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ISLAMIC BANKING VERSUS

COMMERCIAL BANKING:
PROSPECTS & OPPORTUNITIES

OUTLINE  
Principals  and  development  of  Islamic  finance  
 
Theory  and  prac<ce  of  Islamic  financial  intermedia<on  
 
Theore<cal  &  prac<cal  differences  between  Islamic  &  conven<onal  banking  
 
Comparison  of  financial  ra<os  of  Islamic  and  conven<onal  banks  
 
Future  challenges  
 
Areas  for  improvement  and  steps  forward

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ISLAMIC BANKING VERSES COMMERCIAL BANKING

Principals  and  development  of  Islamic  finance
I.  Principals  of  Islamic  financial  system  
1)  Prohibi)on  of  Interest  (RIBA)  

§  “An  excess”  Any  unjus<fiable  increase  of  capital  whether  are  
loans  or  sales  in  the  central  tenant  of  the  system.  
§  Islamic  regula<ons  encourage  the  earning  of  profit  but  forbid  
the  charging  of  interest.  
   

2)  Money  as  a  poten)al  capital  

§  It  joins  hands  with  other  resources  to  undertake  a  produc<ve  
ac<vity.  

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ISLAMIC BANKING VERSES COMMERCIAL BANKING

Principals  and  development  of  Islamic  finance
3)  Risk  sharing  

§  When  interest  is  prohibited,  suppliers  of  fund  become  investors  instead  
of  creditors.    
§  Investors  &  financial  intermediary  rela<onship  is  based  on  profit  &  loss  
sharing  principals.  

4)  Prohibi)on  of  specula)ve  behavior  

§  Discouraging  hoarding  &  prohibits  transac<ng  featuring  extreme  
uncertain<es.  

5)  Sanc)ty  of  contracts  

§  Upholding  contractual  obliga<ons  &  the  disclosure  as  a  sacred  duty  to  
reduce  the  risk  of  asymmetric  informa<on  &  moral  hazard.  

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ISLAMIC BANKING VERSES COMMERCIAL BANKING

  §  Any  business  Dealing  with  alcohol.   5 ISLAMIC BANKING VERSES COMMERCIAL BANKING .  gambling  or  casinos  is   prohibited.  any  transac<on  leads  to  injus<ce  &  exploita<on  is   prohibited.   7)  Social  jus)ce   §  In  Principle  .Principals  and  development  of  Islamic  finance 6)  Sharing-­‐approved  ac)vi)es   §  Only  ac<vi<es  that  don’t  violate  the  rules  of  shariah  qualify  for   investment.

 Ci<bank…etc.   §  Not  only  Islamic  countries.Principals  and  development  of  Islamic  finance II.   §  Islamic  finance  industry  has  reached  $1.   6 ISLAMIC BANKING VERSES COMMERCIAL BANKING .   §  The  market  current  turnover  is  es<mated  to  be  $350  Billion  compared   with  $5  Million  in  1985.   §  Global  conven<onal  banks  (HSBC.  more  than  300  financial  ins<tu<ons  in  over  50   countries  prac<ce  some  form  of  Islamic  finance.  Development  &  growth  of  Islamic  finance   1)  Development  of  Islamic  finance   §  A  rapidly  growth  part  of  the  financial  sector  in  the  world  (  >15%  annual   growth  rate).4  Trillion  by  the  end  of  2011.   expected  to  be  $4  Trillion  over  medium  term.)  have  setups  separate   windows  to  offer  Islamic  banking  services.

  o   recently.  Iran.  Islamic  windows  in  leading  banks   pursuing  this  market  very  aggressively.  besides  establishing  Islamic  banks.Principals  and  development  of  Islamic  finance 2)  Emergence  &  evolu)on  of  Islamic  ins)tu)ons  in  recent  history   §  In  Muslim  countries:     o  1963.   o  Sudan.  local  saving  banks  was  established  in  Egypt  to  prac<ce  their  work  on  a  none-­‐ interest  bases  to  enhance  the  banking  habit.  many  Islamic  banks  were  established  in  different  Muslim  countries  due  to   the  sharp  increase  of  the  oil  prices.   o  Aher  1974.   §  In  the  western  world:   o  In  1983  Islamic  finance  house  started  in  Luxemburg.       7 ISLAMIC BANKING VERSES COMMERCIAL BANKING .  Pakistan  started  the  Islamiza<on  of  banking  system  during  1980s.

