Comparison of Islamic and Conventional Banking

Since the 1970s, Islamic banking has emerged as a new reality in the international financial scene. Its philosophies and principles are however, not new, having been outlined in the Holy Qur’an and the Sunnah of Prophet Muhammad (p.b.u.h) more than 1,400 years ago. The emergence of Islamic banking is often related to the revival of Islam and the desire of Muslims to live all aspects of their lives in accordance with the teachings of Islam.

The Islamic Banking System (IBS) is defined as a banking system whose principles underlying its operation and activities are founded in Islamic or Shariah rules. The main factor that distinguishes Islamic banks from conventional banks is that all transactions are administered without involving elements of interest or Riba’. The principles objective of the establishment of Islamic banking is to cater the needs of Muslims in banking transactions. The success of the Islamic bank in catering the deposit and credit needs of clients proved that Shariah principle were still applicable and could be adopted by modern-day business.

In Malaysia, split Islamic legislation and banking regulations exists side-by-side with those for the conventional banking system. The legal basis for the establishment of Islamic banks was the Islamic Banking Act (IBA) which came into effect on 7 April 1983. The IBA provides Central Bank of Malaysia (BNM) with powers to supervise and regulate Islamic banks, similar to the case of other licensed banks. The Government Investment Issue (GII), which are government securities issued based on Shariah principles. As the GII are regarded as liquid assets, the Islamic banks could invest in the GII to meet the prescribed liquidity requirements as well as to invent their surplus funds.

The first Islamic bank established in the country was Bank Islam Malaysia Berhad (BIMB) which commenced its operations starting from 1 July 1983. In line with its objectives, the banking activities of the bank are based on Shariah principles. After more than a decade in operations, BIMB has proved to be a practicable banking institution with its activity expanding rapidly throughout the country with a network of 112 branches. The bank was listed on the Main Board of FBM KLCI formerly known as Main Board of the Kuala Lumpur Stock Exchange on 17 January 1992.

The long-term objective of BNM is to create an Islamic banking system operating on a parallel basis with the conventional banking system. However, similar to any banking system, an Islamic banking system requires three fundamental elements to qualify as a viable system, i.e.:-

• A large number of players;
• A broad variety of instruments; and
• An Islamic money market.

In addition, an Islamic banking system must also reflect the socio-economic values in Islam, and must be Islamic in both substance and form.

Recognizing the above, BNM adopted a step-by-step approach to achieve the above objective. The first step to spread the virtues of Islamic banking was to disseminate Islamic banking on a nationwide basis, with as many players as possible and to be able to reach all Malaysians. After a careful consideration of various factors, BMN decided to allow the existing banking institutions to offer Islamic banking services using their existing infrastructure and branches. The option was seen as the most effective and efficient mode of increasing the number of institutions offering Islamic banking services at the lowest cost and within the shortest time frame. Following from the above, on 4 March 1993 BNM introduced a scheme known as “Skim Perbankan Tanpa Faedah” (Interest-free Banking Scheme) or SPTF in short.

In terms of products and services, there are more than 40 Islamic financial products and services that may be offered by the banks using various Islamic concepts such as Mudharabah, Musyarakah, Murabaha, Nai’ Bithaman Ajil (Bai’ Muajjal), Ijarah, Qardhul Hasan, Istisna’ and Ijarah Thumma Al-Bai’. To link the institutions and instruments, the Islamic Interbank Money Market (IIMM) was introduced on 4 January 1994.

In October 1996, BNM issued a model financial statement for the banking institutions participating in the SPI requiring the banks to disclose the Islamic banking operations (balance sheet and profit and loss account) as an additional item under the Notes to the Accounts.

As part of the effort to streamline and harmonize the Shariah interpretations among bank and Takaful companies, BNM established the National Shariah Advisory Council on Islamic Banking and Takaful (NSAC) on 1 May 1997 as the highest Shariah authority on Islamic banking and Takaful in Malaysia.

The conceptual development of Islamic banking gained momentum after the mid-1940s. Islamic scholars such as Qureshi (1946), Ahmad (1952), Uzair (1995), Maududi (1961), Al-Arabi (1996), Siddiqi (1967), and Al-Sadr (1974) made significant contributions to the evolution of the Islamic banking model. Islamic banking has made steady progress over recent decade. In recent years it has emerged as the fastest-growing segment of global finance. There has been an unprecedented growth and deepening of Islamic banking products – Sukuks or Islamic bonds, Takaful or Islamic insurance services, equity funds, hedge funds, assets and wealth management, risk and liquidity management, real estate and corporate finance.

