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Does islamic banking
1. WORLD ACADEMIC JOURNAL OF BUSINESS & APPLIED SCIENCES-MARCH-SEPTEMBER 2013 EDITION
Journal of Economics & Finance (JEF)
APRIL 2013 VOL.1, No,2
Does Islamic Banking Have Any Future? A Comparative Study
Ammar Ali Gull (Corresponding author)
MBA/ MS (Banking & Finance)
GC University Faisalabad, Pakistan
Rehan Nasir
MBA/ MS (Banking & Finance)
GC University Faisalabad, Pakistan
Muhammad Bilal
MBA/ MS (Banking & Finance)
GC University Faisalabad, Pakistan
Asad Zaman
MBA/ MS (Banking & Finance)
GC University Faisalabad, Pakistan
Saqib Iqbal
MBA/ MS (Banking & Finance)
GC University Faisalabad, Pakistan
Accepted 10 April 2013
Abstract
The purpose of this research was to assess the future growth of Islamic banking. Study is based on
comparative analysis of both interest and Sharia based banks listed at Karachi stock exchange over the
period of 2007 to 2011 by applying regression analysis. Financial data regarding key performance
indicators of banking industry was collected from websites of KSE, State bank of Pakistan and sample
banks. Findings of analysis suggested that performance of non-interest banks is much better as
compare to conventional banks of Pakistan. Key difference is that Islamic banks are promoting equity
financing on the other hand lending procedure of conventional banks is totally based on debt financing.
Return on assets for Islamic banks is higher than conventional banks, it represents that working style
of these banks is efficient than interest base banks. In nutshell Islamic banks had bright future within
banking industry of our country.
Key Words: Islamic Banks, Conventional Banks, Return on Assets and Return on Equity.
1.
Introduction
Islamic and conventional banks both are operating for providing financial intermediary services.
Financial intermediary mean that banks working for two types of customers. First are those who need
money to meet their expenditures because their expenditures are higher than their income. That’s why
they need more money in shape of further capital or borrowing. Banks provide facility of lending to
customers meeting their needs easily without effecting the operations of business. Second type of
customers has income higher than their expenditures. So they have surplus money after meeting their
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2. WORLD ACADEMIC JOURNAL OF BUSINESS & APPLIED SCIENCES-MARCH-SEPTEMBER 2013 EDITION
expenditures and those deposit surplus money in banks. Banks use this surplus money for lending
purpose to needy customers, who have higher expenditures than income for fulfilling their needs. So
banks are working as middle men and take commission from borrowing customer and pay to
depositing customer according to their packages and provide many more financial facilities.
Interest free banking system is fully based on Islamic rules and its banking operations are performed
in accordance with Islamic principles and its functional utilization was continued by creating Islamic
economic system. In the era of 1940 Islamic banks intensified their growth and became a new rival in
banking sector. Islamic banking reached its peak level and expanded in all Muslim and non-Muslims
countries. Islamic banks became an alternative for economy and majority of countries were adapting
to Islamic banking.
Within few decades the Islamic economy concept rapidly promoted in four continents likes Asia,
Africa, Europe and North America. Presently approximately 300 financial institutions are working as
Islamic banks in 70 countries of world and their investment reached up to $500 Billion to $800 Billion.
In recent era Islamic banks are having $4 trillion market value. In Arab countries this concept has
become a popular economic concept. Bahrain is from those countries who rapidly adopted Islamic
economic system and Malaysia is on second due its excellent policies regarding Islamic banking. In
Pakistan Islamic banks had 7% market participation and six Islamic banks are operating in Pakistan.
Conventional Banking is fully based on financial model which follow capitalistic economy, in this
system banks mainly borrow from Savers who have surplus money and lend to enterprises or
individuals who need money for meeting their needs. In conventional banks the profits of banks is
interest spread which is difference among interest earning and interest expenses. In this system banks
also gain revenue from secondary sources by providing services for international trading such as letter
of credit and letter of guarantee. In these transactions they work as middle men between exporters and
importers and receive commission. Financial sector of Pakistan consist of conventional banks
including domestic and foreign, financial institution, Islamic banks, insurance companies and stock
exchange.
