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Assignment: Comparison between Efficiency of Islamic and Conventional Banks in Pakistan. Submitted By: Saima Naurin Submitted On: March 14, 2013

Preston University, Islamabad.

Comparison between Efficiency of Islamic and Conventional Banks in Pakistan

Abstract
There is a rising debate among different school of thoughts regarding the efficacy of the Islamic Banks (IB) and Conventional Banks (CB) in Pakistan. The topic has remained controversial from the time since the first IB was established in the country. The economists and other finance related scholars that were more inclined towards the IB supported it by showing their growth and efficiency far more than the CBs while others who thought IB as pre-mature portrayed them as less efficient. These arguments took a new shape after the economic crisis of 2008 in the country in which most of the CBs were badly affected while the IBs showed much resilience due to their investment in real estate and other tangible or fixed assets instead of financial assets but, as far as the profitability of the banks are concerned, the IBs are less profitable than the CBs.

Introduction to Islamic Banking in Pakistan

The establishment of first modern Islamic bank in Egypt in 1963[1] enlightened the Muslim world to adapt the banking system that is completely in compliance with the Islamic Shariah. This groundbreaking in banking industry in Egypt succeeded the Organization of Islamic Conference (OIC) to support the Islamic financial system in 1973 at Jeddah, Saudi Arabia. Finally, the wave of Islamic Banking also overwhelmed Pakistan when state bank of Pakistan incorporated the definition of Islamic banking in the banking policy as: Banking in consonance with the ethos and value system of Islam and governed, in addition to the conventional good governance and risk management rules, by the principles laid down by Islamic Sharia'h. This encouraged the establishment of Islamic bank in the country that finally led to the establishment of first Islamic Bank, Meezan Islamic bank of Pakistan, in 2002. Currently, there are more than Ten Islamic and conventional Islamic banks working nationally. People of the country are gradually inclining towards the Islamic banking by virtue of their professed binding with the conjunctions of Islam. Therefore, the popularity of the Islamic banks is increasing day by day in the country.

Currently, at global level, the Islamic financial industry has reached $1 trillion US dollar and is growing about 20 percent annually. Its growth is not restricted to the Muslim societies but Islamic financial products are also gaining popularity among non-Muslim countries. Many global banks have also opened separate windows to serve their Muslim clients. Similarly, about all global agencies like IMF, World Bank, IFC, ADBP, etc, have set up special cell to investigate into this new phenomenon [4].

Islamic and Conventional Banks:

Like Conventional bank, Islamic bank is an intermediary and trustee of money of people. On contrary, it shares profit and loss with its depositors and introduces the element of mutuality in Islamic banking. Conventional banking follows Conventional interest-based principle, whereas, Islamic banking is based on interest free principle and principle of Profit-and-Loss (PLS) sharing in performing their businesses as intermediaries [3]. Thus, it can be interpreted that in IBs, risk is shared among borrower, lender and the bank while in CBs risk is fully transferred to others. Furthermore, the analysis portfolio investment of IBs and CBs elaborates a clear distinction in their investment priorities. The IBs prefer investing in trade (Modarba transaction), real estate, tangible assets, and other non-interest related business activities and they are least inclined towards the treasury bills and other interest based instruments. On the other hand, the CBs invest more in financial instruments that are liquid and interest based. This makes their reliance on the volatile interest rate that at one side is a good income generator on the other side it is riskier too. Thus, the universal law of financial management i.e. Risk is directly proportional to Return is much applicable here. The IBs have less risk oriented investment while the CBs have more risk oriented investment.

Efficiency of Islamic Banks and Conventional Banks:

Pakistan is in the process of building a strong banking platform where its central bank, State Bank of Pakistan (SBP), regulates the sector to gradually bring reforms which on one hand may open new windows of opportunity for the industry players, and on the other hand may create distortions resulting in inefficient resource allocation. Besides this there is also the proliferation of financial crises and inefficient banks. The recent financial crisis experienced by the conventional banking sector around the world has pushed the Islamic banking sector to further emphasize on transparency and avoidance of undue risk to insulate themselves from the crises. Islamic and conventional banks are in direct competition and efficiency has proved to be a tool for winning the competition. Having the same factors of production, the efficient usage of inputs determines the success [2]. Generally there are two ways to study banking efficiency; traditional financial ratios and nonparametric approaches like data envelopment analysis (DEA). DEA measures the technical, pure technical and scale efficiency scores for the banks, and ratio analysis compares and contrasts with the results of DEA. Hence, the two methods are supplement and not the substitute for each other.