In contrast, conventional banking has been established much longer than Islamic banking. In terms of experience and product choices conventional banks are more advanced. Conventional banking is based on a pure financial intermediation model, whereby banks mainly borrow from savers and then lend to enterprise or individuals. They make profit from the margin between the borrowing and lending rates of interest. They also provide banking services, like letters of credit and guarantees. A proportion of their profit comes from the low-cost funds that they obtain through demand deposits. Conventional banks are prohibited from trading and their shareholding is severely restricted to a small proportion of their net worth.

Standard Chartered Bank Malaysia Berhad (SCBMB) is a member of the Standard Chartered Group was established in Malaysia in 1875 when its first branch opened for business at Downing Street, Penang. The bank was locally incorporated as a Standard Chartered bank Malaysia Berhad on 29 February 1984. As Malaysia’s first bank with over 130 years of history, SCBMB employs more than 5,000 employees within its Malaysian operations which covers more than 30 branches across the country, a global market shared service centre, a wholly owned subsidiary – Price Solutions which markets its retail financial products, an offshore facility in Labuan.

SCBMB leads the way through product innovation, consistent and strong growth performance and sustainability initiatives. It provides a comprehensive range of financial products and services including retail, Islamic and wholesale banking for individuals, small and medium-sized enterprise, as well as corporate and institutions.

Malayan Banking Berhad (Maybank) is Malaysia largest financial services group and has a strong regional presence in South East Asia. Maybank aim to maximize value for their shareholders by staying diversified across geography and business units and capturing growth opportunities in high growth markets.

Malayan Banking Berhad or also known as Maybank Group is the leading financial services provider in Malaysia catering the needs of consumers, investors, entrepreneurs, non-profit organizations and corporations. The Group, which has expanded international, has the largest networking among Malaysian banks of over 1,750 branches and offices in 14 countries, employing 40,000 workers and serving over 18 million customers.

This study has been carried out to examine and analyze the experience with Islamic banking of Bank Islam Malaysia Berhad (BIMB), in order to evaluate the Islamic bank’s performance in comparison with the Conventional banks in Malaysia, in this case are Standard Chartered Bank Malaysia Berhad (SCBMB) and Malayan Banking Berhad (Maybank) through financial ratios and tested by Descriptive Statistics and ANOVA by using Minitab version 15.0. This study is performed to measure the performance of BIMB, SCBMB and Maybank for the period of 10 years ranging from 2000 until 2009.

Differences between the Islamic Banking and Conventional Banking

One must refrain from making a direct comparison between Islamic banking and conventional banking. This is because Islamic banking and conventional banking are extremely different in many ways. The main difference is that Islamic Banking is based on Shariah foundation. Thus, all dealing, transactions, business approach, product feature, investment focus, responsibility are derived from the Shariah law, which lead to the significant difference in many part of the operations the conventional banking.

The foundation of Islamic bank is based on the Islamic faith and must stay within the limits of Islamic Law or the Shariah in all of its action and deeds. The original meaning of the Arabic word Shariah is “the way to the source of life” and is now used to refer to legal system in keeping with the code of behavior called for by the Holly Qur’an. Among the governing principles of an Islamic bank are:

• The absence of interest-based (Riba’) transactions;
• The avoidance of economic activities involving domination (Zulm);
• The avoidance of economic activities involving speculation (Gharar);
• The introduction of an Islamic tax, Zakat
• The discouragement of the production of goods and services which contradict the Islamic value (Haram)

On the other hand, conventional banking is essentially based on the debtor-creditor relationship between the depositors and the bank on one hand, and between the borrowers and the bank on the other. Interest is considered to be the price of credit, reflecting the opportunity cost of money.

Islamic law considers a loan to be given or taken, free of charge, to meet any contingency. Thus in Islamic banking, the creditor should not take advantage of the borrower. When money is lent out on the basis of the interest more often that it leads to some kind of injustice. The first Islamic principle underlying for such kind of transactions is “deal not unjustly, and ye shall not be dealt with unjustly” [2:279] which explain why commercial banking in an Islamic framework is not based on the debtor-creditor relationship.