 the  customer  should  pay  the  bank   later  the  whole  amount.   b) Bay  Al-­‐Muajjil   §  A  sale  transac<on  with  deferred  payment  allows  the  sale  of  a  product  on  the   bases  of  deferred  payment.  Both   agree  on  a  profit  margin  added  to  the  cost.  Basic  contracts  &  instruments   1)  Financing  instruments   Used  to  finance  obliga<ons  arising  from  the  trade  and  sale  of   commodi<es  or  property  and  collateralized  by  the  product  being   financed.   8 ISLAMIC BANKING VERSES COMMERCIAL BANKING .Theory  &  prac<ce  of  Islamic  financial  intermedia<on I.  such  as:   a) Murabahah   §  A  bank  purchases  a  product  for  a  customer  who  doesn’t  have  a  capital.

Theory  &  prac<ce  of  Islamic  financial  intermedia<on c)  Bay  Al-­‐Salam   §  The  buyers  pays  the  seller  the  full  price  of  a  product  which  the  seller  promises  to   deliver  at  a  specific  future  date.   d)  Ijarah   §  A  medium  term  financial  instrument  gives  something    in  return  for  rent.   resembles  the  leasing  contract.   e)  Is<snah   §  To  facilitate  the  manufacture  of  an  asset  at  the  request  of  the  buyer.  the   transac<on  of  Is<snah  comes  into  existence.   9 ISLAMIC BANKING VERSES COMMERCIAL BANKING .  Once  the   manufacturer  undertakes  to  manufacture  the  asset  for  the  buyer.

  a) Mudarabah   §  A  fund  management  instrument  .Theory  &  prac<ce  of  Islamic  financial  intermedia<on 2)  Inves)ng  instruments   Vehicles  for  capital  instrument  in  the  form  of  a  partnership.   whereby  an  investor  entrust  capital  to  an  agent  to  undertake  a  project.  could    be  short.  medium  or  long  term.   b) Musharakah   §  An  equity  partnership  instrument  which  could  be  either  medium  or  long   term  partnership.   10 ISLAMIC BANKING VERSES COMMERCIAL BANKING .  where  two  or  more  persons  combine  either  their   capital  or  their  labor  to  share  the  profit  &  losses.

  Structure  &  components  of  financial   statements  for  Islamic  banks   11 ISLAMIC BANKING VERSES COMMERCIAL BANKING .Theory  &  prac<ce  of  Islamic  financial  intermedia<on II.

Theory  &  prac<ce  of  Islamic  financial  intermedia<on Theore)cal  Balance  Sheet  of  an  Islamic  bank  based  on  maturity  profile   12 ISLAMIC BANKING VERSES COMMERCIAL BANKING .

Theory  &  prac<ce  of  Islamic  financial  intermedia<on Theore)cal  Balance  Sheet  of  an  Islamic  bank  based  on  func)onality   13 ISLAMIC BANKING VERSES COMMERCIAL BANKING .

Theory  &  prac<ce  of  Islamic  financial  intermedia<on Composi)on  of  an  Islamic  bank  Balance  Sheet   14 ISLAMIC BANKING VERSES COMMERCIAL BANKING .

Theory  &  prac<ce  of  Islamic  financial  intermedia<on 15 ISLAMIC BANKING VERSES COMMERCIAL BANKING .

ISLAMIC BANKING DEPOSIT PRODUCTS CONTRACT OF WADIAH Wadiah is a contract ( akad )between the owner of goods and custodian of the goods. destroyed etc. To ensure the safe custody of the goods 16 ISLAMIC BANKING VERSES COMMERCIAL BANKING . To protect the goods from being stolen.