In furthermore, although interest free base and conventional banks are operating in the same
intermediation function, the basis utilized by Islamic Banks is the profit or revenue sharing principle,
differ from conventional banks that based on market interest. The revenue sharing basis might
influence the Islamic bank’s capital structure. The efficient working of banking operations contributes
in economic growth of country because banks play a major and vital role as financial intermediaries.
Banks in Pakistan provide financial services and demand commission as reward for these services.
Important point is that the funding of banks is financed by deposits the expense of which is also
interest rate. Margin of bank’s profit is the difference between the amount earned as interest from
lenders and amount paid to depositors.
1.1. Problem statement
Banking industry promotes saving and investment activities for growth of business and trade
activities in country. Pakistani banking sector had experienced worst changes in six decades of its life.
The start of Islamic banking created a competitive environment for banking sector especially for
conventional banks due to its rapid growth in Pakistan. This study will investigate the service quality
of banks and its effect on proficiency of interest based and interest free baking.
1.2. Objectives of study
Following are the major purposes of this research.
To describe the concept of Islamic banking.
Performance comparison of Islamic and conventional banks operating in Pakistan.
To measure the performance efficiency and growth of Pakistan’s banking sector.
2. Literature Review
The study of Jaffar and Manarvi (2011) showed the effectiveness and efficiency of conventional
and Islamic banks working in Pakistan by using CAMEL technique and its sub factors such as capital
structure, asset management of banks, efficiency of management, earnings and effective liquidity of
banks. Financial data used for financial evaluation of Islamic and conventional banks was collected
from financial statements of banks. Financial statements were available on websites of concerned
bank and State Bank of Pakistan. CAMEL technique was used for assessing financial proficiency of
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3. WORLD ACADEMIC JOURNAL OF BUSINESS & APPLIED SCIENCES-MARCH-SEPTEMBER 2013 EDITION
banks. The paper concluded that the conventional banks were founder of banking and had excellent
earning ability and Islamic banks were more dependent on equity finance rather than debt finance and
also active in liquidity. Asset quality management among the banks was almost similar.
The purpose of this paper written by Qureshi and Shaikh (2012) was to analyze the relevant
proficiency of Pakistani banking sector, which consist of Islamic and conventional banks. For this
determination they used two techniques for assessment, first one was financial ratios to evaluate the
production and revenue efficiency and second was envelopment analysis for relevant analysis of banks.
They find out that Islamic banks were able to overcome on cost for banking services and have less
ability to generate efficient income. They claimed that Islamic Banks could be fortified to become an
outstanding leader in financial sector by decreasing bank’s wastage than conventional banks.
The study of Shahid, Rehman and Raoof (2010) evaluated the competency of Islamic banks and
conventional banks in Pakistan. History of conventional banks in Pakistan from last sixty years was
compared with Islamic banks. Islamic banks had short term history in Pakistan and less than seven
Islamic banks which are following fully Islamic rules. For conducting research total ten banks were
selected which includes five Islamic and five conventional banks from 2005 to 2009. A DEA model
was functional to assess the extra outcomes of banking industry. The fallouts were presented that the
TE of interest base banks was favorable but in CE and AE both factors were describing that there was
a heavy rivalry.
Ansari and Rehman (2011) described the financial efficiency of Pakistani Islamic and interest
base banks. For this description they considered five interest free and five interest base banks. Key
measurement element was return on total assets and with other helping factors assessment of banking
sector was done. The research presented a unique aspect of financial service provider firms which
were working as middle men between lender and borrower in Pakistan. Profitability assessment
measure was same for both types of banks. At the end of study, they finalized that Islamic banks were
providing excellent results than interest base banks and furthermore Islamic banks had bright
opportunity and capacity for market share.
