Comparison of Efficiency of Islamic and Conventional Banks in Pakistan

8/13/2019 Comparison of Efficiency of Islamic and Conventional Banks in Pakistan

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SUBJECT NAME

Course Instructor

Assignment:Comparison between Efficiency of Islamic and Conventional Banks in

Pakistan.

Submitted By:Saima Naurin

Submitted On:March 14, 2013


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Preston University, Islamabad.

Comparison between Efficiency of

Islamic and Conventional Banks in

Pakistan

Abstract

There is a rising debate among different school of thoughts regarding the efficacy of the IslamicBanks (IB) and Conventional Banks (CB) in Pakistan. The topic has remained controversial fromthe time since the first IB was established in the country. The economists and other finance

related scholars that were more inclined towards the IB supported it by showing their growth andefficiency far more than the CBs while others who thought IB as pre-mature portrayed them asless efficient. These arguments took a new shape after the economic crisis of 2008 in the countryin which most of the CBs were badly affected while the IBs showed much resilience due to theirinvestment in real estate and other tangible or fixed assets instead of financial assets but, as far asthe profitability of the banks are concerned, the IBs are less profitable than the CBs.

Introduction to Islamic Banking in Pakistan

The establishment of first modern Islamic bank in Egypt in 1963[1]enlightened the Muslim world

to adapt the banking system that is completely in compliance with the Islamic Shariah. Thisgroundbreaking in banking industry in Egypt succeeded the Organization of Islamic Conference(OIC) to support the Islamic financial system in 1973 at Jeddah, Saudi Arabia. Finally, the waveof Islamic Banking also overwhelmed Pakistan when state bank of Pakistan incorporated thedefinition of Islamic banking in the banking policy as:

Banking in consonance with the ethos and value system of Islam and governed, in addition tothe conventional good governance and risk management rules, by the principles laid down by

Islamic Sharia'h.

This encouraged the establishment of Islamic bank in the country that finally led to the

establishment of first Islamic Bank, Meezan Islamic bank of Pakistan, in 2002. Currently, thereare more than Ten Islamic and conventional Islamic banks working nationally. People of thecountry are gradually inclining towards the Islamic banking by virtue of their professed bindingwith the conjunctions of Islam. Therefore, the popularity of the Islamic banks is increasing dayby day in the country.


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Currently, at global level, the Islamic financial industry has reached $1 trillion US dollar and isgrowing about 20 percent annually. Its growth is not restricted to the Muslim societies butIslamic financial products are also gaining popularity among non-Muslim countries. Many globalbanks have also opened separate windows to serve their Muslim clients. Similarly, about allglobal agencies like IMF, World Bank, IFC, ADBP, etc, have set up special cell to investigate

into this new phenomenon

[4]

.

Islamic and Conventional Banks:

Like Conventional bank, Islamic bank is an intermediary and trustee of money of people. Oncontrary, it shares profit and loss with its depositors and introduces the element of mutuality inIslamic banking. Conventional banking follows Conventional interest-based principle, whereas,Islamic banking is based on interest free principle and principle of Profit-and-Loss (PLS) sharingin performing their businesses as intermediaries [3]. Thus, it can be interpreted that in IBs, risk isshared among borrower, lender and the bank while in CBs risk is fully transferred to others.

Furthermore, the analysis portfolio investment of IBs and CBs elaborates a clear distinction intheir investment priorities. The IBs prefer investing in trade(Modarba transaction), real estate,tangible assets, and other non-interest related business activities and they are least inclinedtowards the treasury bills and other interest based instruments. On the other hand, the CBs investmore in financial instruments that are liquid and interest based. This makes their reliance on thevolatile interest rate that at one side is a good income generator on the other side it is riskier too.Thus, the universal law of financial management i.e. Risk is directly proportional to Return ismuch applicable here. The IBs have less risk oriented investment while the CBs have more riskoriented investment.