The other principle pertaining to financial transactions in Islam is that there should not be any reward without taking a risk. This principle is applicable to both labor and capital. As no payment is allowed for labor, unless it is applied to work, there is no reward for capital unless it is exposed to business risk.

Thus, financial intermediation in an Islamic framework has been developed on the basis of the above-mentioned principles. Consequently financial relationships in Islam have been participatory in nature.

REVIEW OF THE RELATED LITERATURE

Islamic Banking and Conventional Banking

In 1963, Islamic banking came into existence on an experiment basis on a small scale in a small town of Egypt. The success of this experiment opened the doors for a separate and distinct market for Islamic banking and finance and as a result, in 1970s Islamic banking came into existence at a moderate scale and a number of full-fledge Islamic banks was introduced in Arabic and Asian countries. Most of these Islamic banks were in Islamic countries. Having started on a small scale, Islamic banks and non-banking financial institutions are now operation even on more intensive scale. Today, Islamic banks are operating in more than sixty countries with assets base of over $166 billion and a marked annual growth rate of 10%-15%. In the credit market, market share of Islamic banks in Muslim countries has risen from 2% in the late 1970s to about 15% today. These facts and figures certify that Islamic banking is viable and efficient as the conventional banking. (Aggarwal and Yousaf 2000).

Islamic banking is regarded as a fastest growing market, on the other side, it is not free from issues, problem, and challenges. Numerous studies have been performed since the inception of the modern Islamic banking and finance. Conceptual issues underlying interest free financing (Ahmad 1981, Karsen 1982) have been the prime focus of these previous studies on Islamic banks. It is hard to find enough coverage in the existing literature on the issues of viability of Islamic banks and ability to mobilize savings, pool risk and facilitate transactions (Hassan & Basher 2005). However, there are few studies that have focused on policy implications of eliminating interest payments. (Khan and Mirakhor 1987)

Ratio Analysis

Kader & Asarpota (2007) applied financial ratio analysis to assess the performance of the Malaysian Islamic bank and UAE Islamic banks respectively. Similarly, to measure efficiency of Islamic banks in Bangladesh, Sarkar (1999) utilized banking efficiency model and claimed that Islamic banks can stay alive even within a traditional banking architecture in which Profit-and-Loss Sharing (PLS) modes of financing are less dominated. Sarkar (1999) further claimed that Islamic financial products have different risk characteristics and consequently different prudential regulations should be in place.

Samad (1999) evaluated the relative efficiency position of the Islamic bank during 1992-1996, and compared it with the conventional banks in the country. His finding was that Bank Islam Malaysia enjoyed relatively higher managerial efficiency than the conventional banks.

Samad and Hassan (2000) evaluated inter-temporal and interbank performance in profitability, liquidity, risk and solvency, and community involvement of an Islamic bank (Bank Islamic Malaysia Berhad (BIMB) over 14years for the period 1984-1997. The study is inter-temporal in that it compares the performance of BIMB between the two time period 1984-1989 and 1990-1997. This is not a new method (Elyasiani 1994). To evaluate interbank performance, the study compares BIMB with two conventional banks (one smaller and one larger than BIMB) as well as with 8 conventional banks. Using financial ratios to measure these performance and F-test and T-test to determine their significance, the results show that BIMB make statistically significance improvement in profitability during 1984-1997, however, this improvement when compared with conventional banks is lagging behind due to several reasons. This result is consistent with that of Samad (1999) and Hassan (1999). The study also revealed that BIMB is relatively less risky and more solvent as compared to conventional banks. These results also conform to risk-return profile that is BIMB is comparatively less profitable and less risky. Performance evaluation of BIMB indicates that it is more liquid as compared to the group of 8 conventional banks. Results of the primary data gathered by surveying 40% to 70% bankers identify that lack of knowledgeable bankers in selecting, evaluating and managing profitable project is a significant cause why Musharaka and Mudarabah are not popular in Malaysia.

Abdus Samad (2004) in his paper examined the comparative performance of Bahrain’s interest-free Islamic banks and the interest-based conventional commercial banks during the post Gulf war period 1991-2001. Using nine financial ratios in measuring the performances with respect to (a) Profitability, (b) liquidity risk, and (c) credit risk, and applying Student’s t-test to these financial ratios, the paper concludes that there exists a significant difference in credit performance between the two sets of banks. However, the study found no major difference in probability and liquidity performances between Islamic banks and conventional banks.