Bilal, Saeed, Gull and Akram (2013) conducted a study to investigate the impact of bank related
and macroeconomic factors on performance of banks. Findings of their research revealed that net
interest margin have a favorable impact on ROA and ROE, while return on equity is adversely
affected by inflation and non-performing loans to total advances ratio.
The study of Siraj and Pillai (2012) compared the output of Islamic and non-Islamic banks which
were working in gulf and Arab countries for last five years. They said that assessment factors had
similarity for Islamic and conventional banks which were established in Arab countries. For this
comparative measurement six interest base and six interest free banks were selected. In this study the
return on equity, return on total assets, operating income, operating expenses, deposits to total equity
and net profit were used as performance indicators. They examined that Islamic banks were more
dependent on owner’s equity than debt financing but conventional banks like debt financing. Interest
base bank’s growing well but they did not achieve desired outcomes due to increase in unsecured
loans. The study notifies that evaluating elements may be affected due to financial crises for the year
2007.
Research of Syafri (2012) analyzed the factors affecting profitability of commercial banks in
Indonesia. Secondary data of commercial banks listed on the Indonesia Stock Exchange between 2002
and 2011 was used for analysis. Bank’s profitability was measured by return on assets as a function of
banks specific determinants. Analysis technique used was pooling data regression model. The
empirical results showed that loan to total assets; total equity to total assets, loan loss provision to total
loan had positive effect on profitability, while inflation rate, the size of bank and cost-to-income ratio
(BOPO) had a negative effect on profitability. Economic growth and non-interest income to total
assets had no effect on bank profitability.
Gull, Akram, Bilal and Muzaffar (2013) studied the importance of board independence in
banking sector of Pakistan. Outcomes of analysis suggested that banks with independent board
structures have outperformed the banks having dependent boards.
In this article Safiullah (2010) emphasized on the financial performance analysis of both stream of
banks to measure superiority and efficiency. The study indicated that liquidity efficiency, financial
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4. WORLD ACADEMIC JOURNAL OF BUSINESS & APPLIED SCIENCES-MARCH-SEPTEMBER 2013 EDITION
structure, surviving in economy and participation in operations were notable. The outcomes were
based on economic obligations, optimal productivity and attractive services revealed that interest base
banks were operating well than Islamic banks. However Islamic bank’s efficiency was reward able in
banking growth and profitability than interest base banks. After comparative research the results
suggested that Islamic banks were growing rapidly.
Basic theme of study conducted by Saeed, Gull and Rasheed (2013) was to assess the impact of
capital structure on banking performance of Pakistan. Study was conducted by applying regression
analysis on a sample of 25 banks listed at KSE over the period of 2007 to 2011. Results of study
revealed a positive relationship between performance of Pakistani banks and measures of capital
structure.
Samad (2004) captured the efficiency results of interest free and interest base banks of Bahrain
during the Gulf war. He also evaluated leverage, liquidity and operation of banks. He used financial
ratios for assessment of services. He applied student’s financial statement analysis projects on Bahrain
banks for ten years trend analysis. The paper finalized that interest base banking and Islamic banking
have minor difference in liquidity, efficiency and services. But his investigation revealed that there
was a fundamental difference in lending of both banks.
The study of Viverita (2012) was aimed to evaluate the efficiency of Indonesian Islamic banks by
using individual banking data for the last 4 years. He used different financial ratios such as cost,
revenue and profit efficiency ratios. He observed that Islamic banks have impressive improvement
within banking sector. He examined in his research with the help of T-test and F-test that Islamic bank
had high cost of production than interest based banks. Furthermore, he investigated that Islamic
banks were more active and efficient in their operations than commercial banks and earned more
dividend. He lastly described that the profitability of large scale Islamic banks was much better than
the huge conventional banks.
