Islamic banking and Conventional banking : Risk management and effect of global financial crisis

NORAINI BT MANANMOHD NUR AZRUL BIN MOHD TARMIZIMOHD NAZIM MAT NAWI

INTRODUCTIONConventional Bank : banks earn profits by

purchasing deposits from the depositors at a low interest rate, then reselling those funds to the borrowers at higher interest rate, based on its competitive advantage at gathering information and underwriting risk.

Islamic Bank : same role as an intermediary, but did not receive a set interest rate and not the borrowers who have been appointed for the depositor, the amount of profits based on revenue sharing arrangement with the investors, and also with the borrowers.

Early sixties/seventies – muslim concern about islam (back to religion spirit)

Dr. . Ahmed Al-Naggar -that established as company based on Islamic principles that known as Mit Ghamr Local Saving Bank.

In 2009 – Islam was 2nd largest religion in the world that has 1.57bilion adherents, making 23% of the world population.

Islamic law and Islamic finance proclaim that Islamic law forbids interest (riba) ( Mahmoud A.El-Gamal)

The source of shariah include theAl- Quran, As-Sunnah (hadith), Ijma’, Qiyas and Ijtihad.

The basis that be used was : -prohibition of collecting the interest

(riba’), -prohibition in entering the uncertain

contract/process (gharar)-prohibition of gambling (masir)-prohibition of the use non-halal product

such as pork and alcohol.

The differences between Islamic banking and Conventional banking

Conventional systemMoney is a product besides medium of

exchange and store of value. Time value is the basis for charging interest on

capital. Interest is charged even in case, the

organization suffers losses. Thus no concept of sharing loss.

While disbursing cash finance, running finance or working capital finance, no agreement for exchange of goods & services is made.

Due to non existence of goods & services behind the money while disbursing funds, the expansion of money takes place, which creates inflation.

Due to inflation the entrepreneur increases prices of his goods & services, due to incorporating inflationary effect into cost of product.

Bridge financing and long term loans lending is not made on the basis of existence of capital goods. Rather, they are disbursed on the basis of project feasibility and credibility of the entrepreneur.

Government very easily obtains loans from Central Bank through Money Market Operations without initiating capital development expenditure.

The expanded money in the money market without backing the real assets, results deficit financing.

Real growth of wealth does not take place, as the money remains in few hands.

Due to failure of the projects the loan is written off as it becomes non performing loan.

Debts financing gets the advantage of leverage for an enterprise, due to interest expense as deductible item form taxable profits. This causes huge burden of taxes on salaried persons. Thus the saving and disposable income of the people is effected badly. This results decrease in the real gross domestic product.

Due to decrease in the real GDP, the net exports amount becomes negative. This invites further foreign debts and the local-currency becomes weaker.

Islamic systemReal Asset is a product. Money is just a medium

of exchange. Profit on exchange of goods & services is the

basis for earning profit. Loss is shared when the organization suffers

loss. The execution of agreements for the exchange

of goods & services is must, while disbursing funds under Murabaha, Salam & Istisna contracts.

Due to existence of goods & services no expansion of money takes place and thus no inflation is created.

Due to control over inflation, no extra price is charged by the entrepreneur.

Musharakah & Diminishing Musharakah agreements are made after making sure the existence of capital good before disbursing funds for a capital project.

Government can not obtain loans from the Monetary Agency without making sure the delivery of goods to National Investment fund.

Balance budget is the outcome of no expansion of money.

Real growth in the wealth of the people of the society takes place, due to multiplier effect and real wealth goes into the ownership of lot of hands.

Due to failure of the project, the management of the organization can be taken over to hand over to a better management.

Sharing profits in case of Mudarabah and sharing in the organization of business venture in case of Musharakah, provides extra tax to Federal Government. This leads to minimize the tax burden over salaried persons. Due to which savings & disposable income of the people is increased, which results the increase in the real gross domestic product.

Due to increase in the real GDP, the net exports amount becomes positive, this reduces foreign debts burden and local-currency becomes stronger.

Balance Sheet Analysis of Islamic and Conventional Banking In financial risk management, there are

many method and approaches can be adopted.

In top-down approach, the balance sheet analysis can be done in evaluating Islamic as compared to conventional banking the risks.

The balance sheet highlights the financial condition of a company and is an integral part of the financial statements.

Understanding the structure and composition of balance sheet is important in managing the risks associated by the institutions.

Thus, the assets and liabilities can be a good components in the structure and level of risks exposed

Balance Sheet of Conventional Banking (CB)The composition of liability in the balance sheet is

accepts demand and saving deposits, issues term certificates such as certificate of deposits (CD), and has capital.

For the asset part, it can consists of marketable securities, trading accounts, lending to corporations and to consumers.

Those assets and liabilities components can be illustrated by the following table.

Assets LiabilitiesLoans and advances to customers

Customers’ deposits

Cash and cash balances with other banks

Due to banks and other financial institutions

Investments in associates, subsidiaries and joint ventures

Other liabilities

Financial assets held for trading Sundry creditorsCash and cash balances with the central bank

Equity and reserves

Balance Sheet of Islamic Banking (IB)As discussed earlier on, Islamic banking and

conventional banking are different in nature and thus reflect the nature of risks exposed

The cornerstone of Islamic banking is mudarabah contract, the use of fund available in the bank based on some form of profit sharing between depositors , bank and entrepreneur.

The bank can be viewed as intermediary of depositors and entrepreneurs in managing or matching the fund and profit is on the services rendered.