Kader and Asarpota (2007) utilized bank level data to evaluate the performance of the UAE Islamic banks. Balance sheets and income statements of 3 Islamic banks and 5 conventional banks in the time period 2000-2004 are used to compile data for the study. Financial ratios are applied to examine the performance of the Islamic banks in profitability, liquidity, risk and solvency, and efficiency. The results of the study show that in comparison with UAE conventional banks, Islamic banks of UAE are relatively more profitable, less liquid, less risky, and more efficient. They conclude that there are two important implications associated with this finding. First, attributes of the Islamic profit-and-loss sharing banking paradigm are likely to be associated as a key reason for the rapid growth in Islamic banking in UAE. Second, UAE Islamic banks should be regulated and supervised in a different way as the UAE Islamic banks in practice are different from UAE conventional banks.

According to Munawar Iqbal (2001) there is a serious lack of empirical studies on Islamic banking. This research attempts to fill that gap to some extent. Using data for the 1990-1998 periods, several hypotheses and common perceptions about the practice of Islamic banking have been tested. The performance of Islamic banks has been evaluated using both trend and ratio analyses. For this purpose, some objective “benchmark” for various ratios has been developed for the first time. The performance of Islamic banks has also been compared with a ‘control group’ of conventional banks. It has been found that in general Islamic banks have done fairly well during the period under study.

Studies which used financial ratio analysis have generally found, contrary to the earlier hypotheses, that Islamic banks are more efficient than conventional banks in terms of resource use, cost effectiveness, profitability, asset quality, capital adequacy and liquidity ratios than conventional banks (Iqbal 2001, Hassan and Bashir 2005). Commercial banks, however, have a more favorable operations ratio. (Hassan and Bashir 2005).

According to Muhammad Jaffar and Irfan Manarvi (2011), the study examined and compared the performance of Islamic and conventional banks operating inside Pakistan during 2005 to 2009 by analyzing CAMEL test standard factors such as capital adequacy, asset quality, management quality, earning ability, and liquidity position. The financial data for the study was mined from the bank’s financial statements existing on state bank of Pakistan website. A sample of 5 Islamic banks and 5 conventional banks were selected to measure and compare their performance. Each year the average ratios were considered, because some of the young Islamic banks in the sample do not have 5 years of financial data. CAMEL test which is a standard test to check the health of financial institutions was used to determine the performance of Islamic and conventional banks. The study found that Islamic banks performed better in possessing adequate capital and better liquidity position while conventional banks pioneered in management quality and earning ability. Asset quality for both modes of banking was almost the same, conventional banks recorded slightly smaller loans loss ratio showing improved loan recovery policy whereas, UNCOL ratio analysis showed nominal better performance for Islamic banks. Jill Johns, Marwan Izzeldin and Vasileos Pappas, examined efficiency in Islamic and conventional banks in the GCC region (2004-2007) using financial ratio analysis (FRA), Islamic banks are less cost efficient more revenue and profit efficient than conventional banks.

Siti Rochmah Ika (2008) investigated whether the financial performance of Islamic banks in the period before fatwa is different from that in the period after fatwa. Furthermore, this study intends to examine the comparative financial performance of Islamic banks and conventional banks in the period both before fatwa and after fatwa. In evaluating bank’s performance, this study used various financial ratios categorized as profitability, liquidity, risk and solvency, and efficiency. To determine the difference, this study used t-test. The result of this study indicates that, in general, comparison of financial performance of Islamic banks in the period before fatwa and after fatwa does not show statistically difference. Likewise, the result of interbank analysis also indicates that there is no major difference in performance between Islamic banks and conventional banks in the period both before fatwa and after fatwa.

Studies which use financial ratio analysis have generally found, contrary to the earlier hypotheses, that Islamic banks are more efficient than conventional banks in terms of resources use, cost effectiveness, profitability, asset quality capital adequacy and liquidity ratios than conventional banks (Iqbal 2001, Hassan and Bashir 2005). Commercial banks, however, have a more favorable operations ratio (Hassan and Bashir 2005).