Before going further for measuring the efficacy of the banks, a comparison of the Islamic Banks and Commercial Banks in made as follows: Parameters
Banks

Islamic Banks Profit, service charges and consultancy fee is the main source of earnings of Islamic banks. Profit is variable which may be negative in case of loss.

Conventional Banks

1. Source of Earning

2. Earnings distribution

3. Lending Objective

4. Lending Preferences

Interest is the main source of income for conventional banks that is charged on different types of loans/products. (Difference between interests charged from borrowers and paid to depositors). It assures a predetermined rate of interest. The profit of Islamic bank is The conventional bank helps distributed among the concentration and depositors which are accumulation of wealth in the thousands in number and in sense that the net profit is this way Islamic bank helps distributed among widen distribution of wealth in shareholders who are few in the society. number and in this way the wealth of shareholders rises exponentially year after year. The lending objective of The lending objective of the Islamic bank is to stimulate conventional bank is to business activities through maximize the wealth of the profit-and-loss sharing and in shareholders and in this way this way it accelerates accumulate wealth through the circulation of wealth and institution of interest facilitates distribution of income. Good projects without Projects without collateral are collateral may be financed on not financed. the basis of profit and loss sharing.[5] It promotes risk sharing between Provider of capital (investor) and user of funds (Entrepreneur).Similar to conventional banking, rates of profits are aimed at maximization subject to Sharia principles. Risk is fully transferred to others.

5. Risk Sharing

It aims at maximizing the profit but subject to principles of Shariah. 6. Profit Maximization Islamic bank works as a trading concern (Mudarib or Wakalah) to generate its income.

It aims at maximizing the profit without any restriction even at the cost of other stakeholders.

7. Objectives

8. Investment Priorities and portfolios

9. Banking philosophy

10. Role in economic development

It generates income as financial intermediary. Its prime goal is the maximization of shareholders value at any cost Islamic banks cannot invest in Investment in interest based government treasury bills, instruments, short term and bonds and Term Finance long term loans on interest; Certificates which carries the risk of lending is fixed rate of interest. transferred completely to the Similarly, they are prohibited borrower. to invest in government bonds, Conventional banks make treasury bills and other more than 50 percent financial instruments like investment in government equity market. These factors Treasury bills, bonds and term in past were responsible for finance certificates for low profitability of Islamic security and smooth return. bank. But now the situation They also earn huge profit has been changed and Islamic from stock market in case of bank faces no more such bull-run and suffer badly in problem due to existence of case of its crash. In 2008 the well-established Islamic investment to deposit ratio of money market, Islamic Sukuk conventional banks in and Islamic mutual funds in Pakistan were 23.85% as almost all Muslim countries. compared to 15.39% of Islamic Banks In theory, Islamic banking is The commercial banks never an example of full-reserve aim to achieve 100% reserve banking, with banks achieving ratio, but on the other hand, it a 100% reserve ratio embraces more risk by maintaining the reserve ratio to 5% only. Islamic banks can play a vital Conventional banks aim at role in the economic capitalistic structure that development by acting upon accumulates the wealth in the conjunctions of Islam in some hands. Thus, this the business operations and consequently decreases money ethics. It works on the money flow in the market that circulation principal that decreases the purchasing increases the money flow in power of the people in the the market and makes the society making them poorer. people increase their

11. Borrowings[8]

purchasing power. Islamic banks pay high return to their depositors and weighted average profit rate on PLS deposits are between 3.56 percent and 3.79 percent. Profit and Loss sharing deposits earns more than one percent high return than interest-bearing deposits.

12. Concept of Money

Islamic bank use money as a medium of exchange to facilitate trade transactions. Islamic bank supplies money to traders to purchase real assets and to industrialists to purchase plants or raw material to augment production process and produce value-added products.

CBs offer different deposit schemes and borrow funds from the depositors. The rates of interest on these schemes are fixed and the banks are liable to pay these fixed rates of interest to depositors at the completion of term whether they earn profit or suffer loss. The depositors have nothing to do with the loss of bank. However, conventional banks use to pay low return to their depositors and charge high interest from their borrowers in order to maximize their profit. The conventional bank uses the money as a commodity which is bought and sold and on such two-way transactions they charge interest on it and make huge profit.

Functions of Islamic Bank

Determining efficiency of Islamic and commercial banks:

Parameters
Banks

Islamic Banks

Conventional Banks

1. Financial Stability

a. Small Islamic banks tend to be financially stronger than small commercial banks; b. Large commercial banks tend to be financially stronger than large Islamic banks; and c. Small Islamic banks tend to be financially stronger than large Islamic banks. A plausible explanation for the above findings is that it is significantly more complex for Islamic banks to adjust their credit risk monitoring system as they become bigger. Another possibility is that small banks concentrate on low-risk investments and fee income, while large banks do more profit-and-loss (PLS) business[7]

2.