ISLAMIC BANKING DEPOSIT PRODUCTS CONTRACT OF WADIAH 17 ISLAMIC BANKING VERSES COMMERCIAL BANKING .

The bank requests permission to make use of the customers’ funds for investment purposes. 18 ISLAMIC BANKING VERSES COMMERCIAL BANKING .ISLAMIC BANKING DEPOSIT PRODUCTS CONTRACT OF WADIAH Operates under the contract of Wadiah Yad Dhamanah (guaranteed custody). The bank accepts deposits from its customers looking for safe custody and convenience.

19 ISLAMIC BANKING VERSES COMMERCIAL BANKING . However.ISLAMIC BANKING DEPOSIT PRODUCTS CONTRACT OF WADIAH The customers may withdraw their balances at any time. the bank may at its absolute discretion rewards the customers by declaring profits to them. Profit generated from the use of the customers’ funds belongs to the bank.

ISLAMIC BANKING DEPOSIT PRODUCTS CONTRACT OF WADIAH DISCRETIONARY REWARD Under the contract of Wadiah. The owner/depositors too cannot demand any rewards or return from their Bank on their savings. the custodian i.e. Wadiah is purely a contract on safe custody of goods without any promise on rewards or returns. 20 ISLAMIC BANKING VERSES COMMERCIAL BANKING . the Bank is not allowed to mention or to promise any reward on the deposit received.

There should be no promise of return or reward either by the borrower or the lender. The Bank cannot demand the borrower to pay anythingabove the principal loan amount. The Bank may use an appropriate portion of its fund to provide benevolent loans to certain selected customers. The borrower is obliged to pay only the principal amount of the loan. 21 ISLAMIC BANKING VERSES COMMERCIAL BANKING .ISLAMIC BANKING DEPOSIT PRODUCTS CONTRACTOF QARDH Qardh literally means a debt or loan without interest . This is an act of social responsibility to help a person who is in need.

22 ISLAMIC BANKING VERSES COMMERCIAL BANKING . (who acts as the entrepreneur) for the purpose of participating in the profits made from the utilisation of the fund. who is the owner of the capital places a specified sum of money with the Bank.ISLAMIC BANKING DEPOSIT PRODUCTS CONTRACT OF MUDHARABAH The depositor.

The customer does not participate in the management of the funds. The customer is the “Capital Provider”. the customer bears all the losses.ISLAMIC BANKING DEPOSIT PRODUCTS Operates under the contract of Mudharabah (Trustee Profit Sharing). Both parties agree with the profit distribution / sharing ratio. 23 ISLAMIC BANKING VERSES COMMERCIAL BANKING . Profits generated from the use of the customers’ funds will be distributed according to the predetermined ratio. In the event of a loss. while the Bank acts as the “entrepreneur”. The Bank accepts deposits from its customers looking for investments opportunities.

ISLAMIC BANKING FINANCING PRODUCTS 24 ISLAMIC BANKING VERSES COMMERCIAL BANKING .

 it   resembles  universal  banks.   § A  hybrid  of  conven<onal  commercial  banks  &  investment  banks.Theory  &  prac<ce  of  Islamic  financial  intermedia<on III.  todays’  Islamic  financial  ins<tu<ons  can  be  divided  into   the  following  broad  categories   1)  Islamic  banks     § Could  be  public  or  private  sector.   25 ISLAMIC BANKING VERSES COMMERCIAL BANKING .  Islamic  financial  ins<tu<ons  in  prac<ce   Early  forms  of  Islamic  financial  ins<tu<ons  were  concentrated  in  commercial   banking  ac<vi<es.   2)  Islamic  windows   § A  setup  in  a  conven<onal  bank  that  offer  Shariah-­‐compliant  product.

