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Performance of Islamic Banking and Conventional Banking in Pakistan: A Comparative Study
Master Degree Project in Finance Syed Adeel Akbar Supervisor: Miss Nosheen Examiner: _____________________ 1

Very first I would like to thank my ALLAH Almighty who gave me the courage, health, and strength to complete my work in due time and without whose help this study which required too much effort would have not been possible to complete within the period. Inspiration, support, guideline, corrections, advises are the key factors required from the supervisor to be pinned down and complete a project of a good standard and a quality within the specified time. I will feel pleasure to extend my gratitude and give due respect to my supervisor Miss Nosheen who is always been there in need of time

and who gave me all these key elements to complete my project within the time frame. My thanks are also due to my examiner ____________________ whose precious comments and advices made a vast contribution in improving my project. Last but not least, I am very thankful to my entire family for moral support and pray for my health and successful completion of my report within time limits. Syed Adeel Akbar

Islamic banking and finance in Pakistan started in 1977-78 by removing interest according to the Principles of Islamic Shariah in Islamic banking practices. Since then, changings in financial system to allow the issuance of new interest-free tool of corporate financing, announcement of ordinance to permit the organization of Mudaraba companies and flowing of Mudaraba Certificates, constitution of Commission for Transformation of Financial System (CTFS), and the organization of Islamic Banking Department by the State Bank of Pakistan are some of the key steps taken place by the governments. The purpose of this study is to examine and to assess the performance of the Islamic banks in Pakistan, i.e. Meezan Bank Limited (MBL) and Bank Islami in comparison with that of a group of 3 Pakistani conventional banks. The study evaluates performance of the Islamic banks in profitability, liquidity, risk, and efficiency for the period of 2007-2009. Financial ratios (15 in total) such as Return on Asset (ROA), Return on Equity (ROE), Yield on Earning Assets, Cash to deposit to deposits ratio, Asset Utilization (AU), and other major ratios are used to evaluate banking performances. Finally

policy recommendation also given in order to how to improve performance of respective banks.


4.3.2 4.4 5 5.1 5.2 6


1.1 INTRODUCTION TO THE STUDY: Islamic banking emerged as a practical reality and started functioning in 1970s. Since then it has been growing continuously all over the world. Presently, Islamic banking industry has reached US$1.0 trillion US dollars by the end of 2008. International Rating Agency, Standard & Poor estimates that Islamic financial industry has potential to grow to US$4.0 trillion over medium term. It is surprising to note that global conventional banks like HSBS, Standard Chartered Bank, Deutsche Bank, Citibank, etc, have also set up separate Windows/Divisions to structure Islamic financial products and are offering Islamic banking services to their Muslim clients and even to those non-Muslim clients who are interested in profit and loss sharing (PLS) financial instruments. UK, France, China, Singapore and many other countries have developed special regulatory to facilitate the working of Islamic banking. The speed of the growth of Islamic banking all over the world including Pakistan has been expedited since 2002. The underlying objective of this study is to investigate the phenomenon that conventional banking, which has been operating for the last three centuries on strong footing, have started tumbling steeply in the last few decades while Islamic banking has been expanding all over the world particularly in Muslim countries with fast speed 5

Although, Islamic banking in Pakistan started around three decades ago with an initiative of removing of interest from the operations of specialized institution and commercial banks in 1977-78, but the serious steps have been the part of recent past only when in January 2000, State Bank of Pakistan (SBP) constituted a Commission for Transformation of Financial System (CTFS) to introduce Shariah compliant modes of financing, and, on 15 September 2003,6 when the State Bank of Pakistan (SBP) established the Islamic Banking Department. As an outcome of these efforts, Islamic banking is now playing an important role in financing and contributing to different economic and social sectors in the country in accordance with the principles of Islamic Shariah in Islamic banking practices. To give a real increment to Islamic banking operations in Pakistan, in an historic beginning, in January 2002, Meezan Bank Limited was granted first Islamic Banking License by the State Bank of Pakistan to be treated as first full-fledged Islamic bank in Pakistan. Islamic banks in Pakistan are only six in total and majority of these Islamic banks started their operations recently except Meezan Bank Limited which is in operation for last more than 6 years. On the other side, conventional commercial banks in Pakistan are comparatively large in size and number, and majority of these banks are present in Pakistan for more than a decade. 1.2 THE SCOPE OF THE STUDY: The scope and objective of the study is to examine and analyze the experience with Islamic banking to assess the Islamic banks performance in comparison with the group of 3 conventional banks in Pakistan. Since MBL and Bank Islami have network over 100 branched and experienced domestic private Islamic banks in Pakistan, it will give us some room to generalize our results with the consideration of performance assessment of Islamic banks in Pakistan. The study will also provide us some understanding about the performance of Islamic banking in comparison to conventional banking in the country.

Another important reason for selecting MBL and Bank Islami is the data availability and the fact of vast network of branches in Pakistan. This also stems reason for choosing latest 3 years (2006 to 2008) to accomplish our analysis. Moreover, 3 conventional have been selected on merit in that these banks, at large, duly represent private banking sector of Pakistan. Government possessed banks and privatized banks have not been made part of this community due to the fact that most of government possessed banks and all privatized banks are quite old and large as compared to the private sector banks in Pakistan. Cause for not selecting foreign bank, whether Islamic or conventional, is to look on financial performance of domestic banks only.

1.3 RESEARCH QUESTION: The main theme of this study is to investigate the phenomenon of Islamic banking and compare it with the conventional banking in the perspective of overall operational framework of banking sector in Pakistan.

1.4 LIMITATIONS OF THE STUDY: There are two basic limitations of this study, which are; 1. In KPMG Banking Survey, Pakistani banking sector has been bifurcated into three segments: large size banks, medium size banks and small size banks on the basis of their size, assets, deposits, loans, and financing of banks. Islamic banks have been included into small size banks, because they are new and take time to become big banks and we are going to examine these new small size Islamic banks with large size conventional banks having strong system from many centuries. 2. Among different instruments and techniques different authors used as performance measure, financial ratios found to be commonly used in the literature. For the study, we used financial ratios to measure and compare

Islamic bank and conventional banks performances in the profitability, liquidity, risk & being solvent, and efficiency.

The ratios analysis is one of the most powerful tools of financial management. Though ratios are simple to calculate and easy to understand, they suffer from serious limitations. Limitations of financial statements: Ratios are based only on the information which has been recorded in the financial statements. Financial statements themselves are subject to several limitations. Thus ratios derived, there from, are also subject to those limitations. For example, non-financial changes though important for the business are not relevant by the financial statements. Financial statements are affected to a very great extent by accounting conventions and concepts. Personal judgment plays a great part in determining the figures for financial statements. Comparative study required: Ratios are useful in judging the efficiency of the business only when they are compared with past results of the business. However, such a comparison only provide glimpse of the past performance and forecasts for future may not prove correct since several other factors like market conditions, management policies, etc. may affect the future operations. Ratios alone are not adequate: Ratios are only indicators; they cannot be taken as final regarding good or bad financial position of the business. Other things have also to be seen. Problems of price level changes: A change in price level can affect the validity of ratios calculated for different time periods. In such a case the ratio analysis may not clearly indicate the trend in solvency and profitability of the company. The financial statements, therefore, be adjusted keeping in view the price level changes if a meaningful comparison is to be made through accounting ratios. Lack of adequate standard: No fixed standard can be laid down for ideal ratios. There are no well accepted standards or rule of thumb for all ratios

which can be accepted as norm. It renders interpretation of the ratios difficult





2.1 EVOLUTION OF ISLAMIC BANKS: The first modern experiment with Islamic banking was undertaken in Egypt under cover, without projecting an Islamic image, for fear of being seen as a manifestation of Islamic fundamentalism which was anathema to the political regime. The pioneering effort, led by Ahmad El Najjar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in l963. This experiment lasted until l967 (Ready l98l), by which time there were nine such banks in the country. These banks, which neither charged nor paid interest, invested mostly by engaging in trade and industry, directly or in partnership with others, and shared the profits with their depositors. Thus, they functioned essentially as saving- investment institutions rather than as commercial banks. The Nasir Social Bank, established in Egypt in l97l, was declared an interest-free commercial bank, although its charter made no reference to Islam or Shariah (Islamic law). The IDB was established in l974 by the Organization of Islamic Countries (OIC), but it was primarily an inter-governmental bank aimed at providing funds for development projects in member countries. The IDB provides fee- based financial services and profit-sharing financial assistance to member countries.