Those application of funding (assets) and sources of funding (liabilities) components can be illustrated by the following table.

Application of funding Sources of fundingCash balances Demand deposits (amanah)Financing assets (murabaha,

salam, ijara, istisna)

Investment accounts (mudarabah)

Investment assets (mudarabah, musharakah)

Special investment accounts (mudarabah, musharakah)

Fee-based services (ju’ala, kafala, and so forth) Reserves

Non-banking assets (property) Equity capital

Comparison of the Balance SheetsEvaluating of the CB balance sheet, it can be seen

that the first risk easily observed is the asset-liability mismatch.

Fund from the depositors are not pre-set liability to be match to thee types of usage in the asset column.

Thus it may create mismatch of asset-liability that can cause uncertainty in meeting risk-return profile of the depositors.

Even after it is matched, then the maturity of the asset-liability expose the bank to the risk of maturity mismatch.

As fund from the depositors consider as short-term in nature, it is used to finance medium-long assets.

Therefore, the bank is exposed to liquidity risk in meeting future obligation of withdrawal from depositors.

Some other risk associate by the bank are market risk, credit risk and rate of return risk.

In contrast with IB, the nature of its balance sheet is to pass and manage the fund from depositor to entrepreneur.

It able to resolve mismatch issues of asset-liability of CB.

However, some other issues need to be address such as estimation and accrual of ex-post returns and the treatment of intra-period withdrawal of deposits (Hennie van Greuning, Zamir Iqbal , 2009).

Conventional bank make use of fixed income that provide low credit risk debt securities.

Islamic banking assets are investments backed by real assets as opposed to paper assets like conventional banking.

Thus, it reduce its exposure to risks such as interest rate risk.

The current innovation of sukuk provide alternative for Islamic banking to diverse its portfolio.

In Islamic bank, the asset and financing are coupled together as compared to conventional bank that separated asset and loan that financing its from depositors.

It can be seen in the asset column of Islamic bank where there is lack of liquid securities due to short of shariah-compliance instrument available.

Perhaps in future, those Islamic financial instruments will be available.

Due to prohibition of interest, Islamic bank will not use interest-bearing debt to finance assets.

As the result, the bank will not have leveraging issues that can effect one the financial crisis occur.

The issues will be discussed in the next part.

Effect of Global Financial Crisis : Islamic Banking versus Conventional Banking It is the current debate that Islamic finance provide

s more stability due it main principles adopted.For the recent financial crisis occurred, many try to

compare and evaluate Islamic finance and how Islamic banking effected by the crisis.

Researchers try to provide answers or proof for the subject matter.

Arguments such as Islamic banking is insulated from the crisis, experience positive impact and so on.

Research studies prior to recent global financial crisis have generally concluded

that the performance of Islamic banks have been better than conventional banks

Islamic banks did delivered better in profitability and were higher capitalized than conventional banks over the period of 2006 to 2009. (Sat Paul Parashar , Jyothi Venkatesh, 2010).

However from the same studies, it is also found that during crisis, Islamic banking suffered more in terms of capital adequacy and leverage while conventional banking suffered more in terms of return on average assets and liquidity.

The empirical studies to various Islamic countries like Egypt and Malaysia and almost all of them, have concluded that Islamic banking performance is relatively better than its conventional counterparts (Zineldin, M., 1990).

Islamic bank in some ways do actually have positive correlation toward what happen to conventional bank.

The profits of Islamic banks could be affected by the international financial crisis, but not the capital, which is protected by Islamic banking unlike conventional banks

It also because Islamic banks do not deal in debt trading and avoid the market speculation that takes place in European and American banks.

There is a strong rationale behind the prohibition of interest as it will make the financial system healthier and more stable by injecting greater discipline into it (Dr. M. Umer Chapra, 2007).

Conclusion Islamic finance does demonstrate good

banking behavior . Islamic financial institutions work on a

philosophy of prohibiting transactions considered immoral and promoting greater social justice by sharing risk and reward.

It help to promote the industry not to be too greed as it will cause instability in the financial system.

It is believed that the recent financial crisis has help to uphold and promote the Islamic banking and Islamic finance as well as.

Balance sheet analysis: Islamic vs. conventional, Hennie van Greuning, Zamir Iqbal, 2009, http://www.newhorizonislamicbanking.com/index.cfm?action=view&id=10862&section=features

http://www.islamic-foundation.org.uk/IslamicEconomicsPDF/Hassan-financialcrisis-if.pdf

Zineldin, M. (1990). The economy of money and banking: a theoretical and empirical study of Islamic interest-free banking, Stockholm: Almquist and Wiksell international.

ISLAMIC BANKING IN THE PREVAILING INTERNATIONAL FINANCIAL PERSPECTIVE, Dr. M. Umer Chapra*, 2007, Islamic Research and Training Institute, Islamic Development Bank Jeddah, Saudi Arabia, www.muchapra.com

www.learnislamicfinance.comCompetitive conditions in Islamic and

conventional banking: A global perspective. Rima Turk Ariss, 2010, Review of Financial Economics VOL 19, page 101–108

Liquidity Risk Management: A comparative study between Conventional and Islamic Banks of Pakistan . Muhammad Farhan Akhtar, Khizer Ali, Shama Sadaqat .Hailey College of Commerce, University of the Punjab, Lahore, Pakistan. Jan 2011. Interdisciplinary Journal of Research in Business Vol. 1, Issue. 1, (pp.35-44)