  26 Ijarah.  market-­‐making   and  under  wri<ng  opportuni<es.   §  Succeeded  in  developing  innova<ve  large-­‐scale  transac<ons  in   infrastructure  finance.  3.   §  Four  models:   1.   Along  the  lines  of  corpora<ve  socie<es.   Equity  partnership  (diminishing    Musharaka).  4.   4)  Islamic  mortgage  companies   §  Targeted  at  the  housing  market  for  Muslim  communi<es  in  western   countries.  (sales  transac<on).  2.   ISLAMIC BANKING VERSES COMMERCIAL BANKING .Theory  &  prac<ce  of  Islamic  financial  intermedia<on 3)  Islamic  investment  banks  &  funds   §  Aiming  to  capitalize  on  large  investment  syndica<ons.   Murabahah.

  27 ISLAMIC BANKING VERSES COMMERCIAL BANKING .  they  are  not  allowed  to   accept  deposits.  The  par<cipants  agree  to  share   their  losses  by  contribu<ng  periodic  premiums  in  the  form  of  investment.  Unlike  the  Islamic  bank.Theory  &  prac<ce  of  Islamic  financial  intermedia<on 5)  Islamic  insurance  companies  (Takaful)   §  Takaful  means  mutual  or  joint  guarantee.     §  Two  types.  Mul<purpose  (more  than  one  investment  purpose)  and   Specific  purpose.   They  have  to  redeem  the  residual  value  of  profits  aher  fulfilling  the  claims   and  premiums.  Takaful  is  a  given  solidarity.   6)  Mudaraba  companies   §  Similar    to  that  of  closed-­‐end  fund  managed  by  specialized  professional   management  companies.  Funded  by  equity  capital.  which  is  a  cri<cal  difference  between  contemporary   insurance  and  Takaful.

09%  -­‐  2.5%  to   3.  Different  concepts  of  borrowing.82%.30%  per  annum  while   borrowing  rate  average  ranged  from  11.20%    -­‐  11.  financing  &  investment   1)  Different  modes  of  borrowing   §  According  to  the  state  bank’s  of  Pakistan  2008.  Islamic  banks  average  rate  on  PLS  deposits  ranged  from  3.   28 ISLAMIC BANKING VERSES COMMERCIAL BANKING .  Profit  &  loss  sharing  deposits  earn  more  than  1%  higher.Theore<cal  &  prac<cal  differences  between  Islamic  &   conven<onal  banking I.79%.56%.  conven<onal  banks   average  for  deposits  ranged  from  2.  The  difference  is   7.

  29 ISLAMIC BANKING VERSES COMMERCIAL BANKING .   3)  Different  modes  of  investment   §  Conven<onal  banks.  and  only  for  produc<on   purposes.  term   finance  cer<ficates  for  security.  can  not  invest  in  government  bonds.  Nevertheless.  the   Sukuk  issued  by  Islamic  government  would  act  as    a  prac<cal  solu<on  for   (IB)  liquidity.  they  suffer  badly  in  case  of  stock  market   crash.  50%  in  government  treasury  bills.   §  Islamic  banks.Theore<cal  &  prac<cal  differences  between  Islamic  &   conven<onal  banking 2)  Different  modes  of  financing   §  Conven<onal  banks  high  rates  of  interest  on  all  types  of  loans.  Which  may   be  the  cause  of  the  business  failure  &  the  default  of  the  loan.  Islamic  bank   provides  loans  on  profit  &  loss  (PLS)  bases.  bonds.

  Different  visualiza<on  of  the  role  of  money   1)  Conven)onal  banks   §  Uses  interest  to  make  money  out  of  money.   2)  Islamic  banks   §  Use  money  as  a  medium  of  exchange  to  facilitate  trade  transac<ons.  If  finance  takers  generate  profit  they  will   share  it  with  the  Islamic  bank.   30 ISLAMIC BANKING VERSES COMMERCIAL BANKING .  They   supply  money  to  traders  to  purchase  real  assets  or  industrialists  to   produce  value-­‐added  products.  If  they  suffer  losses  the  bank  will  share  the   loss.Theore<cal  &  prac<cal  differences  between  Islamic  &   conven<onal  banking II.  They  use  money  as  a   commodity  which  is  bought  &  sold.