2.2 ISLAMIC BANKING: Islamic banking is the system of banking consistent with principles of Islamic law (Shariah) and guided by Islamic economics. Islamic economics is referred to that body of knowledge which helps realize human well-being through an allocation and 9

distribution of scarce resources that is in conformity with Islamic teachings without unduly curbing individual freedom or creating continued macroeconomic and ecological imbalances (Chapra 1996). A key element of Islamic economics is distribution of equitable rewards to the different factors of production. Islamic economic system seeks system of Redistributive justice where concentration of wealth in a few hands is countered and flow of money into the economy is fluent. Islamic banking is, therefore, seen as a lynchpin to achieving the economic and social goals of the Islamic economic system As system of Islamic banking is grounded in Islamic principles and all the undertakings of the banks follow Islamic morals so it could be said that financial transactions within Islamic banking are a culturally-distinct form of ethical investing. Two basic principles behind Islamic banking are the sharing of profit and loss and, significantly, the prohibition of Usury, the collection and payment of interest, also commonly called Riba in Islamic discourse. Although collecting and paying interest is not permitted under Islamic law, revenue-sharing arrangements are generally permitted. Riba is forbidden by the Qur'an. For example: And that which you give in gift (loan) (to others), in order that it may increase (your wealth by expecting to get a better one in return) from other peoples property, has no increase with Allh; but that which you give in Zakt (sadaqa - charity etc.) seeking Allhs Countenance, then those, they shall have manifold increase. Sura ArRum (30:39). That they took riba (usury), though they were forbidden and that they devoured menssubstance wrongfully We have prepared for those among men who reject faith a grievous punishment. Sura An-Nisa (4:161). However, this does not mean that Islam prohibits any gain on principle sums. In Islam, profit is the recognized reward for capital. When capital employed in permissible business yields profit that profit (excess over capital) becomes the rightful and just claim of the owner of the capital. As a corollary, the risk of loss also rests exclusively with the capital and no other factor of production is expected to incur it. Another important element of Islamic finance is that profit or reward can only be claimed in the instance where either risk of loss has been assumed or effort has been expended. Profit is therefore received by the provider of capital and


wages/remuneration by labor/manager. A depositor in an Islamic bank can therefore make earnings on his or her deposit in several ways: Through return on his capital when that capital is employed in a business venture. Through sharing of profit when his capital is par of capital is employed in a partnership Through rental earnings on an asset that has been partially financed buy his capital. 2.3 PRELIMINARY ISLAMIC BANKING MODEL: The people having savings or valuable articles, used to keep them under the custody of trusted persons who were known for their trustworthiness and having capability to discharge their obligations promptly whenever demanded. The underlying objective was to keep small savings in the shape of deposits with trusted persons for safekeeping and not for earning profit. This was the early shape of deposit-taking which is one of the functions of modern banking. Similarly, the wealthy people supplied funds to honest and experienced traders to finance their trade ventures and earn profit. The traders used to purchase commodities from the areas where they were abundant and sold where they were scarce and whatever the profit they earned they handed over to the owner of capital after charging their fee and traveling expenses. This was the early model of financing which is the core business of modern banking. This kind of financing is known in Islamic financial literature as Modarba transaction. Now we quote practical examples from the history of Islam to illustrate early Islamic banking model



The people of Makka used to deposit their money and valuables with the Holy Prophet (PBUH) because he was the most honest and commonly known as Amin (trustworthy) even before the declaration of his prophethood. These deposits and valuables remained under his custody until his emigration from Makka to Medina. Before, his departure, the Holy Prophet handed over these deposits and valuables to his cousin and son-in-law, Hazrat Ali for their onward return to their owners.

2.3.2 EXAMPLES OF ISLAMIC BUSINESS FINANCING MODEL: As mentioned above that the family of the Holy Prophet, Muhammad (MPUH) was prominent in business circle of of Makkah, His father, Abdullah, was also a leading business figure. But he was died when he was returning from a business trip of Syria at 25 years of age. in the young age. The grandfather of the Holy Prophet, Abu Mutlib, was also a leading businessman of Makka but he was also died when the child was at 8. His uncle, Abu Talib, brought him up and oftenly accompanied him in his business tours. His honest business practice popularized him as a man of high integrity. Khadija bint Khuwailid, a wealthy and noble widow of Macca hired his services for his business. He made handsome profits for her. She was very much happy and impressed by the honesty and dedication of the Holy Prophet and later was married to the Holy Prophet when he was at the age of 25 while she was at 40 in 595 A.D. This example illustrates the fact that an entrepreneur can avail financing from a wealthy woman for his business venture and form partnership with her. 2.4 EVOLUTION OF CONVENTIONAL BANKING: Early conventional banking had its origins in Italy. The profession grew out of the trade boom of the so- called commercial revolution of the High Middle Ages (1000 1350). By the early modern period, however, banking spread throughout Europe and became complex and increasingly involved in credit transactions.


By the late thirteenth and fourteenth centuries there were three types of banks: 1. International merchant banks; 2. Local deposit banks, and 3. Pawn broking establishments These categories were not exclusive: the same businessmen sometimes engaged in two or all three types simultaneously. Although the Florentine banking system fell into crisis in the sixteenth century, yet Italians remained active in international banking into the seventeenth century. In the meantime, banking on the Italian model grew in southern Germany and other parts of Europe. The most notable of the firms was the great Fugger Banking Companies of Augsburg named after Hans Fugger, a renowned trader of fourteen century weaver. These banks were engaged in a range of activities, including speculation in the money market and trade in commodities. The conventional banking system that was originated in Italy moved to Spain and then to Holland, until it settled in England. The commercial activity in England was motivated by a group of Lombardian traders emigrated from Italy in the 14th century A.D. The new comers settled in that part of London which is known today as the famous Limbard Street. With their arrival in London, the most important part of banking operations, the documentary credit and lending operation of usury were commenced. Most of these emigrants were Jews.