Efficiency of Islamic Banks and Conventional Banks:Pakistan is in the process of building a strong banking platform where its central bank, StateBank of Pakistan (SBP), regulates the sector to gradually bring reforms which on one hand mayopen new windows of opportunity for the industry players, and on the other hand may createdistortions resulting in inefficient resource allocation. Besides this there is also the proliferationof financial crises and inefficient banks. The recent financial crisis experienced by theconventional banking sector around the world has pushed the Islamic banking sector to furtheremphasize on transparency and avoidance of undue risk to insulate themselves from the crises.

Islamic and conventional banks are in direct competition and efficiency has proved to be a toolfor winning the competition. Having the same factors of production, the efficient usage of inputs

determines the success

[2]

.

Generally there are two ways to study banking efficiency; traditional financial ratios and non-parametric approaches like data envelopment analysis (DEA). DEA measures the technical, puretechnical and scale efficiency scores for the banks, and ratio analysis compares and contrastswith the results of DEA. Hence, the two methods are supplement and not the substitute for eachother.


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Before going further for measuring the efficacy of the banks, a comparison of the Islamic Banksand Commercial Banks in made as follows:

ParametersIslamic Banks Conventional Banks

1. Source of Earning

Profit, service charges andconsultancy fee is the mainsource of earnings of Islamicbanks. Profit is variable whichmay be negative in case ofloss.

Interest is the main source ofincome for conventional banksthat is charged on differenttypes of loans/products.(Difference between interestscharged from borrowers andpaid to depositors). It assures apredetermined rate of interest.

2. Earningsdistribution

The profit of Islamic bank isdistributed among thedepositors which arethousands in number and inthis way Islamic bank helpswiden distribution of wealth inthe society.

The conventional bank helpsconcentration andaccumulation of wealth in thesense that the net profit isdistributed amongshareholders who are few innumber and in this way thewealth of shareholders risesexponentially year after year.

3. Lending Objective

The lending objective ofIslamic bank is to stimulatebusiness activities throughprofit-and-loss sharing and inthis way it acceleratescirculation of wealth andfacilitates distribution ofincome.

The lending objective of theconventional bank is tomaximize the wealth of theshareholders and in this wayaccumulate wealth through theinstitution of interest

4. Lending Preferences

Good projects withoutcollateral may be financed onthe basis of profit and losssharing.[5]

Projects without collateral arenot financed.

5. Risk Sharing

It promotes risk sharingbetween Provider of capital(investor) and user of funds

(Entrepreneur).Similar toconventional banking, ratesof profits are aimed atmaximization subject toSharia principles.

Risk is fully transferred toothers.

Banks


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6. Profit Maximization

It aims at maximizing theprofit but subject to principlesof Shariah.

It aims at maximizing theprofit without any restrictioneven at the cost of otherstakeholders.

7. Objectives

Islamic bank works as a

trading concern (Mudarib orWakalah) to generate itsincome.

It generates income as

financial intermediary. Itsprime goal is themaximization of shareholdersvalue at any cost

8. Investment Prioritiesand portfolios

Islamic banks cannot invest ingovernment treasury bills,bonds and Term FinanceCertificates which carriesfixed rate of interest.Similarly, they are prohibitedto invest in government bonds,

treasury bills and otherfinancial instruments likeequity market. These factorsin past were responsible forlow profitability of Islamicbank. But now the situationhas been changed and Islamicbank faces no more suchproblem due to existence ofwell-established Islamicmoney market, Islamic Sukuk

and Islamic mutual funds inalmost all Muslim countries.

