Does Islamic Banking Have Any Future? A Comparative Study:

7/27/2019 Does Islamic Banking Have Any Future? A Comparative Study:

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WORLD ACADEMIC JOURNAL OF BUSINESS & APPLIED SCIENCES-MARCH-SEPTEMBER 2013 EDITION

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Does Islamic Banking Have Any Future? A Comparative Study

Ammar Ali Gull(Corresponding author)

MBA/ MS (Banking & Finance)GC University Faisalabad, Pakistan

Rehan NasirMBA/ MS (Banking & Finance)

GC University Faisalabad, Pakistan

Muhammad BilalMBA/ MS (Banking & Finance)


Asad ZamanMBA/ MS (Banking & Finance)


Saqib IqbalMBA/ MS (Banking & Finance)


Accepted 10 April 2013

Abstract

The purpose of this research was to assess the future growth of Islamic banking. Study is based oncomparative analysis of both interest and Sharia based banks listed at Karachi stock exchange over theperiod of 2007 to 2011 by applying regression analysis. Financial data regarding key performanceindicators 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 ascompare to conventional banks of Pakistan. Key difference is that Islamic banks are promoting equityfinancing 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 styleof 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. IntroductionIslamic 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 needmoney to meet their expenditures because their expenditures are higher than their income. Thats whythey need more money in shape of further capital or borrowing. Banks provide facility of lending tocustomers meeting their needs easily without effecting the operations of business. Second type ofcustomers has income higher than their expenditures. So they have surplus money after meeting their

Journal of Economics & Finance (JEF) APRIL 2013 VOL.1, No,2


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expenditures and those deposit surplus money in banks. Banks use this surplus money for lendingpurpose to needy customers, who have higher expenditures than income for fulfilling their needs. Sobanks are working as middle men and take commission from borrowing customer and pay todepositing 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 performedin 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 inbanking sector. Islamic banking reached its peak level and expanded in all Muslim and non-Muslimscountries. Islamic banks became an alternative for economy and majority of countries were adaptingto 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 asIslamic 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 Islamiceconomic system and Malaysia is on second due its excellent policies regarding Islamic banking. InPakistan 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 thissystem 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 isinterest spread which is difference among interest earning and interest expenses. In this system banksalso gain revenue from secondary sources by providing services for international trading such as letterof credit and letter of guarantee. In these transactions they work as middle men between exporters andimporters and receive commission. Financial sector of Pakistan consist of conventional banksincluding domestic and foreign, financial institution, Islamic banks, insurance companies and stockexchange.

In furthermore, although interest free base and conventional banks are operating in the sameintermediation 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 mightinfluence the Islamic banks capital structure. The efficient working of banking operations contributesin 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 alsointerest rate. Margin of banks profit is the difference between the amount earned as interest fromlenders and amount paid to depositors.

1.1.Problem statementBanking 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 forconventional banks due to its rapid growth in Pakistan. This study will investigate the service qualityof banks and its effect on proficiency of interest based and interest free baking.1.2.Objectives of studyFollowing 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 Pakistans banking sector.2. Literature Review

The study of Jaffar and Manarvi (2011) showed the effectiveness and efficiency of conventionaland Islamic banks working in Pakistan by using CAMEL technique and its sub factors such as capitalstructure, 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 collectedfrom 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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banks. The paper concluded that the conventional banks were founder of banking and had excellentearning ability and Islamic banks were more dependent on equity finance rather than debt finance andalso 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 thisdetermination 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 lessability to generate efficient income. They claimed that Islamic Banks could be fortified to become anoutstanding leader in financial sector by decreasing banks wastage than conventional banks.The study of Shahid, Rehman and Raoof (2010) evaluated the competency of Islamic banks andconventional banks in Pakistan. History of conventional banks in Pakistan from last sixty years wascompared with Islamic banks. Islamic banks had short term history in Pakistan and less than sevenIslamic banks which are following fully Islamic rules. For conducting research total ten banks wereselected which includes five Islamic and five conventional banks from 2005 to 2009. A DEA modelwas functional to assess the extra outcomes of banking industry. The fallouts were presented that theTE of interest base banks was favorable but in CE and AE both factors were describing that there wasa 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. Keymeasurement element was return on total assets and with other helping factors assessment of bankingsector was done. The research presented a unique aspect of financial service provider firms whichwere working as middle men between lender and borrower in Pakistan. Profitability assessmentmeasure 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 brightopportunity and capacity for market share.

Bilal, Saeed, Gull and Akram (2013) conducted a study to investigate the impact of bank relatedand macroeconomic factors on performance of banks. Findings of their research revealed that netinterest margin have a favorable impact on ROA and ROE, while return on equity is adverselyaffected 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 whichwere working in gulf and Arab countries for last five years. They said that assessment factors hadsimilarity for Islamic and conventional banks which were established in Arab countries. For thiscomparative measurement six interest base and six interest free banks were selected. In this study thereturn on equity, return on total assets, operating income, operating expenses, deposits to total equityand net profit were used as performance indicators. They examined that Islamic banks were moredependent on owners equity than debt financing but conventional banks like debt financing. Interest

base banks growing well but they did not achieve desired outcomes due to increase in unsecuredloans. The study notifies that evaluating elements may be affected due to financial crises for the year2007.