Let us begin with the view of Quaid-e-Azam Muhammad Ali Jinnah (the founder of Pakistan) on Islamic Banking he expressed on the occasion of the Opening Ceremony of The State Bank of Pakistan on July 1, 1948: We must work our destiny in our own way and present to the world an economic system based on true Islamic concept of equality of manhood and social justice. We will thereby be fulfilling our mission as Muslims and giving to humanity the message of peace which alone can save it and secure the welfare, happiness and prosperity of mankind Islamic banking in Pakistan started in 1977-78, which included the elimination of interest from the operation of specialized institution and commercial banks. On June 26, 1980, amendments were made in the corporate and financial system to allow the issuance of new interest-free instrument of corporate financing named, Participation Term Certificate (PTC). In the same time, with the aim of rising risk based capital, Ordinance was introduced to permit the establishment of Mudaraba companies and floatation of Mudaraba Certificates. July 1, 1985, all commercial banks in Pak Rupee were made interest free which was mark-up technique with or without buy-back agreement. However, in November 1991, Federal Shariat Court (FSC) declared it unIslamic (Source: IIFM). In January 2000, in the State Bank of Pakistan, a Commission for Transformation of Financial System (CTFS) was constituted to introduce Shari'ah compliant modes of financing. CTFS was held responsible primarily for creating legal infrastructure conducive for working of Islamic financial system, launching a massive education and training programs for bankers and their clients, to create awareness for the general public about the Islamic financial system and also to deal with major products of banks and financial institutions, both for assets and liabilities side (Source: IIFM). In September 2001, Government of Pakistan decided to make shift to interest free economy in a gradual and phased manner without causing any disruptions. It was also agreed that State Bank Pakistan would consider for establishing subsidiaries by the commercial banks for the purpose of carrying out Shari'ah compliant transactions, specifying branches by the commercial banks exclusively dealing in Islamic products and, creating new full-fledged commercial banks to carry out utterly banking business based on proposed Islamic financial products (Source: IIFM).


In January 2002, Meezan Bank Limited was granted first Islamic Banking License by State Bank of Pakistan. On 15 September 2003, The State Bank of Pakistan (SBP) established the Islamic Banking Department with the mission to promote and regulate Islamic Banking Industry in line with best international practices ensuring Shari'ah Compliance and transparency and the with the vision of making Islamic banking the banking of first choice for theproviders and users of financial Services. The foremost task of the department is to promote and develop the Shari'ah Compliant Islamic Banking as a parallel and compatible banking system in the country. Department is comprised of three divisions: Policy Division, Shari'ah Compliance Division, and Business Support Division. A Shari'ah Board comprised of experts to guide the Islamic banking industry is also in place at SBP. 3.2 ISLAMIC BANKS IN PAKISTAN: Presently, there are six full-fledged Islamic banks operating in Pakistan. These banks with their year of incorporation are: AlBaraka Islamic Bank Pakistan (1991) Meezan Bank Limited (2002 restructured as Islamic bank) BankIslami Pakistan Limited (2003) Dubai Islamic Bank Pakistan Limited (2005) Emirates Global Islamic Bank Limited (2007) Dawood Islamic Bank Limited (2007)

Among the banks listed above, Albaraka Islamic Bank (AIB) is the only foreign Islamic bank operating in Pakistan as branches of AlBaraka Islamic Bank Bahrain since 1991, and Meezan Bank Limited (MBL) has the honor of being the first domestic commercial bank offered full-fledged Islamic banking license by SBP in January 2002. There is massive demand for Islamic financial services and the growth of Islamic Banking in Pakistan has been commendable during the last two years. However, the lackof infrastructure support & lack of professional Islamic Bankers has constrained the growth.


Banks of Pakistan have been involved basically in catering to the needs of the government organizations, subsidizing the fiscal deficit, engaging in trade financing, and serving a few large corporations. Small and medium enterprises, housing sector and the agricultural sectors which create most of the growth and employment in Pakistan were deprived of lending. Moreover, financial system of Pakistan was also under political influence in that there was utmost political intervention in lending decisions and in the appointment of managers. 3.3. ISLAMIC BANKING SECTOR: Islamic banking industry has sustained the high growth rates of assets, deposits and financing & investment during the quarter ended-March 2010. The YoY growth in assets, deposits and financing & investment was 33, 40 and 25 percent, respectively in March 2010. The share of Islamic banking has further improved as assets and deposits of Islamic banking Institutions (IBIs) stood at around 6 percent each of the banking sector in Pakistan (Table 1). During Q1-2010, the assets and deposit showed positive growth compared with a negative growth in both asset and deposit of the banking industry. This primarily reflects the depositors confidence and keen interest in Islamic banking offerings.



As shown in Table 2, the earning and profitability ratios shows mixed picture. The ROE and ROA of IBIs remained lower than the industry at 7 percent and 0.8 percent respectively. The intermediation cost of IBIs is on the higher side as compared to the industry. The operating expense also remained high compared to the industry; the operating expense to gross income ratio of IBIs was 70 percent compared to 52 percent for the industry. The higher operating/intermediation cost is largely attributable to the expansion phase of the IBIs; the branch network of IBIs more than doubled during last two years, which would take some time to achieve break-even and start making profits. Further, the limited investment avenues to place the growing deposit base and low ADR at 52% also contributed in relatively lower income and thus higher operating expenses to gross income ratio of IBIs


3.3.2 Outreach Expansion: The branch network of IBIs has increased to 654 branches in March 2010. The geographical coverage of Islamic banking extends across the four provinces and Azad Kashmir, Northern areas and Federal capital covering 81 cities. In terms of bank and unbanked areas, the Islamic banking coverage is highly skewed towards banked areas as unbanked area only account for 2.2 percent of the Islamic banks branches. 3.3.3 Asset Quality: The asset quality of IBIs continued exhibiting signs of weakness during the quarter with non-performing financing (NPF) increasing to Rs 11.87 billion, which is almost double the level in March 2009. The NPFs to financing ratio increased to 7.3% during the quarter from 6.3% in December 2009 and 4.5% in March 2009. The rising trend in NPFs, is attributable to the overall slowdown and weakness in the economy which has been under stress since last couple of years due to some adverse developments both on domestic and international front. When compared with the non-performing portfolio of the overall banking industry, the position of IBIs is however relatively better, the level of infected portfolio of the industry has reached to 13.1% of total financing as compared to 7.3% for IBIs. The relatively better asset quality of the IBI viz-a-viz the industry could be attributed largely to cautious approach adopted by IBIs in assets acquisition (financing). The IBIs have been selective in their financing decisions to book a better risk even at the cost of significantly lowering their profit margins; the declining ADR of IBIs also highlights their cautious approach in asset acquisition. This conservatism though sounds good in regulatory perspective, however, may not be good for long term sustainability and growth of IBIs. The low profitability ratios of IBIs viza- viz the overall banking industry among others are also attributable to this over conservatism. The improvement in profit margins of IBIs will thus require some diversification in asset mix, improvement in risk appetite, product innovation, and expansion of outreach to new areas/sectors like SMEs, Agribusiness which are so far largely untapped.


3.3.4 FINANCING PRODUCTS: The financing mix remained concentrated in Murabaha, Ijarah and Diminishing Musharakahall fixed income modes. Some financing activity has been initiated through Salam and Istisna, which together constituted about 10% of IBIs financing mix as of March 31, 2010. However, negligible activity was observed in participatory modes like Musharakah and Mudarbah. IBIs, despite having excess liquidity have shown reluctance to venture into non-traditional areas like agriculture and SMEs and diversify their product mix from totally fixed returns to a mix of fixed and variable returns. While there has been relatively lower demand for participatory products, the IBIs' cautious approach in assets acquisition also partly explains the absence of Musharaka/Mudarbah in IBIs financing mix. 3.4 TYPES OF BUSINESS THE ISLAMIC BANKS PERFORMS:


Islamic banks have different modes of financing under which they operate. In Pakistan Islamic banks works under seven modes of financing which are Murabaha, Musawama, Ijarah, Salam, Istisna, Musharka and Modarbah (Usmani, 2002). Memon (2007) state that in Murabah asset is purchased by Islamic banks at the request of their customer and then sell it to its customer with a markup reflecting it profit earning. Musawama is similar to Murabah but in this case sell is not obliged to reveal his cost, Ijarah financing mainly used for Car Finance products in Ijarah according Parvez (1991) Islamic bank purchase an asset and lease it to its customers, Lease can be based on simply rental which customers pay to Islamic bank. Salam financing based on agricultural based financing. In Salam, the seller undertakes to supply some goods at give date in exchange of advance payment they receive at spot (Usmani, 2002). According to Ahmed (2006) Istisna is used for long term financing facility involving for example construction of new power plant. Islamic banks either own their plant, charge a fee based on profit or sale the plant to deferred bases with charging markup as a profit similar to Murabaha Transaction. Musharka is the agreement between two or more parties enters in to a contract by providing their capital in different or similar amount for running a business with the condition that they will share profit or loss as agreed in the contract before. Usmani (2002) states in his famous Islamic banking book that Modarbah is that kind of partnership where one partners gives money to another in order to invest it in a commercial enterprise. The investment amount comes from the first partner and the management who is responsible for managing that firm are working partners and the profit generally share between the two as determined ratio agreed before the contract. Investor called the Rab-ul-Maal and the management called the Mudarib.


Figure 2 describes the breakup of mode of financing for Islamic banking in the quarter ended September 2010. It is shown clearly in the figure that all major components of Islamic financing declined over the quarter apart from Istisna and Musharka.

3.5 PERFORMANCE OF ISLAMIC BANKING IN PAKISTAN: Islamic banks in the turmoil time of economic setbacks with floods/rains affecting many areas of Pakistan and increasing effect of credit risk still Islamic banks showed tremendous amount of growth although there are some decline in performance indicators (see Table 6). Islamic banking market share increase with 30 bps also there was also increase of 3.2% growth in assets as compared to the declining asset base of conventional banks in Pakistan. The branch network as discussed above was also increase by 5.4% and most of the increase was dedicated solely to Islamic banking division as compared to conventional banks who are operating Islamic bank branches.


Islamic banks performance is indicated in below mentioned Table 7 the profitability of Islamic banking in Pakistan which is mainly based on Return on Assets; Return on equity is lower than the industry average. This declining profitability can be predicted and we can see that there are many factors attributed to difficult economic condition prevail in the country as many other commercial banks also suffer from that of limping economy. The number of expansion of new branches in local as well as Islamic banks we can assume that thats the main reason as number of branches still havent achieve its break even resulting in the declining of the profit for Islamic bank in the quarter ended September 2010.

Performance can also be measure in terms of its enhancement of deposits (Farrukh, 2005). Figure 3 indicated that structure of funding growth during the last quarter in September 2010 shown growth as deposits was increase by 2.5. However as compare


with year to year basis deposits showed impressive growth by 38% approximately (see Figure 3).

Islamicity means Islamic status of an issue which means whether or not it is legal in Islam or not (Usmani, 2002). For operating of Islamic banks the Shariah under the guidance of renowned Islamic scholars Mr. Taqi Usmani working on the principle of Islamic Shariah. Meezan banks have developed a board which approves or disapproves the products or services that are currently being launched in Islamic banks. Other banks and branches of conventional banks also work on the similar principle of Islamicity. All the products that are currently being involved are work on the basis of Islamic rules and regulations. 3.6 FUTURE PROSPECTS OF ISLAMIC BANKING IN PAKISTAN: Islamic banking established itself globally as do in Pakistan growing at a rapid pace. The size of Islamic banking is expected to reach an estimated USD 1,300 billion in near future ahead1. In Pakistan State Bank of Pakistan launched Islamic bank in 2001 with full fledge commencement of Islamic operations was first initiated to Meezan Bank of Pakistan. Islamic bank since its inception shown a good sign of growth as total assets word Rs. 411 billion in June 2010 showing an increase of 31% growth compared to last one (State Bank of Pakistan, 2010). Islamic banks in future has a great role to play for banking industry of Pakistan, as it mentioned below the key future prospects for Islamic banking in the country are:

Islamic Finance in the Global Economy Second edition by Ibrahim Warde 2010.


Pakistan being the Muslim country and 97% of the people being Muslim has a fairly large number of market share offer to Islamic banks. Majority of people still dont have bank account and since majority of people lives in rural areas and general disliking among the nation of this country is Interest (Riba). Therefore Islamic banks should be more advertsized and publically one has to introduce the concept of Islamic banking which is still lacking in this country (Imran, 2005).

Large Un-served agricultural sector is also look upon by Islamic sectors. Pakistan being agrarian economy therefore micro finance institution should be developed in order to develop the needs of this class. Currently Islamic banks are largely developed in urban areas and offering the customers needs in big cities therefore they should target the agricultural sector in this country and expand their branch network to smaller towns and rural areas (Ariff, 2007).

SME is also potential area for Islamic banks. Presently only 0.2 million SMEs have been access to financing out of 3.1 million SMEs across the country (SBP Data). Conventional banks place their funds in government securities which is risk free, meanwhile Islamic banks doesnt have this type of opportunity yet.

Housing finance is also one area which Islamic banks have started but still there are many opportunities surrounding which they can cater and eventually fulfill vast market of Pakistan in housing finance.

Therefore as mention above Islamic banks would indeed have a good future ahead and eventually there is good market for Islamic banks and Islamic banks should lead to economic growth in the country and development of banking industry.


The volume of literature on Islamic banking profitability is rapidly expanding and a handsome research work has been done by Muslim researchers during last two decades. As Islamic banking is a new industry and as such sometimes researchers face problem of the scarcity of relevant data. In this section, we have intended to review some of the leading research studies on Islamic and conventional banking. Let us see what previous studies say about the profitability of Islamic banking.

5.1 RESEARCH ON ISLAMIC BANKS IN PAKISTAN: Abdul Ghafoor Awan has analyzed the vertical growth of Islamic banking and compared it with its counterpart conventional banking. Six newly formed Islamic banks in Pakistan and six conventional banks of the same size were selected for the purpose of comparison. Data relating to their performance and profitability were collected from primary and secondary sources from 2006 to 2008. The ratio analysis technique was applied to measure the performance of key indicators of both Islamic


and conventional banks. The results of the study are very encouraging because the performance and profitability of Islamic banks are far better than selected conventional banks. Islamic banks outperform conventional banks in assets, deposits, financing, investments, efficiency, and quality of services and recovery of loans. It predicts the bright future of Islamic banking in Pakistan. The performance evaluation of Islamic Banks and Conventional Banks in Pakistan has examined by Muhammad Shahzad Moin in 2008. The aim of this study is to examine and to evaluate the performance of the first Islamic bank in Pakistan, i.e. Meezan Bank Limited (MBL) in comparison with that of a group of 5 Pakistani conventional banks. The study evaluates performance of the Islamic bank (MBL) in profitability, liquidity, risk, and efficiency for the period of 2003-2007. Financial ratios (12 in total) such as Return on Asset (ROA), Return on Equity (ROE), Loan to Deposit ratio (LDR), Loan to Assets ratio (LAR), Debt to Equity ratio (DER), Asset Utilization (AU), and Income to Expense ratio (IER) are used to assess banking performances. T-test and F-test are used in determining the significance of the differential performance of the two groups of banks. The study found that MBL is less profitable, more solvent (less risky), and also less efficient comparing to the average of the 5 conventional banks. However, there was no significant difference in liquidity between the two sets of banks. The reasons are due to the facts that conventional banks in Pakistan have longer history and experience in doing banking business and hold dominating position in the financial sector with its large share in the overall financial assets of Pakistan, as compared to Islamic banks, which in true sense, started only a few years back with all letter and spirit. The study found that MBL is less profitable, more solvent (less risky), and less efficient during 2003-2007, however, it is improving considerably over time indicating convergence with the performance of the conventional banks. Ashfaq Ahmed, Kashif-ur-Rehman and Muhammad Iqbal Siaf have done study on comparison between Islamic and Conventional Banks from customer prospective in 2010. This study examines the relationship between service quality and customer satisfaction regarding Islamic banks as well as conventional banks in Pakistan. It also investigated how service quality affects customer satisfaction by assessing the magnitude of the relationship between selected variables. This study is important due 26