Investment in interest basedinstruments, short term andlong term loans on interest;the risk of lending istransferred completely to theborrower.Conventional banks make

more than 50 percentinvestment in governmentTreasury bills, bonds and termfinance certificates forsecurity and smooth return.They also earn huge profitfrom stock market in case ofbull-run and suffer badly incase of its crash. In 2008 theinvestment to deposit ratio ofconventional banks in

Pakistan were 23.85% ascompared to 15.39% ofIslamic Banks

9. Banking philosophy

In theory, Islamic banking isan example offull-reservebanking,with banks achievinga 100%reserve ratio

The commercial banks neveraim to achieve 100% reserveratio, but on the other hand, itembraces more risk bymaintaining the reserve ratioto 5% only.

10.Role in economicdevelopment

Islamic banks can play a vitalrole in the economic

development by acting uponthe conjunctions of Islam inthe business operations andethics. It works on the moneycirculation principal thatincreases the money flow inthe market and makes thepeople increase their

Conventional banks aim atcapitalistic structure that

accumulates the wealth insome hands. Thus, thisconsequently decreases moneyflow in the market thatdecreases the purchasingpower of the people in thesociety making them poorer.
http://en.wikipedia.org/wiki/Full-reserve_bankinghttp://en.wikipedia.org/wiki/Full-reserve_bankinghttp://en.wikipedia.org/wiki/Reserve_ratiohttp://en.wikipedia.org/wiki/Reserve_ratiohttp://en.wikipedia.org/wiki/Full-reserve_bankinghttp://en.wikipedia.org/wiki/Full-reserve_banking


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purchasing power.

11.Borrowings[8]

Islamic banks pay high returnto their depositors andweighted average profit rateon PLS deposits are between

3.56 percent and 3.79 percent.Profit and Loss sharingdeposits earns more than onepercent high return thaninterest-bearing deposits.

CBs offer different depositschemes and borrow fundsfrom the depositors. The ratesof interest on these schemes

are fixed and the banks areliable to pay these fixed ratesof interest to depositors at thecompletion of term whetherthey earn profit or suffer loss.The depositors have nothing todo with the loss of bank.However, conventional banksuse to pay low return to theirdepositors and charge highinterest from their borrowers

in order to maximize theirprofit.

12.Concept of Money

Islamic bank use money as amedium of exchange tofacilitate trade transactions.Islamic bank supplies moneyto traders to purchase realassets and to industrialists topurchase plants or rawmaterial to augmentproduction process and

produce value-added products.

The conventional bank usesthe money as a commoditywhich is bought and sold andon such two-way transactionsthey charge interest on it andmake huge profit.


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Functions of Islamic Bank


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Determining efficiency of Islamic and commercial banks:

ParametersIslamic Banks Conventional Banks

1. FinancialStability

a. Small Islamic banks tend to be financially stronger than smallcommercial banks;

b.Large commercial banks tend to be financially stronger than largeIslamic banks; and

c. Small Islamic banks tend to be financially stronger than largeIslamic banks.

A plausible explanation for the above findings is that it is significantlymore complex for Islamic banks to adjust their credit risk monitoringsystem as they become bigger. Another possibility is that small banksconcentrate on low-risk investments and fee income, while large banksdo more profit-and-loss (PLS) business[7]

2. EARNINGRATIOS

IBs have relatively high earning ratios as compared to small CBs butwhen large IBs are compared with the large CBs their earning ratioscomes relatively lower.

3. Asset QualityThe Non-performing loans of CBs are much higher than IBs. This

elaborates the prudent and vigilant lending policies of IBs as comparedto CBs.

4. DebtManagement

Ratios

Islamic banks are far behind than conventional banks for their debtmobilization due to their recent start-up as compared to commercialbanks.