Theore<cal  &  prac<cal  differences  between  Islamic  &   conven<onal  banking III.  Also  banks   receive  fixed  rates  from  borrowers  regardless  their  losses  in  case  of   business  failure.  The  bank  as  well.   §  Islamic  banks.   31 ISLAMIC BANKING VERSES COMMERCIAL BANKING .  Different  altude  of  risk  sharing  &  income  distribu<on   1)  Different  concepts  of  risk  sharing   §  Conven<onal  banks.  their  deposits  and  investors  are  ready  to  share  risk  with   the  bank  in  case  of  financial  shocks.  is  responsible  to   take  risk  in  case  of  business  failure.  their  depositors  do  not   share  the  risk  with  the  bank  in  case  of  economic  shock.  being  interest  rates  based.

 While  the   conven<onal  bank  works  for  a  specific  class  that  is  rich.   32 ISLAMIC BANKING VERSES COMMERCIAL BANKING .  unlike   Islamic  financial  system  which  play  a  vital  role  in  eradica<on  of  poverty   through  Zakat  and  profit  &  loss  sharing  principle.   3)  Having  different  objec)ves  and  goals   §  Islamic  bank  works  for  all  benefit  of  the  overall  society  and  for  equitable   alloca<on  of  resources  through  credit  distribu<on.Theore<cal  &  prac<cal  differences  between  Islamic  &   conven<onal  banking 2)  Different  approaches  of  income  distribu)ons   §  The  interest-­‐based  financial  system  is  pro-­‐rich  and  an<  poor.

07 -0.93 (ROE) Return on Equity 1.Comparison  of  financial  ra<os  of  Islamic  and   conven<onal  banks Based  on  the  findings  of  a  recent  research  in  Pakistan  on  two  similar  groups  of   conven)onal  &  Islamic  banks  (Average  of  6  banks  each  group).079 -0.34 Ratios 33 ISLAMIC BANKING VERSES COMMERCIAL BANKING .27 (EPS) Earning per Share 0.75 (ROD) Return on Deposits 0.   1)  Earning  ra)os   Islamic Banks Conventional Banks (ROA) Return on Assets 0.38 -0.297 -2.

3 8.17 Ratios 34 ISLAMIC BANKING VERSES COMMERCIAL BANKING .Comparison  of  financial  ra<os  of  Islamic  and   conven<onal  banks 3)  Debt  management  ra)os   Islamic Banks Conventional Banks Debt / equity 2.85 Equity / equity + debt 31.78 0.3 17.0 Deposit times capital 3.71 Debt / assets 0.78 5.

06 5.24 ISLAMIC BANKING VERSES COMMERCIAL BANKING .Comparison  of  financial  ra<os  of  Islamic  and   conven<onal  banks 2)  Asset  quality  management   35 Ratios Islamic Banks Conventional Banks NPLs / advances Non-performing loans / advances 1.22 6.89 NPL / deposits Non-performing loans / deposits 1.09 40.88 Provisions / NPLs Provision / non-performing loans 47.

7% 1.83% Ratios 36 ISLAMIC BANKING VERSES COMMERCIAL BANKING .Comparison  of  financial  ra<os  of  Islamic  and   conven<onal  banks 4)  Liquidity  ra)os   Islamic Banks Conventional Banks Earning assets / total assets 95% 93% Advances / deposits 83% 70% Yield on earning assets 2.

78% 14.59% Equity / deposits 36.Comparison  of  financial  ra<os  of  Islamic  and   conven<onal  banks 5)  Solvency  ra)os   Islamic Banks Conventional Banks Equity / total assets Capital adequacy ratio (CAR) 21.79 115.2% 20.98 Ratios 37 ISLAMIC BANKING VERSES COMMERCIAL BANKING .09% The earning assets / deposits 143.