Awan (2009) observed that in discouraging global financial conditions, Islamic banking has
become an outstanding substitute for financial market. It had noticed the rapid growth within two
decades. He conducted a vertical analysis of Islamic banking and then compared it with commercial
banks. For the purpose of study he selected new Islamic and commercial banks for the sake of
assessment. Primary and secondary data resources were used for measurement of efficiency of banks
for 3 years. He used different ratios to analyze the performance of both kinds of banks.
Islamic Banks were working on the profit or revenue sharing principle, which was different from
conventional banks that were based on market interest. The profit /revenue sharing basis might
influence the Islamic bank’s capital structure but it was also helpful in international banking crises to
reduce capital risk. Mostly conventional banks have defaulted due to high liquid liabilities but Islamic
banks survived in worst conditions due its unique capital structure.
3. Data and methodology
Data for the purpose of this research is collected from secondary sources such as websites of
Karachi Stock Exchange (KSE), State Bank of Pakistan (SBP) and concerned banks for the period of
five years from 2007 to 2011. This five years period was selected because during this period banking
sector passed through worst economic conditions. Five Islamic banks and five conventional banks
were selected as sample from the banking sector of Pakistan. All these banks are well known, listed at
KSE and have a big market share. For analysis of data collected from above mentioned sources
descriptive statistics, correlation and regression analysis are applied as Statistical techniques.
3.1 INDEPENDENT VARIABLES
3.1.1 Capital Adequacy Ratio (CAR)
It is an indicator which measures the strength of bank’s capital. It shows the risk weight of credit
exposure. CAR ratio is very useful for checking the capital of financial institutions.
3.1.2 Return on Equity (ROE)
This ratio is used to measure the return of total capital of a company. ROE is calculated by using
firm’s net profit and total equity finance. ROE is shown in percentage.
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5. WORLD ACADEMIC JOURNAL OF BUSINESS & APPLIED SCIENCES-MARCH-SEPTEMBER 2013 EDITION
3.1.3 Deposits to Total Assets Ratio (DTAR)
DTAR shows the credit standing of bank by considering relationship between deposits and total assets
of banks.
Advances Turnover Ratio (ATR)
Advances turnover represent that how much interest is earned from total advances of bank. It is a
useful measure to check the efficiency of bank performance
Net spread ratio (NSR)
Spread ratio is used to measure the net interest income earned by a bank. This ratio represents the
basic income of banks.
3.2 DEPENDENT VARIABLES
3.2.1 Return on Assets (ROA)
ROA is a performance indicator that is used to measure the efficiency of total assets of a
company. ROA is obtained with the use total average asset of bank and net profit after tax, ROA is
shown as a percentage. Sometimes it’s written as investment on total assets of bank.
4. Hypothesis
Ho: Islamic banks are performing better than interest base banks.
H1: Conventional banking institutions are performing efficiently than Islamic banks.
3.4, Empirical model
Yit = β0 + βXit + µit
Return on Assets
ROAit = β0it+ β1CARit + β2NSRit + β3ATRit+ β4DTARit + β5ROEit + µit
Where:
Yit is dependent variable.
β0 represents the intercept.
Xit is independent variable.
µit are the error terms.
i
is number of banking companies and
t
is number of years.
4., Results and Discussions
This segment explains the statistical results of variables related to study. This section consists of group
statistics, correlation and regression analysis of variables and furthermore theoretical discussion on
outcomes of these tests.
4.1 Group Statistics
Table- 1 and 2 are used to describe the 5 years summary of statistical analysis for Islamic and
non-Islamic banks. Combined descriptive statistics of both banks are presented in table- 3. In Islamic
and non-Islamic bank’s mean, median and standard deviation of the dependent variable ROA is
-0.3496, -3.1972 0.02, 1.21 and 1.446543, 21.48512 respectively. Return on assets of Islamic banks is
better and more consistent than conventional banks. In Islamic and conventional banks ROE, NSR,
DTAR, CAR and ATR are independent variables and their means, are 2.46,11.18, 47.7252,37.5244
72.3556,76.1204 23.9012,14.1096 and 14.2088,16.4168 respectively. In case of Islamic banks Mean
of independent variables NSR and CAR are higher than conventional banks but ROE, DTAR and ATR
are lower than conventional banks. Standard deviation of ROE, NSR, DTAR, CAR and ATR
(independent variables) for interest free and interest base banks are 8.979317,27.46183
10.79265,20.10444 13.03161,6.946273 13.73281,7.77835 and 6.91089,3.775496
respectively.