Research of Syafri (2012) analyzed the factors affecting profitability of commercial banks inIndonesia. Secondary data of commercial banks listed on the Indonesia Stock Exchange between 2002and 2011 was used for analysis. Banks 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 totalloan 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 totalassets had no effect on bank profitability.

Gull, Akram, Bilal and Muzaffar (2013) studied the importance of board independence inbanking sector of Pakistan. Outcomes of analysis suggested that banks with independent boardstructures 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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structure, surviving in economy and participation in operations were notable. The outcomes werebased on economic obligations, optimal productivity and attractive services revealed that interest basebanks were operating well than Islamic banks. However Islamic banks efficiency was reward able inbanking growth and profitability than interest base banks. After comparative research the resultssuggested 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 regressionanalysis on a sample of 25 banks listed at KSE over the period of 2007 to 2011. Results of studyrevealed a positive relationship between performance of Pakistani banks and measures of capitalstructure.

Samad (2004) captured the efficiency results of interest free and interest base banks of Bahrainduring the Gulf war. He also evaluated leverage, liquidity and operation of banks. He used financialratios for assessment of services. He applied students financial statement analysis projects on Bahrain

banks for ten years trend analysis. The paper finalized that interest base banking and Islamic bankinghave minor difference in liquidity, efficiency and services. But his investigation revealed that therewas a fundamental difference in lending of both banks.

The study of Viverita (2012) was aimed to evaluate the efficiency of Indonesian Islamic banks byusing 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 ofT-testandF-testthat Islamic bankhad 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 moredividend. He lastly described that the profitability of large scale Islamic banks was much better thanthe huge conventional banks.

Awan (2009) observed that in discouraging global financial conditions, Islamic banking hasbecome an outstanding substitute for financial market. It had noticed the rapid growth within twodecades. 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 ofassessment. Primary and secondary data resources were used for measurement of efficiency of banksfor 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 fromconventional banks that were based on market interest. The profit /revenue sharing basis mightinfluence the Islamic banks capital structure but it was also helpful in international banking crises toreduce 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 methodologyData 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 offive years from 2007 to 2011. This five years period was selected because during this period bankingsector passed through worst economic conditions. Five Islamic banks and five conventional bankswere selected as sample from the banking sector of Pakistan. All these banks are well known, listed atKSE and have a big market share. For analysis of data collected from above mentioned sourcesdescriptive 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 banks capital. It shows the risk weight of creditexposure. 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 usingfirms net profit and total equity finance. ROE is shown in percentage.


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3.1.3 Deposits to Total Assets Ratio (DTAR)DTAR shows the credit standing of bank by considering relationship between deposits and total assetsof 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 acompany. ROA is obtained with the use total average asset of bank and net profit after tax, ROA isshown as a percentage. Sometimes its 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 modelYit= 0 + Xit + itReturn on AssetsROAit= 0it+ 1CARit+ 2NSRit+ 3ATRit+ 4DTARit+ 5ROEit + itWhere:Yit is dependent variable.0 represents the intercept.Xit is independent variable. it are the error terms.i is number of banking companies andt is number of years.4., Results and DiscussionsThis segment explains the statistical results of variables related to study. This section consists of groupstatistics, correlation and regression analysis of variables and furthermore theoretical discussion onoutcomes of these tests.4.1 Group Statistics

Table- 1 and 2 are used to describe the 5 years summary of statistical analysis for Islamic andnon-Islamic banks. Combined descriptive statistics of both banks are presented in table- 3. In Islamicand non-Islamic banks 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, 47.7252,37.524472.3556,76.1204 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 ATRare lower than conventional banks. Standard deviation of ROE, NSR, DTAR, CAR and ATR(independent variables) for interest free and interest base banks are 8.979317,27.4618310.79265,20.10444 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 thatIslamic 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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conventional banks. Correlation research is a statistical technique which is used to check the multi colinearity among independent variables. When Correlation is positive then values will move in samedirection 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 associationwith CAR. Conventional banks ROE having a favorable relationship with NSR, CAR and ATR, whilenegatively related with DTAR. Islamic banks NSR is negatively correlated with all variables except

CAR. Non-Islamic banks NSR is found to have a positive dependence upon CAR and ATR. NSR andDTA are adversely correlated. DTAR of interest free an interest based banks is positively associatedwith 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 correlationwith NSR and ROE but it is negatively associated with DTAR. In correlation matrix Islamic banksATR 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 negativelyassociated with DTAR and ATR but favorably related to CAR. DTAR have an adverse relationshipwith 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 positivesignificant impact on dependent variable (ROA) and all other variables have an insignificantrelationship with ROA. R squared of dependent variable for Islamic banks is 0.671548, which means67% of sample describes ROA and its F statistics is 7.769405. In case of Conventional banks ROE andCAR are favorably associated with ROA. NSR, DTAR and ATR are having a negative insignificantimpact 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 independentvariables are having an insignificant impact on dependent variable and ROE has a strong positiveassociation with ROA. R square and F statistics of combined regression model are 0.632108 and15.1201.

