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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.

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. Thats 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



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 banks 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 banks 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 Pakistans 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


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 banks 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 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 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. 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 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


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 banks 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 students 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 banks 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 banks 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 firms net profit and total equity finance. ROE is shown in percentage.



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 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 model Yit = 0 + Xit + it Return on Assets ROAit = 0it+ 1CARit + 2NSRit + 3ATRit+ 4DTARit + 5ROEit + it Where: Yit is dependent variable. 0 represents the intercept. Xit is independent variable. it 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 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, 47.7252,37.5244 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


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 banks ROE having a favorable relationship with NSR, CAR and ATR, while negatively 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 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 banks 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 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 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.


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. 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 Banking Performance (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: A Comparative 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 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. Syafri. (2012). Factors Affecting Bank Profitability in Indonesia, Paper Presented at The 2012 International Conference on Business and Management, Phuket- Thailand. Viverita. (2010). Performance Analysis of Indonesian Islamic and Conventional Banks. Electronic copy available at: List of Tables Table- 1 Mean Median Std. Dev. Observations ROE 2.46 0.09 8.979317 25 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

Descriptive Statistics (Islamic Banks) Table- 2 ROE Mean Median Std. Dev. Observations 9.2368 11.18 27.46183 25

ROA -3.1972 1.21 21.48512 25

NSR 37.5244 35.83 20.10444 25

DTAR 76.1204 76 6.946273 25

CAR 14.1096 11.35 7.77835 25

ATR 16.4168 16.05 3.775496 25

Descriptive Statistics (Conventional Banks) Table- 3 ROE OA Mean Median Std. Dev. 5.8484 4.865 20.50823 -1.7734 0.51 15.13897

NSR 42.6248 43.3 16.77996

TAR 74.238 76.89 10.50844

CAR 19.0054 14.365 12.10218

TR 15.3128 14.995 5.623013










Descriptive Statistics (All Banks) Table- 4 ROE ROE NSR DTAR CAR ATR 1 0.165986 0.373151 -0.47588 0.582182





1 -0.26903 0.364653 -0.14538 1 -0.69399 0.262491 1 0.48572 1

Correlation Analysis (Islamic Banks) Table- 5 ROE ROE NSR DTAR CAR ATR 0.484697 -0.20929 0.259216 0.121465 -0.44872 0.569388 0.121902 -0.77756 0.339989 -0.17463 1 1 1 1 1 NSR DTAR CAR ATR

Correlation Analysis (Non-Islamic Banks) Table- 6 ROE ROE NSR DTAR CAR ATR 1 0.352529 0.038702 -0.07474 0.240036 1 -0.33473 0.470585 -0.06915 1 -0.71408 0.305751 1 0.44975 1 NSR DTAR CAR ATR

Correlation Analysis (Combined)