Islamic banks SD is less as compare to conventional banks which shows that Islamic banks are
performing well than interest based banks. Minor fluctuations in standard deviation are suggesting that
Islamic banks are more consistent than conventional banks.
4.2 Correlation Analysis
Table-4 and 5 represents the correlation matrix of the independent variables for Islamic and
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6. WORLD ACADEMIC JOURNAL OF BUSINESS & APPLIED SCIENCES-MARCH-SEPTEMBER 2013 EDITION
conventional banks. Correlation research is a statistical technique which is used to check the multi co
linearity among independent variables. When Correlation is positive then values will move in same
direction but when they move in opposite direction correlation is negative.
Islamic banks ROE has a positive relation with NSR, DTAR and ATR but a negative association
with CAR. Conventional bank’s ROE having a favorable relationship with NSR, CAR and ATR, while
negatively related with DTAR. Islamic bank’s NSR is negatively correlated with all variables except
CAR. Non-Islamic bank’s NSR is found to have a positive dependence upon CAR and ATR. NSR and
DTA are adversely correlated. DTAR of interest free an interest based banks is positively associated
with ATR and negatively related with CAR. Islamic banks CAR have a positive correlation with NSR
but it is negatively associated with ROE and DTA. Conventional banks CAR have Positive correlation
with NSR and ROE but it is negatively associated with DTAR. In correlation matrix Islamic banks
ATR is positively related with ROE, DTAR and CAR and negatively related to NSR. Conventional
banks ATR having an optimistic relationship with all independent variables except CAR.
Table- 6 illustrates the combine correlation analysis of Islamic and non-Islamic banks. ROE is
having a favorable connection with all independent measures other than CAR. NSR is negatively
associated with DTAR and ATR but favorably related to CAR. DTAR have an adverse relationship
with CAR and positively correlated to ATR. Finally CAR and ATR are correlated in same direction.
4.3, Regression Results
Outcomes of regression analysis of both banks are separately given in Table-7. According to
results demonstrated in above mentioned table ROE of non-interest based banks has a positive
significant impact on dependent variable (ROA) and all other variables have an insignificant
relationship with ROA. R squared of dependent variable for Islamic banks is 0.671548, which means
67% of sample describes ROA and its F statistics is 7.769405. In case of Conventional banks ROE and
CAR are favorably associated with ROA. NSR, DTAR and ATR are having a negative insignificant
impact on ROA. R square and F statistics of conventional banks are 0.807808, 15.97187 respectively.
Combined results of regression test are elaborated in Table-8. Except ROE all other independent
variables are having an insignificant impact on dependent variable and ROE has a strong positive
association with ROA. R square and F statistics of combined regression model are 0.632108 and
15.1201.
5. Conclusion
This research is conducted on the basis of comparative analysis of both banking approaches. First
one is Islamic banking based on Sharia guidelines and other is Non-Islamic based on manmade
principles. Conventional banking institutions are working in Pakistan from four to five decades and
having penetration in their services concern. Islamic banks started their operations recently but their
position in banking industry is satisfactory. Banks working in accordance of Islamic principles are
outperforming conventional banks in recent financial crises. One logical reason is that Islamic banks
are not dependent upon debt finance like conventional banks. This is an edge for Islamic banks over
conventional banking institutions that they rely on equity financing rather than debt financing. Finally
it is reduce bank’s investment risk. This edge is very helpful for Islamic banks to survive in
international financial crises.
