quantitative Finance and Accounting, 28(2), pp. 147-162 Saita, F., 2007. Value at risk and bank capital management. Academic Press Scott, H., 2005. Capital adequacy beyond Basel: banking, securities, and insurance. Oxford University Press US Siddiqui, A., 2008. Financial contracts, risk and performance of Islamic banking. Managerial Finance, 34(10), pp. 680-694 Stolz, S., 2007. Bank capital and risk-taking: the impact of capital regulation, charter value, and the business cycle. Springer Suflan, F., Noor, M., 2009. The determinants of Islamic banks' efficiency changes: Empirical evidence from the MENA and Asian banking sectors. International Journal of Islamic and Middle Eastern Finance and Management, 2(2), pp. 120-138 Tarullo, D., 2008. Banking on Basel: the future of international financial regulation. Peterson Institute Usmani, M., 2002. An introduction to Islamic finance. BRILL Vishwanath, S., 2007. Corporate Finance: Theory and Practice. SAGE Appendix Efficiency Frontier Techniques Figure 1 – Graphical representation of the research structure of the proposed study Y*1 B D. Y*2 0 Figure 2 – Efficiency, graphical representation (as similar in Bikker et al., 2008, 11) Read More