EARNING RATIOS

IBs have relatively high earning ratios as compared to small CBs but when large IBs are compared with the large CBs their earning ratios comes relatively lower. The Non-performing loans of CBs are much higher than IBs. This elaborates the prudent and vigilant lending policies of IBs as compared to CBs.

3. Asset Quality

4. Debt Management Ratios 5. Liquidity Ratios

Islamic banks are far behind than conventional banks for their debt mobilization due to their recent start-up as compared to commercial banks. The Earning assets of Islamic Banks are 95 percent as compared to 93

percent earning assets of Conventional Banks. The ratio of advances to deposits for Islamic and Conventional Banks is 0.83 and 0.70 percent respectively. The point to be noted is that Islamic banks financing is 83 percent of their assets as compared to 70 percent of Conventional banks 6. Solvency Ratios 7. Investment ratio The solvency ratio of Islamic banks is far better than selected conventional banks. The conventional banks mostly invest in the Government fixed-income securities, deposit ratio means is the percentage of the amount of deposits to be i private Term Finance Certificates and in equity markets while Islamic banks mostly invest in sovereign and private Islamic Sukuks (bonds), equity market and other Islamic instruments. When we look at the investment portfolio of conventional banks we find that conventional banks have invested 23.85 percent of their deposits and 9.25 percent of their total assets in fixed income and other securities. While Islamic Banks have invested 15.39 percent of their deposits and 4.37 percent of their total assets in Islamic Sukuks,etc. This comparison clearly shows the lack of investment opportunities for Islamic banks the ratio of their investment is far less than the investment portfolio of conventional Banks. However, high percentage of financing by Islamic banks compensates them otherwise they are not able to earn profit on their idle cash assets.

8. Borrowing ratios

The borrowing to total deposits of Conventional Banks is 11.92 percent as compared to 5.86 percent borrowings of Islamic Banks. The borrowing to total advances of Conventional banks is 16.05 percent against 12.93 percent borrowings of Islamic Banks. Thus, there is a wide gap between the percentage of borrowing of conventional banks

and Islamic Banks. It means that Islamic banks is relying more on their own resources and having sufficient funds to discharge their obligations as compared to conventional banks which are borrowing heavily .It also shows that conventional banks are facing liquidity crunch.

Conclusion
Islamic banks in Pakistan have showed good performance. Many writers in the world have compared Islamic banking performance with Conventional banking. The results showed that Islamic banks were better in maintaining Capital Adequacy and Asset quality than the Conventional banks. Islamic banks are less profitable, more solvent and less efficient comparing to Conventional banks. In terms of liquidity, no major difference is seen between the two sets of banks. Islamic banks profitability is positively related to equity and loans. It is sometimes suggested that Islamic banks are rather complacent. They tend to behave as though they had a captive market in the Muslim masses who will come to them on religious grounds. This complacency seems more pronounced in countries with only one Islamic bank. Many Muslims find it more convenient to deal with conventional banks and have no qualms about shifting their deposits between Islamic banks and conventional ones depending on which bank offers a better return. This might suggest a case for more Islamic banks in those countries as it would force the banks to be more innovative and competitive. Another solution would be to allow the conventional banks to undertake equity financing and/or to operate Islamic 'counters' or 'windows', subject to strict compliance with the Shariah rules. It is perhaps not too wild a proposition to suggest that there is a need for specialized Islamic financial institutions such as mudaraba banks, murabaha banks and musharaka banks which would compete with one another to provide the best possible services.

References:
[1]

Ashfaq Ahmad, (2009), A Comparative Study of Islamic Banking in Pakistan: Proposing and Testing a Model, Foundation University, Islamabad, Unpublished doctoral thesis.
[2]

Danesh,(2007), International Journal of Business and Management, www.ccsenet.org/ijbm Vol. 7, No. 7; April 2012Published by Canadian Center of Science and Education.
[3]

Jaffar, Muhammad; Manarvi ,Irfan, (2011), Performance comparison of Islamic and Conventional banks in Pakistan, Global Journal of Management And Business Research, Volume 11 (1), Publisher: Global Journals Inc. (USA).
[4]

Abdul Ghafoor Awan, (2009),Comparison Of Islamic And Conventional Banking In Pakistan, Islamia University, Bahawalpur-Pakistan, Unpublished Research Journal.
[5]

Mohamed Ariff, (1994),Islamic Banking, Asian-Pacific Economic Literature Vol. 2(2) pp. 48-

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