As per findings of this study in Pakistan Islamic banks are performing better than interest base
banks. Return on Assets of Islamic banking is at optimal level and supportive than conventional
banking organizations. Islamic banks CAR ratio is too good that is an indication of low risk and
secured financing. Conventional bank’s deposit to asset ratio is very attractive for potential customers
and also higher than non-conventional banks. It means conventional approach majorly relies on debt
financing and in contrast Islamic banks are dependent upon equity financing. Over all Islamic banks
have higher growth rate in banking industry as compare to conventional banks.
References
Ansari, S., & Rehman, K. (2011). Comparative Financial Performance of existing Islamic Banks and
Contemporary Conventional Banks in Pakistan. Paper Presented at second International Conference
on Economics, Business and Management, IPEDR 22, 45-49.
Awan, A. G. (2009). Comparison of Islamic and conventional banking in Pakistan. Proceedings second
CBRC, Lahore- Pakistan. 1-36.
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7. WORLD ACADEMIC JOURNAL OF BUSINESS & APPLIED SCIENCES-MARCH-SEPTEMBER 2013 EDITION
Bilal, M., Saeed, A., Gull, A. A., & Akram, T. (2013). Influence of Bank Specific and Macroeconomic
Factors on Profitability of Commercial Banks: A Case Study of Pakistan. Research Journal of Finance
and Accounting, 4(2), 117-126.
Gull, A. A., Akram, T., Bilal, M., & Muzaffar, Z. (2013). Do Board Independence Carry Value? (A
Case Study of Pakistani Banks). Research Journal of Management Sciences, 2(5), 1-5.
Jaffar, M., & Manarvi, I. (2011). Performance comparison of Islamic and Conventional banks in
Pakistan. Global Journal of Management and Business Research, 11(1), 60-66.
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Non-parametric Approach. International Journal of Business and Management, 7(7), 40-50.
Saeed, M. M., Gull, A. A., & Rasheed, M. M. (2013). Impact of Capital Structure on Banking
Performance (A Case Study of Pakistan). Interdisciplinary Journal of Contemporary Research in
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Safiullah, Md. (2010). Superiority of Conventional Banks & Islamic Banks of Bangladesh: A
Comparative Study. International Journal of Economics and Finance, 2(3), 199-207.
Samad, A. (2004). Performance of interest-free Islamic banks vis-à-vis interest-e-based conventional
banks of Bahrain. IIUM Journal of Economics and Management, 12(2), 1-15.
Shahid, H., Rehman, R., Niazi, G. S. H., & Raoof, A. (2010). Efficiencies Comparison of Islamic and
Conventional Banks of Pakistan. International Research Journal of Finance and Economics, (49),
24-42.
Siraj, K. K., & Pillai, P. S. (2012). Comparative Study on Performance of Islamic and Conventional
Banks in GCC region. Journal of Applied Finance and Banking, 2(3), 123-161.
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copy available at: http://ssrn.com/abstract=1868938.
List of Tables
Table- 1
Mean
Median
Std. Dev.
Observations
ROE
2.46
0.09
8.979317
25
Descriptive Statistics (Islamic Banks)
Table- 2
ROE
ROA
-0.3496
0.02
1.446543
25
NSR
47.7252
47.7
10.79265
25
DTAR
72.3556
78.75
13.03161
25
CAR
23.9012
17.65
13.73281
25
ATR
14.2088
13.61
6.91089
25
ROA
NSR
DTAR
CAR
ATR
Mean
9.2368
-3.1972
37.5244
76.1204
14.1096
16.4168
Median
11.18
1.21
35.83
76
11.35
16.05
Std. Dev.
27.46183
21.48512
20.10444
6.946273
7.77835
3.775496
Observations
25
25
25
25
25
25
NSR
TAR
CAR
TR
Descriptive Statistics (Conventional Banks)
Table- 3
ROE
OA
Mean
5.8484
-1.7734
42.6248
74.238
19.0054
15.3128
Median
4.865
0.51
43.3
76.89
14.365
14.995
20.50823
15.13897
16.77996
10.50844
12.10218
5.623013
Std. Dev.
46