5. ConclusionThis 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 manmadeprinciples. Conventional banking institutions are working in Pakistan from four to five decades andhaving 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 areoutperforming conventional banks in recent financial crises. One logical reason is that Islamic banksare not dependent upon debt finance like conventional banks. This is an edge for Islamic banks overconventional banking institutions that they rely on equity financing rather than debt financing. Finallyit is reduce banks investment risk. This edge is very helpful for Islamic banks to survive ininternational financial crises.

As per findings of this study in Pakistan Islamic banks are performing better than interest basebanks. Return on Assets of Islamic banking is at optimal level and supportive than conventionalbanking organizations. Islamic banks CAR ratio is too good that is an indication of low risk andsecured financing. Conventional banks deposit to asset ratio is very attractive for potential customers

and also higher than non-conventional banks. It means conventional approach majorly relies on debtfinancing and in contrast Islamic banks are dependent upon equity financing. Over all Islamic bankshave higher growth rate in banking industry as compare to conventional banks.

ReferencesAnsari, S., & Rehman, K. (2011). Comparative Financial Performance of existing Islamic Banks andContemporary Conventional Banks in Pakistan. Paper Presented at second International Conferenceon Economics, Business and Management, IPEDR 22, 45-49.Awan, A. G. (2009). Comparison of Islamic and conventional banking in Pakistan. Proceedings secondCBRC, Lahore- Pakistan. 1-36.


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Bilal, M., Saeed, A., Gull, A. A., & Akram, T. (2013). Influence of Bank Specific and MacroeconomicFactors on Profitability of Commercial Banks: A Case Study of Pakistan.Research Journal of Financeand Accounting, 4(2), 117-126.Gull, A. A., Akram, T., Bilal, M., & Muzaffar, Z. (2013). Do Board Independence Carry Value? (ACase 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.Qureshi, M. A., & Shaikh, M. (2012). Efficiency of Islamic and Conventional Banks in Pakistan: A

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 BankingPerformance (A Case Study of Pakistan). Interdisciplinary Journal of Contemporary Research in

Business, 4(10), 393-403.Safiullah, Md. (2010). Superiority of Conventional Banks & Islamic Banks of Bangladesh: AComparative Study.International Journal of Economics and Finance, 2(3), 199-207.Samad, A. (2004). Performance of interest-free Islamic banks vis--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 andConventional 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 ConventionalBanks in GCC region.Journal of Applied Finance and Banking, 2(3), 123-161.Syafri. (2012). Factors Affecting Bank Profitability in Indonesia, Paper Presented at The 2012International Conference on Business and Management, Phuket- Thailand.Viverita. (2010). Performance Analysis of Indonesian Islamic and Conventional Banks. Electroniccopy available at: http://ssrn.com/abstract=1868938.

List of TablesTable- 1

ROE ROA NSR DTAR CAR ATR

Mean 2.46 -0.3496 47.7252 72.3556 23.9012 14.2088Median 0.09 0.02 47.7 78.75 17.65 13.61

Std. Dev. 8.979317 1.446543 10.79265 13.03161 13.73281 6.91089Observations 25 25 25 25 25 25

Descriptive Statistics (Islamic Banks)Table- 2

ROE 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

Descriptive Statistics (Conventional Banks)Table- 3

ROE OA NSR TAR CAR TR

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

Std. Dev. 20.50823 15.13897 16.77996 10.50844 12.10218 5.623013
http://ssrn.com/abstract=1868938http://ssrn.com/abstract=1868938


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Observations 50 50 50 50 50 50

Descriptive Statistics (All Banks)Table- 4

ROE NSR DTAR CAR ATR

ROE 1

NSR 0.165986 1

DTAR 0.373151 -0.26903 1

CAR -0.47588 0.364653 -0.69399 1

ATR 0.582182 -0.14538 0.262491 0.48572 1

Correlation Analysis (Islamic Banks)Table- 5

Correlation Analysis (Non-Islamic Banks)Table- 6

Correlation Analysis (Combined)


ROE 1

NSR 0.484697 1

DTAR -0.20929 -0.44872 1

CAR 0.259216 0.569388 -0.77756 1

ATR 0.121465 0.121902 0.339989 -0.17463 1


ROE 1

NSR 0.352529 1

DTAR 0.038702 -0.33473 1

CAR -0.07474 0.470585 -0.71408 1

ATR 0.240036 -0.06915 0.305751 0.44975 1


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Does Islamic Banking Have Any Future? A Comparative Study:

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