to an emerging trend of Islamic banking practices in Pakistan in the existence of conventional banking system. Data were collected from 720 bank customers by using stratified random sampling. SPSS 15.0 version is applied for data analysis. The results indicate that there is significant difference in perception of service quality among customers of Islamic banks on the basis of gender but there is no significant difference in service quality perception of male and female customers of conventional banks. The study has a number of implications for bankers, policy makers and academicians. It provides a guideline to Islamic banks for provision of marketable products to meet expectations of male and female customers according to their specific requirements. This study enables policy makers and bankers to make effective and quality oriented arrangements to have satisfied and delighted customers for long term benefits. Agha Zohaib Khan has measure the growth of Islamic Banks in Pakistan since relaunching by methodology of Financial ratios, questionnaire, interview. The study proves that the strategy for introduction of Islamic banking in Pakistan has worked well. The growth has been impressive by any standards. Achieving a market share of 4.5% in about 5 years in a rapidly growing banking sector is a remarkable accomplishment compared to the best in class countries. The re-launch experience has been invaluable and serves as a strong base on which the strategy has been put in place.

5.2 RESEARCH DONE ON ISLAMIC BANKS IN DIFFERENT COUNTRIES: Jill Jhones, Marwan Izzeldinn and Vasileios Pappas examined efficiency in Islamic and conventional banks in the GCC region (2004-2007) using financial ratio analysis (FRA) and data envelopment analysis (DEA). They found that From the FRA, Islamic banks are less cost efficient but more revenue and profit efficient than conventional banks. Bootstrapping confirms these small sample results. From the DEA, average efficiency is significantly lower in Islamic than conventional banks. A decomposition method new to the banking context shows that the efficiency difference is more a consequence operating under Islamic rules than of managerial in-adequacies.


Productivity growth has been slight, and is caused mainly by positive technology change.

Badrul-Hisham, Muhammad Samaun and Rohani Muhammad (2008) have evaluate the performance of Islamic banking operations in Malaysia, by investigating for the first time, both cost and profit efficiency of full-fledged Islamic banks and Islamic window operations of domestic and foreign banks. The application of Data Envelopment Analysis (DEA) technique has provided several efficiency measures such as allocative, pure technical and scale efficiency that explain cost and profit efficiency differentials among banks. The findings of the study show that Islamic banking operators are relatively more efficient at controlling costs than at generating profits. IMF working paper 2008, prepared by Martin Cihak and Heiko Hesse. They have done an empirical study on Islamic Banks and Financial Stability. The relative financial strength of Islamic banks is assessed empirically based on evidence covering individual Islamic and commercial banks in 18 banking systems with a substantial presence of Islamic banking. They find that (i) small Islamic banks tend to be financially stronger than small commercial banks; (ii) large commercial banks tend to be financially stronger than large Islamic banks; and (iii) small Islamic banks tend to be financially stronger than large Islamic banks, which may reflect challenges of credit risk management in large Islamic banks. They also find that the market share of Islamic banks does not have a significant impact on the financial strength of other banks. Islamic Banking in Bangladesh; A case study of Islami Bank Bangladesh Ltd. (IBBL) is done by Muhammad Nurul Alam. The aim of the study was to see how Islamic banking activities differ from a conventional bank and also to see how Islamic banks may contribute to render financial services towards small and rural sector. The author found that IBBLs shows an overall success in both deposits and investment positions since it started its banking activities. As regards to the deposits side it may be observed that the total deposits increased over past ten years even though, the average deposit growth rate from 1988 to 1994 is only 23%. It is also observed that, the bank 28

did not succeed much in accumulating deposits under various term deposits. This ultimately results in a reduction of the long-term investment of the bank, especially investment towards industrial sectors. It is always assigned that the growth rate of bank branches should increase the savings position of the bank, which was not the case with the Islami Bank. This occurred, despite the fact that, one of the important advantages of opening a PLS Savings Account with the Islami Bank is that one can open a Savings Account with only Taka 100.00 (2.5 US $) where as the initial deposit figure in any other commercial banks in Bangladesh is not less than Taka 4000 (US $ 100). Moreover the formalities for opening a Savings Account with the Islami Bank are very easy and simple. Hadeel Abu Loghod has done research on Do Islamic banks perform better than conventional Banks? It is a case study of Gulf Cooperation Council Countries. The author found that during his researches that The Gulf Cooperation Council Countries (GCC), have dual banking system where Islamic and conventional banks are operating side by side. The purpose of this paper is to compare the financial performance (profitability, liquidity and structure) of the two banking styles over the 2000-2005 time period. Among other findings the empirical results show no significant differences in terms of profitability. However, Islamic banks are less exposed to liquidity risk. On the other hand, conventional banks depend more on external liabilities than Islamic banks. Naturally, GCC markets showed that customers were more attracted to use financial instruments offered by Islamic banks. Finally, no statistical significant differences were found on internal growth rate for both types of banking, which implies that this largely depends on the management style and the general performance of the specific bank.



The study is aimed at comparative financial performance of Islamic banking vis--vis conventional banking in Pakistan. Specifically, study makes comparison of two Islamic banks with a group of three conventional banks performances each year in 2007-2009. Data for each year have been compiled from the income statements and balance sheets of these two sets of banks. In the bank performance study, this type of inter-bank analysis is pretty common. In todays competitive financial market, one can better understand the performance of a bank by an analysis of inter-bank comparison. Various indexes have been provided by financial management theories for measuring banks performance. Using accounting ratios is one of them. To measure performance, financial ratios have been used quite commonly and extensively in the literature. In order to see how Islamic bank has performed in comparison with the conventional banks over 3 years, the study uses 12 financial ratios for the banks performance. These ratios are broadly categorized into four groups: (a) profitability ratios; (b) liquidity ratios; (c) risk and solvency ratios; and (d) efficiency ratios. Since there are five conventional banks in a group to compare with one conventional bank, so we first calculated ratio of each bank in that group and then calculated average of those five ratios to compare that average ratio with one ratio of Islamic bank in each year. Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured.


4.1 RESEARCH DESIGN: This research study has been designed in such a way that it helps compare the performance and profitability of Islamic banks with the conventional banks. The area of the study is the whole Pakistan where Islamic and selected Conventional banks are operating under the same legal, political, social and economic framework 4.2 SAMPLE OF RESEARCH: At present six full-fledged Islamic Commercial Banks and 23 Conventional Commercial Banks are operating in Pakistan. Total five Commercial banks, two Islamic Commercial Banks and three Conventional Banks have been included into the sample of this research study. Two Islamic Banks that included into this study are: Meezan Bank Ltd Bank Islami Pakistan

Three Conventional Commercial Banks that have been included into the sample are: Habib Bank Ltd. Muslim Commercial Bank Bank Al-Falah Ltd.

