Literature Review on Islamic 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)

2.2 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).