5. LiquidityRatios The Earning assets of Islamic Banks are 95 percent as compared to 93

Banks


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percent earning assets of Conventional Banks. The ratio of advances todeposits for Islamic and Conventional Banks is 0.83 and 0.70 percentrespectively. The point to be noted is that Islamic banks financing is 83percent of their assets as compared to 70 percent of Conventional banks

6. SolvencyRatios The solvency ratio of Islamic banks is far better than selectedconventional banks.

7. Investmentratio The conventional banks mostly invest in the Government fixed-income

securities, deposit ratio means is the percentage of the amount ofdeposits to be i

private Term Finance Certificates and in equity markets while Islamicbanks mostly invest in sovereign and private Islamic Sukuks (bonds),equity market and other Islamic instruments. When we look at theinvestment portfolio of conventional banks we find that conventionalbanks have invested 23.85 percent of their deposits and 9.25 percent of

their total assets in fixed income and other securities. While IslamicBanks have invested 15.39 percent of their deposits and 4.37 percent oftheir total assets in Islamic Sukuks,etc. This comparison clearly showsthe lack of investment opportunities for Islamic banks the ratio of theirinvestment is far less than the investment portfolio of conventionalBanks. However, high percentage of financing by Islamic bankscompensates them otherwise they are not able to earn profit on their idlecash assets.

8. Borrowingratios The borrowing to total deposits of Conventional Banks is 11.92 percent

as compared to 5.86 percent borrowings of Islamic Banks. Theborrowing to total advances of Conventional banks is 16.05 percentagainst 12.93 percent borrowings of Islamic Banks. Thus, there is awide gap between the percentage of borrowing of conventional banks


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and Islamic Banks. It means that Islamic banks is relying more on theirown resources and having sufficient funds to discharge their obligationsas compared to conventional banks which are borrowing heavily .It alsoshows that conventional banks are facing liquidity crunch.

Conclusion

Islamic banks in Pakistan have showed good performance. Many writers in the world havecompared Islamic banking performance with Conventional banking. The results showed thatIslamic banks were better in maintaining Capital Adequacy and Asset quality than theConventional banks.

Islamic banks are less profitable, more solvent and less efficient comparing to Conventionalbanks. In terms of liquidity, no major difference is seen between the two sets of banks. Islamicbanks profitability is positively related to equity and loans.

It is sometimes suggested that Islamic banks are rather complacent. They tend to behave asthough they had a captive market in the Muslim masses who will come to them on religiousgrounds. This complacency seems more pronounced in countries with only one Islamic bank.Many Muslims find it more convenient to deal with conventional banks and have no qualmsabout shifting their deposits between Islamic banks and conventional ones depending on whichbank offers a better return. This might suggest a case for more Islamic banks in those countriesas it would force the banks to be more innovative and competitive. Another solution would be toallow the conventional banks to undertake equity financing and/or to operate Islamic 'counters' or'windows', subject to strict compliance with the Shariahrules. It is perhaps not too wild aproposition to suggest that there is a need for specialized Islamic financial institutions such asmudarababanks, murabahabanks and musharakabanks which would compete with one another

to provide the best possible services.

References:[1]Ashfaq Ahmad, (2009),A Comparative Study of Islamic Banking in Pakistan: Proposing andTesting a Model,Foundation University, Islamabad, Unpublished doctoral thesis.

[2]Danesh,(2007), International Journal of Business and Management,www.ccsenet.org/ijbm

Vol. 7, No. 7; April 2012Published by Canadian Center of Science and Education.

[3]Jaffar, Muhammad; Manarvi ,Irfan, (2011),Performance comparison of Islamic and

Conventional banks in Pakistan, Global Journal of Management And Business Research,Volume 11 (1), Publisher: Global Journals Inc. (USA).

[4]Abdul Ghafoor Awan, (2009),Comparison Of Islamic And Conventional Banking In Pakistan,Islamia University, Bahawalpur-Pakistan, Unpublished Research Journal.

[5]Mohamed Ariff,(1994),Islamic Banking, Asian-Pacific Economic Literature Vol. 2(2) pp. 48-64
http://www.ccsenet.org/ijbmhttp://www.ccsenet.org/ijbmhttp://www.ccsenet.org/ijbmhttp://www.ccsenet.org/ijbm

Comparison of Efficiency of Islamic and Conventional Banks in Pakistan

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