4.3 SOURCE OF DATA: 4.3.1 SECONDARY DATA: The author also collected data from secondary source because the primary data was not sufficient to meet the requirement of this study. This data was collected from the following sources 1. Annual and quarterly financial statements of six Islamic Commercial Banks and selected Conventional Commercial Banks 2. Database of the State Bank of Pakistan. 31

3. Quarterly Brochures of the State Bank of Pakistan on Islamic Banking. 4. Leading Pakistani Newspapers. 5. Different Research Journals 6. Books on Islamic Banking and Finance

4.4 RESEARCH TECHNIQUES: Ratio analysis technique was used to measure the asset quality, profitability and earning potential of Islamic and conventional banks comparing them from three financial years. Following below ratios used for analysis: (a) Profitability Ratios: 1. Return on Total Assets (ROA) = net profit after taxes / total assets. 2. Return on Equity (ROE) = net profit after tax / shareholders equity. 3. Yield on Earning Assets = funded income / average gross earning assets. Funded income is total income earned during the period by way of interest on securities. Investments and interest received on advances. The denominator is average gross earning assets represented by opening plus closing balances of advances plus investments divided by two. 4. Cost of funds = interest paid / average deposits + borrowings. 5. Net profit margin = net profit after tax / net sales. 6. Spread = Yield on earning asset cost of fund. (b) Liquidity Ratios: 1. Cash to deposits. 2. Advances to deposits. (c) Business development Ratios: 1. Deposits growth ratio. 2. Advances growth ratio. 3. Earning growth ratio. (d) Efficiency Ratios: 1. Asset Utilization = Total Revenue / Total Assets. 2. Operating efficiency = Total operating expense / Total operating revenue. (e) Risk and Solvency Ratios: 1. Debt to total assets = debts / total assets. 2. Equity Multiplier = Total assets / shareholder capital.



Financial analysis have been done on five selected banks categorize in conventional and Islamic banks. The first parts deal with the basic introduction and history of selected five banks and the second parts deals with the financial analysis with the help of ratio and its interpretation have been done in order to find out which banks performance is better as comparison with each other based on 2007 to 2009 financial performance. 6.1 Banks Introduction: Following are the backgrounds or history of selected banks; 6.1.1 Habib Bank Limited: HBL established operations in Pakistan in 1947 and moved its head office to Karachi. With a domestic market share of over 40%, HBL was nationalized in 1974 and it continued to dominate the commercial banking sector with a major market share in inward foreign remittances (55%) and loans to small industries, traders and farmers. International operations were expanded to include the USA, Singapore, Oman, Belgium, Seychelles and Maldives and the Netherlands. On December 29, 2003 Pakistan's Privatization Commission announced that the Government of Pakistan had formally granted the Aga Khan Fund for Economic Development (AKFED) rights to 51% of the shareholding in HBL, against an investment of PKR 22.409 billion (USD 389 million). On February 26, 2004, management control was handed over to AKFED. The Board of Directors was reconstituted to have four AKFED nominees, including the Chairman and the President/CEO and three Government of Pakistan nominees. 6.1.2 MCB Bank Limited:


MCB is one of the leading banks of Pakistan with a deposit base of Rs. 431 Billion and total assets over Rs. 550 Billion. Incorporated in 1947, MCB soon earned the reputation of a solid and conservative financial institution managed by expatriate executives. In 1974, MCB was nationalized along with all other private sector banks. The Bank has a customer base of approximately 4 million, a nationwide distribution network of over 1,000 branches and over 550 ATMs in the market. During the last fifteen years, the Bank has concentrated on growth through improving service quality, investment in technology and people, utilizing its extensive branch network, developing a large and stable deposit base. 6.1.3 Bank Alfalah Limited: Bank Alfalah Limited started its operation in November 1997 as a public limited company under the Companies Ordinance 1984. Since its inception being driven by the Abu Dhabi Group has invested with innovative and revolutionary technology based product and services. Bank Alfalah limited being the fifth largest bank of Pakistan in terms of assets (According to Pakistan Credit Rating Agency Limited). Bank Alfalah business portfolio comprises in all sectors of conventional banking. Innovative and high value products that they offer include, Car financing, home financing, Credit Cards, Debit Cards, Online Banking, ATM Cards, Term Deposit Certificates and consumer durables products. Bank Alfalah also started Islamic banking division in order to cater the needs of Islamic ideological customers. Islamic banking division is completely independent of the business of conventional one. They have separate branches that offer Islamic products and service with Shariah compliant. 6.1.4 Meezan Bank Limited: Meezan Bank Limited is a publicly listed company first incorporated on January 27, 1997. In January, 2002 in an historic initiative, Meezan Bank was granted the nation's first full-fledged commercial banking license dedicated to Islamic Banking, by the State Bank of Pakistan. The banking sector is showing a significant paradigm shift away from traditional means of business and is catering to an increasingly wise and demanding financial consumer who is also becoming keenly aware of Islamic 34

Banking. Meezan Bank strives to find commonalties with the conventional banking system with absolutely no compromise on Shariah rulings. The bank has developed an extraordinary research and development capability by combining investment bankers, commercial bankers, Shariah scholars and legal experts to develop innovative, viable, and competitive value propositions that not only meet the requirements of today's complex financial world, but do so with the world-class service excellence that our customers demand, all within the bounds of Shariah. 6.1.5 Bank Islami: Bank Islami Pakistan Limited was the first Bank to receive the Islamic Banking license under the Islamic Banking policy of 2003 on March 31, 2005. The Bank envisioned to focus primarily on Wealth Management as the core area of business in addition to Shariah compliant Retail Banking products, Proprietary and Third party products, and Integrated financial planning services. The State Bank of Pakistan declared Bank Islami Pakistan Limited as a Scheduled Bank with effect from March 17, 2006. Bank Islami started its Banking operations on 7th April 2006 with its first branch in SITE, Karachi. By the end of 2006, the Bank had 10 branches, nine in Karachi and one in Quetta. The Bank further concentrated in building a nationwide network and by the end of year 2007; its branch network grew to 36 branches in 23 cities. In 2008, the Bank opened 66 new branches nationwide which expanded its network to 102 branches in 49 cites. This gives Bank Islami the distinction of having the fastest expanding network in Pakistan as well as offering the widest network by any Islamic Bank in Pakistan. 6.2 Interpretation of Ratio Analysis: The findings of ratio analysis are derived from annual reports of five selected banks. Ratios have been derived from Balance Sheet and Income statement for the year 2007 to 2009. The five banks that are selected from conventional banks are Habib Bank Limited, Bank Alfalah Limited and MCB Bank Ltd meanwhile from Islamic banks Meezan Bank and Bank Islami are selected. The averaged of both conventional and Islamic and banks are compared in order to find out the financial analysis of these banks that which banks performance are better in terms of financial analysis. 35

6.2.1 Profitability Ratios: The return on assets ratio of conventional banks is higher than that of Islamic banks mean average ratios comparing with three years. As we can see in Table 6.1 Return on Assets of Conventional banks are 2.04% in 2007 and then we see a downward trend with 1.72% in 2009. This shows that Conventional banks return on assets are decreasing compared to previous years. Meanwhile Islamic banks ratio also seen a deeper downward trends which shows 2.32% in 2007 which is also higher than that of Conventional banks with 2.04%, but Islamic banks ROA saw a downward trend with eventually decreasing to -0.22%. The minus sign shows that as the cumulative averages of Islamic banks are found out from averages of Meezan Bank and Bank Islami. Bank Islami in 2009 saw a -562,909 (000) net loss which decreasing the profitability of Islamic banks as compare to assets.