25% Islamic Banks Conventional Banks Borrowing / total assets 4.05% 7)  Investment  to  deposit  ra)os   Ratios 8)  Borrowing  ra)os   Ratios 38 ISLAMIC BANKING VERSES COMMERCIAL BANKING .86% 11.92% Borrowing / total advances 12.85% Investments / total assets 4.39% 23.55% Islamic Banks Conventional Banks Investments / deposits 15.93% 16.25% Borrowing / total deposits 5.6)  Cash  to  deposit  ra)o   Ratios Islamic Banks Conventional Banks Cash & balance / total deposits 11.55% 12.37% 4.37% 9.

Future  Challenges 1)  Liquidity   §  Liquidity-­‐  enhancing  financial  instruments  &  the  development  of  capital   market.   3)  Concentrated  banking   §  Diversifying  their  base  of  depositors.  introduc<on   of  Internet  banking.   §   Measurement  &  management  of  risk  need  to  be  supplemented  with   analy<cal  method.   2)  Limited  scope   §  Can  benefit  from  economies  of  scale  &enhancement  of  scope.   39 ISLAMIC BANKING VERSES COMMERCIAL BANKING .   4)  Concentrated  banking   §  Risk  management  framework  can  be  enhanced  by  improving  the   transparency  in  current  financial  disclosure.  reduce  their  exposure.  geographical  diversity  on  the  liabili<es  side.  Both   approaches  offer  diversifica<on  benefits.

  ü  Crea)ng  a  secondary  market  to  enhance  the  liquidity.  provided  to  be   Shariah  complaint.   ISLAMIC BANKING VERSES COMMERCIAL BANKING .  to  reduce  the  risk  of  asset  backed  securi<es.  Shariah  Standards   across  markets  &  borders.  new  securi<es  or  new   process  of  crea<ve  solu<on  to  corporate  finance  problems.  Joalah.  &  Harmoniza)on  of.   ü  There  is  need  to  achieve  Uniformity  in.   ü  To  develop  Fee  -­‐Based  Services  like.  development  &   implementa<on  of  innova<ve  financial  instruments.   ü  There  is  need  to  establish  suppor<ng  ins<tu<ons  to  act  as  a  Lender  of  Last   Resort  .  Wakalah  &  Kifalah  to  exploit  the   full  capabili<es  of  Islamic  banks  by  diversifying  the  scope  of  non  bank  financial   services.Areas  of  improvement  &  steps  forward 40 ü  To  enhance  Financial  Engineering  that  includes  the  design.   ü  Developing  benchmarks  based  on  the  rate  of  return  reflec<ng  Islamic  modes   of  financing  instead  of  using  interest  base  benchmarks  such  as  the  London   interbank  offered  rate  (LIBOR)  which  has  been  accepted  on  an  adhoc  based.  &  standardizing   contracts.

 also  it  will  economically   empowered  the  poor  segments  of  society  since  they  will  be  able  to  move   from  being  non-­‐bankable  to  bankable.  ins<tu<onal   investors.  much  needed  for  enhancing  liquidity  in  the  market.   ü  Having  a  Shariah  board  for  every  ins<tu<on  is  not  efficient.  A  Shariah  board   for  the  system  as  a  whole  is  needed  to  ensure  that  rules  are  defined  &   enforced  in  compliance  with  the  contractual  obliga<ons  to  all  stockholders.     41 ISLAMIC BANKING VERSES COMMERCIAL BANKING .Areas  of  improvement  &  steps  forward ü  Standardizing  the  opera)ons  &  instruments  will  pave  the  way  for  pooling   assets.   ü  By    expanding  the  scope  of  services.   ü   Well  developed  Islamic  capital  market  will  benefit  borrowers.     ü  A  well  developed  Islamic  microfinance  industry  will  promote  economic   development  in  underdeveloped  Islamic  countries.  this  will  expand  the  base  of  the   depositors  &  investors.  together  with  enhancing  the  stability  of  Islamic  banks.  Islamic  bank  could  spread  the  fixed   costs  since  they  are  similar  to  universal  banking  in  a  form  of  hybrid  between   commercial  &  investment  banking.

Questions? 42 ISLAMIC BANKING VERSES COMMERCIAL BANKING .