Table 6.1: Return on Assets Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks 2.04% 1.83% 1.72% 1.86% Cumulative Avg. Islamic Banks 2.32% 0.56% -0.22% 0.88%

Figure 6.1
Return on Total Assets 2.5 2 1.5 1 0.5 0 -0.5 Conventional Banks Islamic Banks





The Return on Equity of Islamic banks is lower than that of conventional banks (See Table 6.2 & Figure 6.2). The trend of ROE is exactly same as ROA, while comparing


return on equity it is shown clearly that Islamic banks in 2007 have better Return on Equity as compare to conventional banks cumulative averages. This performance should be seen as a positive sign. But in recent years with great set back of economy in Pakistan both conventional banks and Islamic banks saw a downward curve. Islamic banks ratio decreases from 22.48% in 2007, 7.37% in 2008 to 3.96% in 2009. Meanwhile conventional banks also saw a similar trend with mean average comparing to three years is 18.04% and for Islamic banks 11.27%. Table 6.2: Return on Equity Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks 21.24% 17.36% 15.51% 18.04% Figure 6.2
Return on Equity 25 20 15 10 5 0 2007 2008 2009 Conventional Banks Islamic Banks

Cumulative Avg. Islamic Banks 22.48% 7.37% 3.96% 11.27%


Yield on earning assets calculated by funded income divided by the sum of investment and advances. Yield on earning asset while comparing the selected three years it can be seen that Islamic banks mean average YOEA is 2.36% which is better than 0.65% mean average ratio of conventional banks from 2007-2009. This shows a better sign for Islamic banks but while comparing with last year both Islamic and conventional banks ratio decreases. Islamic banks saws a great downward trend that is it drops down from 4.11% to 1.83%. It is concluded that in recent times earning have affected banks performance very heavily.


Table 6.3: Yield on Earning Assets Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks 0.85% 0.62% 0.47% 0.65% Figure 6.3
Yield on Earning Assets

Cumulative Avg. Islamic Banks 4.11% 1.15% 1.83% 2.36%

5 4 3 2 1 0 2007 2008 Years 2009

Conventional Banks Islamic Banks

Cost of funds calculated by dividing Interest paid to the customers with the sum of borrowing taken from other institution and other sources and total average deposits. The lesser the cost of funds the better its for banks. From Table 6.4 & Figure 6.4 it shows that Conventional banks cost of funds are increasing as compared to last year, in 2007 the cost of funds of conventional banks is 3.75% with 4.87% in 2008 and eventually increases to 5.41% cost of fund. This shows that conventional banks have invested its deposit in to high cost deposit which increases interest paid to customer. For Islamic banks they shows a downward trend which is a good sign but still as compare to conventional banks its cost of funds is at higher side with 7.68% as compare to 4.68% mean average. Table 6.4: Cost of Funds Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks 3.75% 4.87% 5.41% 4.68% Cumulative Avg. Islamic Banks 8.89% 7.41% 6.74% 7.68% 38

Figure 6.4
Cost of Funds 10 8 6 4 2 0 2007 2008 Years 2009

Conventional Banks Islamic Banks

Spread is the difference between Yield on earning assets and Cost of funds. As we can see in Figure 6.5 conventional banks curve are on downward trend meanwhile for Islamic banks in 2007 the spread was -4.78%, -6.26% in 2008 and -4.91% in 2009. Spread measures the actual difference between what banks earning on its assets and how much interest they are giving to the customers. Therefore it is concluded that both Islamic and conventional banks ratio is not up to the mark. Table 6.5: Spread Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks -2.90% -4.26% -4.94% -4.03% Figure 6.5

Cumulative Avg. Islamic Banks -4.78% -6.26% -4.91% -5.32%

0 -2 -4 -6 -8 Years % 2007 2008 2009

Conventional Banks Islamic Banks

Net Profit Margin ratios of conational banks are seen a downward trend (See Table 6.6). Islamic banks net profit margin saw -5.84% in 2009 that is due to Bank Islami net loss, Islamic banks shows a negative sign in net profit margin in the year 2009. It


is concluded that conventional banks have better net profit margin than that of Islamic banks. Table 6.6: Net Profit Margin Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks 26.71% 19.91% 16.72% 21.12% Figure 6.6
Net Profit Margin 30 20 10 0 -10 2007 2008 2009
Conventional Banks Islamic Banks

Cumulative Avg. Islamic Banks 7.46% 2.76% -5.84% 1.46%


6.2.2 Business development Ratios: The growth ratios are calculated horizontally from year to year. In this we have taken 2002 as a base year to compare the growth of Islamic banks and conventional banks in terms of total deposits, advances and earnings. Deposits growth ratio of both Islamic banks and conventional banks are increasing in last four years, which shows positive trend that more customers are depositing their money heavily as compared to last year in their respective banks. Table 6.7 shows that as 2007 is the base year for comparison. Deposits grow 111.84% in 2008 and 124.41% since 2007 in 2009 for conventional banks. Islamic banks as compared to conventional banks deposits increasing much greater than conventional banks. From Table 6.7 the deposit growth ratio of Islamic banks is 261% in 2008 and 328.44% in 2009 as compared to the base year 2007.


Table 6.7: Deposit Growth Ratio Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks Base Year 111.84% 124.41% 118.12% Cumulative Avg. Islamic Banks Base Year 261.00% 328.44% 1.46%

Figure 6.7
Deposit Growth Ratio 400 300 200 100 0 2007 2008 2009
Conventional Banks Islamic Banks


Advances growth ratio shows that increase of financing of both Islamic banks and Conventional banks are increasing in relative to base year 2007. Both Islamic and conventional banks advances are increasing as compared to 2007. Islamic banks advances grow heavily as compare to conventional banks (See Figure 6.8). Table 6.8: Advances Growth Ratio Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks Base Year 117.05% 114.82% 115.94% Cumulative Avg. Islamic Banks Base Year 222.46% 328.72% 275.59%

Figure 6.8 41

Advances Growth Ratio 400 300 200 100 0 2007 2008 2009
Conventional Banks Islamic Banks


Earning or net profit of both Conventional banks are slightly increasing as compared to its base year. Islamic banks show a negative trend as Bank Islami suffering from net loss since 2007. As compared to 2007 Bank Islami suffers major losses which eventually showing in Islamic banks cumulative earning growth ratio. Therefore it can be concluded that conventional banks earnings are growing better than Islamic banks which shows downward trend and in losses due to Bank Islami. Table 6.9: Earning Growth Ratio Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks Base Year 83.34% 87.68% 85.51% Figure 6.9
Earning Growth Ratio 200 0 2007 2008 2009
Conventional Banks Islamic Banks

Cumulative Avg. Islamic Banks Base Year -39.25% -593.60% -316.42%

-200 -400 -600 -800


6.2.3 Liquidity Ratios:


Comparing liquidity ratio of the Islamic banking and conventional banking reveals that, Advances to deposits ratio of both Islamic banks and conventional banks are decreasing in 2008 with respect to 2007. There is a Statutory Reserve Requirement SRR for every bank to keep a reserve amount of deposits as per requirement of State Bank policy. Conventional and Islamic banks has different SRR requirement for its bank to keep it. From Table 6.10 Cash to deposits ratio of Islamic banks are decreasing from 16.74% in 2007 to 11.64% in 2009 and for conventional banks its decreases to 10.78% in 2008 from 11.60% in 2007 and eventually increases to 11.01% in 2009.

Table 6.10: Cash to Deposits Ratio Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks 11.60% 10.78% 11.01% 11.13% Figure 6.10
Cash to Deposits Ratio 20 15 10 5 0 2007 2008 2009
Conventional Banks Islamic Banks

Cumulative Avg. Islamic Banks 16.74% 13.89% 11.64% 14.09%


Advances to deposits ratio measure the ratio between the customers deposited its money to the financing given to customers in order to earn profits. This ratio shows that in 2009 compared to last two years both Islamic and conventional banks Advances to deposits ratio are decreasing with average mean of conventional banks show 69.17% and 58.21% of Islamic banks.


Table 6.11: Advances to Deposits Ratio Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks 69.85% 73.20% 64.46% 69.17% Figure 6.11
Advances to Deposits Ratio

Cumulative Avg. Islamic Banks 64.75% 57.83% 52.04% 58.21%

80 60 40 20 0 2007 2008 Years 2009 %

Conventional Banks Islamic Banks

6.2.4 Efficiency Ratios:

Assets utilization ratios indicates that both Islamic and Conventional banks ratio are increasing, which shows that both banks are effectively and efficiently using its assets to generate sales more productively and efficiently. Although from Table 6.12 it can be seen that Islamic banks ratio decreases in 2008 to 8.91% from 13.69% in 2007. But they recover well and in 2009 their assets utilization ratio increases to 9.12%. Conventional banks are effectively and efficiently utilizing its assets very affectively as its ratio increasing as compared to last year. Table 6.12: Assets Utilization Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks 7.64% 8.78% 9.36% 8.59% Figure 6.12 Cumulative Avg. Islamic Banks 13.69% 8.91% 9.12% 10.58%


Assetss Utilization 15 10 Conventional Banks Islamic Banks

5 0 2007 2008 2009


Operating Efficiency ratio of Islamic banks as shown in Table 6.13 indicates that there is an increase in the ratio from 247.45% in 2002 to 455.19% in 2006. This trend shows that Islamic banks expenses are high and earnings are low, especially in 2008. Conventional banks on the other hand also have operating efficiency on the higher side which again shows that their expenses are increasing day by day and earning is not effectively increasing. This shows in all conventional banks that are Bank Alfalah, Habib Bank and MCB Bank. Table 6.13: Operating Efficiency Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks 136.80% 182.13% 205.16% 174.70% Figure 6.13
Operating Efficiency 500 400 300 200 100 0 2007 2008 2009
Conventional Banks Islamic Banks

Cumulative Avg. Islamic Banks 247.45% 455.19% 366.31% 356.32%


6.2.5 Risk and Solvency Ratios:


Debt to total assets ratio of conventional banks are neither increasing too much and nor decreasing. Their debts to total assets ratio are on average mean moving towards 90.76% of all the three years. This shows that liability as compared to total assets is on normality side and for Islamic banks their ratio increasing from 81.37% in 2007 to 89.58% in 2009.

Table 6.14: Debt to Total Assets Ratio Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks 90.97% 91.03% 90.28% 90.76% Cumulative Avg. Islamic Banks 81.37% 82.15% 89.58% 84.37%

Figure 6.14
Debt to Total Assets Ratio 95 90 85 80 75 2007 2008 2009
Conventional Banks Islamic Banks


Equity Multiplier ratio of cumulative average of Islamic banks are decreasing from 18.63% to 10.42% in 2009 which shows that Islamic banks are more riskier as compared to conventional banks. Conventional banks on other hand their average moving on average. Their equity ratio decreases slightly in 2008 with 8.97% and increases to 9.72% in 2009.

Table 6.15: Equity Ratio Year 2007 2008 2009 Mean Cumulative Avg. Conventional Banks 9.03% 8.97% 9.72% 9.24% Cumulative Avg. Islamic Banks 18.63% 17.85% 10.42% 15.63%


Figure 6.15
Equity Ratio 20 15 10 5 0 2007 2008 2009
Conventional Banks Islamic Banks


7. Conclusion & Recommendations:

7.1 Conclusion: 47

This comparison shows that the financial performance of conventional banks is better than that of Islamic banks. Although Islamic banks performance is slightly better than as compared to last year but still major improvement has to be done in order to move well with conventional banks. Islamic banks businesses are developing well as it is indicated that deposits, earnings and financing are increasing day by day. As a whole Islamic banks earnings is not suitable as Bank Islami one of the major banks of Islamic banks industry still suffering from net losses and suffering higher losses as compared to last years. The major drawback of Islamic banks that is their deposits is increasing but they are not taking full advantage of it and just holding their funds or not utilizing their funds effectively in order to earn money on them. Ideally its deposits are holding and not effectively are in order to earn good margin in it. In addition Islamic banks are not using its assets more effectively and efficiently as conventional banks. On the other hand conventional banks in recent times like Islamic suffers sever set backs from earning section. As return on assets, return on equity all go downward in the year 2009 which shows that due to economic crises prevailing in the country its also affecting heavily in banking Industry. Therefore it is concluded that although with severe economic crises still conventional banks performance are better than that of Islamic banks and Islamic banks have to take the full advantage of these drawbacks in order to capture the market and run effectively with conventional banks. 7.2 Recommendations: Islamic banks must focus more on their main earning assets to utilize them more efficiently along with any non-operating income they have been generating. It is because non-operating income inflates total profitability of Islamic banks. Thus, Islamic banks in aggregate need to improve their yield on the earning assets to reach to the level of conventional banks.

They need to pay special concern to the level of their liquidity because it is very important as far as banks are considered. They must minimize their all type of expenditures especially reduction in all non-operating expenses is much more needed. 48

This would help Islamic banks to improve their net profit margin and to some extent their cash-to-deposits would also be improved ultimately improving the liquidity position. Finally, the banks must focus to generate more and more advances out of given deposits so that their earning on advances would also improve yield on earning assets. Islamic banks need to penetrate more and capture more market than they have done so far. This would help them increase deposits and other liabilities. They should continually create more and more innovative products to attract more prospective customers and investors. This way Islamic bank would increase their solvency by increasing debt compared to equity.

8. References:


Annual Reports of 6 Islamic banks from State Bank of Pakistan and banks websites.(Quarterely Data Sept 2010)

Ahmed, K (2006), Islamic Banking in Pakistan, Pakistan & Gulf Economist, Vol. 25, no. 35, pp. 35-36, Karachi.

Farrukh, Z (2005), Case Study on Comparative Performance of two Islamic and two Commercial Banks, Market Force, Vol. 1, no.3, pp. 48-53, PAF-KIET, Karachi.

Hussain, Dr. I (2006), Evolution of Islamic banking, Journal of Islamic Banking & Finance, Vol. 23, no. 3, pp. 73-79, Karachi.

Mehmood, Z (2005), Islamic Banking: A performance comparision of Islamic bank versus conventional bank in Pakistan, Bradford School of Management, USA.

Memon, Dr. NA (2007), Overview of Islamic Banking in Pakistan, Journal of Islamic Banking & Finance, Vol. 24, no. 2, pp. 106-112, Karachi.

Nasir, M (2008), Performance of Islamic Banks, Pakistan & Gulf Economist, Vol. 27, no.7, p.57, Karachi.

Parvez, IA (1991), Islamic Banking, Journal of Islamic Banking & Finance, Vol. 8, no. 1, pp. 17-41, Karachi.


State Bank of Pakistan (2009), Fionancial Stability Review 2008-09. State Bank of Pakistan (2010), Islamic Banking Bulletin For Quarterely Ended Period September 2010.

State Bank of Pakistan (2010), Banking Industry Review.

Usmani, Dr. MIA (2002), Meezan Banks Guide to Islamic banking, Darul Ishaat, Karachi.


9. Appendix: