Euro-Mediterranean Economics and Finance Review explores role of accountants in financial crisis

EURO-MEDITERRANEAN
ECONOMICS AND FINANCE

REVIEW
ISSN 1967-502X

Editors
Mondher Bellalah and Jean-Luc Prigent

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2 THE EURO-MEDITERRANEAN ECONOMICS AND FINANCE REVIEW
EDITORS
Mondher Bellalah, University of Cergy-Pontoise, France
Jean-Luc Prigent, University of Cergy-Pontoise, France

ADVISORY BOARD
Harry Markowitz, Nobel Prize Laureate, University of California, San Diego, USA
Edward Prescott, Nobel Prize Laureate, Arizona State University, USA

ASSOCIATE EDITORS

Michael Adler
Columbia University, USA
Rudy Aernoudt
Brussels Business School, Belgium
Aman Agarwal
Indian Institute of Finance, India
Gordon Alexander
UCLA, USA
Mohamed Arouri
University of Auvergne, France
Mohamed Ayadi
HEC Montreal, Canada
Giovanni Barone-Adesi
University of Lugano, Switzerland
Hatem Ben Ameur
HEC Montreal, Canada
Jean-Franois Boulier
CA Asset Management, France
Michael Brennan
UCLA, USA
Eric Briys
Cyberlibris, Belgium
Harvey R. Campbell
Duke University, USA
K.C. Chen
California State University, USA
Ephraim Clark
Middlessex University, UK
Georges Constantinides
University of Chicago, USA
Manuel Jos Da Rocha Armada
University of Minho, Portugal
Gabriel Desgranges
University of Cergy-Pontoise, France
Joao Duque, ISEG Portugal
Alain Finet
ULB, Belgium
Philippe Foulquier
EDHEC Business School, France
Bertrand Jacquillat
IEP, France
Frank Janseen
Catholic University of Louvain, Belgium
Cuong Le Van
PSE & University of Paris 1, France
Michel Levasseur
University of Lille 2, France
Patrick Navatte
University of Rennes 1, France
Andr de Palma
University of Cergy-Pontoise, France
Bernard Paranque
Euromed Management, France
Kuntara Pukthuanthong
San Diego University
Franois Quittard-Pinon
University of Lyon 1, France
Richard Roll
UCLA, USA
Olivier Scaillet
HEC, Genve, Switzerland
Stefan Straetmans
Maastricht University, Netherlands
Hracles Vladimirou
University of Cyprus, Cyprus
Jose Scheinkman
Princeton University, USA
Paul Willmott
Editor Derivatives, UK
VOLUME 8, NUMBER 5, 2014 SPECIAL ISSUE 3

EDITORIAL
Special Issue: Financial crisis in conventional and Islamic Banking

Guest Editor: Prof. Dr. Omar Masood
The current global financial crisis has affected both the conventional and the Islamic financial
system. The lessons learnt from the crisis need to be addressed for the betterment and stability of
both systems. This special issue will focus on three key areas. First, it will briefly set out the
various lessons learnt from the crisis. Secondly, it will expound on solutions derived from the
lessons learnt. Finally, it will explore the means to reshape the behavioural patterns and
responsibilities of economic agents in the financial system.


TABLE OF CONTENTS Volume 8
Number 5
2014

EDITORIAL .................................................................................................................................................. 3
1 Role of Accountants and Fair Value accounting leading towards the Global Financial Crisis . 5
2 An Empirical Analysis of Credit Risk Management in Islamic Banks of Pakistan ................... 21
3 How do the historical perspective and systemic effects of house price movements help to
explain the pattern of consumption in the U.K? .................................................................................... 31
4 Significant role of derivatives in islamic capital market ............................................................... 45
5 The Stability Estimation and Growth Analysis of Islamic Banks: The case of OIC countries . 62


1 Role of Accountants and Fair Value accounting leading
towards the Global Financial Crisis

Omar Masood
*
, Royal Docks Business School, University of East London, London, United
Kingdom
Mondher Bellalah
, University of Cergy and ISC Paris Business School, Paris, France

ABSTRACT
Since the 2007 market turmoil surrounding complex structured credit products, fair
value accounting and its application through the business cycle has/have been a topic of
considerable debate. As the illiquidity of certain products became more severe, financial
institutions turned increasingly to model-based valuations that, despite increased
disclosure requirements, were nevertheless accompanied by growing opacity in the
classification of products across the fair value spectrum. In this study, we make an
attempt to review an analysis regarding implications of the subprime crisis for
accounting. These implications depend on the interplay among attributes of subprime
mortgages and other positions, the evolution of market prices and illiquidity during the
crisis, and the requirements of the applicable accounting standards, while credit losses
on subprime positions are recorded under various standards. We focus on losses
recorded based on the fair value measurement guidance provided in FAS 157, Fair
Value Measurements. First, we overviewed the institutional and market aspects of
subprime mortgages and other positions, focusing on those with the greatest relevance
for accounting. Second, we discussed the critical aspects of FAS 157s definition of fair
value and guidance for fair value measurements. We focused on practical difficulties
that have arisen in applying that definition and guidance to subprime positions in the
current illiquid markets. We also raise potential Criticisms of Fair Value Accounting
during the Credit Crunch.
KEYWORDS: Subprime crisis; credit crunch; fair value accounting; securitization.
JEL Classification: M 00, M40, M41, M42

1. INTRODUCTION
Fair value accounting is a financial reporting approach in which companies are required or
permitted to measure and report on an ongoing basis certain assets and liabilities (generally
financial instruments) at estimates of the prices they would receive if they were to sell the assets
or would pay if they were to be relieved of the liabilities. Under fair value accounting, companies
report losses when the fair values of their assets decrease or liabilities increase. Those losses
reduce companies reported equity and may also reduce companies reported net income. Some
parties have strong opinion that fair value accounting has a major contribution in strengthen
credit crises, specially pointing to the obvious difficulties of measuring the fair values of
subprime positions in the current illiquid markets and the feedback effects noted above. This is
untenable. The subprime crisis was caused by firms and households making bad operating,
investing, and financing decisions, managing risks poorly, and in some instances committing
fraud. The best way to stem the credit crunch and damage caused by these actions is to speed the

*
Omar Masood is at the Royal Docks Business School, University of East London, London, United
Kingdom
Mondher Bellalah is at the University of Cergy and ISC Paris Business School, Paris, France
price adjustment process by providing market participants with the most accurate and complete
information about subprime positions. While imperfect, fair value accounting provides better
information about these positions and is a better platform for mandatory and voluntary
disclosure than alternative measurement attributes, including any form of cost-based accounting.
This is not to say that guidance for the measurement of fair values in illiquid markets cannot be
improved. While FAS 157 provides a clearer definition of fair value and considerably expanded
guidance specifying how fair value should be measured than prior GAAP, the current market
illiquidity has raised significant challenges for the interpretability of this definition and guidance.
FAS 157s definition of fair value reflects the idea that there can be orderly transactions based
on the conditions that exist at the measurement date. During the subprime crisis, this idea has
become increasingly difficult to sustain even in thought experiments and, more importantly,
practically useless as a guide to preparers estimation of fair values. FAS 157s fair value
measurement guidance includes a hierarchy of inputs that favours observable market inputs over
unobservable firm-supplied inputs, but that ultimately requires preparers to employ the
assumptions that market participants would use in pricing the asset or liability. This hierarchy
provides little help to preparers who have to decide whether to base their fair valuations on the
poor quality signals currently being generated by markets versus highly judgmental firm-
supplied inputs such as forecasts of house price depreciation. For the duration of the crisis,
preparers will need to exercise considerably more than the usual professional judgment to apply
FAS 157s language to their specific circumstances.
As the successive waves of the subprime crisis have hit, firms have repeatedly and sharply
revised upward their estimates of credit losses. These revisions are inevitable consequences of
how the subprime crisis evolved, and they do not imply there have been any problems either
with accounting standards or how preparers have applied them. However, these revisions and
the high potential for further upward revisions have contributed to the aforementioned feedback
effects between reported losses and market illiquidity. Needless to say, this market illiquidity is
damaging our real estate and credit markets and overall economy, and it needs to be cured
through means that do not simply push the problem into the future. As always, essential
components of such a cure are for firms to provide relevant, reliable, and understandable
financial report information and for users to conduct careful and dispassionate analysis of that
information.
The remainder of the essay is structured as follows. In Section II, we overview the short synopsis
of credit crises. In Section III, we describe the critical aspects of FAS 157s definition of fair value
and guidance for fair value measurements. We describe the practical difficulties that have arisen
in applying that definition and guidance to subprime positions in the current illiquid markets.
We also discuss a potential issue regarding the application of FAS 159, The Fair Value Option for
Financial Assets and Financial Liabilities, during credit crunch. Section IV reveals our findings
regarding potential Criticisms of Fair Value Accounting during the Credit Crunch Section V
contain our concluding remarks.
2. SHORT SYNOPSIS OF CREDIT CRISES
The International Monetary Fund (2008) estimates that the credit crisis will cost about $945 billion
dollars, the latest in a long list of estimates presented in Figure 1 below. No one knows the
ultimate cost of the crisis, but it certainly will exceed the costs of the last major financial crisis
presented by the collapse of the savings and loan industry. This problem began in the subprime
mortgage market and then quickly spilled over into other areas of the mortgage industry and the
capital markets, culminating in a liquidity and credit crisis that is still unfolding. Unsurprisingly,
litigation has been on the rise.

Figure 1. Estimates of Losses Due to the Subprime and Credit Crises

3. CRISES
Just as in the credit crisis, the lawsuits initially started in the mortgage industry. For the most
part, these were suits against mortgage lenders. The subjects of litigation then moved on to be the
issuers and underwriters of securities whose cash flows are backed by the principal and interest
payments of mortgages. Now, the litigation has also engulfed investors who either purchased
these securities or packaged them into other securities. As the liquidity crisis intensifies, areas
that are not directly related to the subprime mortgage sector are starting to suffer losses,
including the commercial paper market, the leveraged buyout industry, and auction-rate
securities, to name a few examples. As the write-downs continue to accumulate, additional types
of lawsuits are expected to emerge.
The value of asset-backed securities (ABS) backed by subprime products has fallen as the
performance of the subprime loans has continued to worsen. Figure 2 illustrates the value of two
indices tracking the BBB rated and BBB- rated tranches of home equity deals based on loans from
the last six months of 2006. An initial investment of $100 (on 19 January 2007) in the BBB index
would have been worth only $5.46 by 8 May 2008; both indices showed a decline of almost 95%
as of 8 May 2008.
Figure 2. Index Values of Subprime Home Equity ABS Deals from the Second Half of 2006, 19
January 2007 to 8 May 2008

Subprime Mortgage-Related Securities Lawsuits
Almost every market participant in the securitization processwhich transforms illiquid assets
such as mortgages, auto loans, and student loans into tradable securitieshas been named as a
defendant. The list of defendants includes lenders, issuers, underwriters, rating agencies,
accounting firms, bond insurers, hedge funds, CDOs, and many more.As of 21 April 2008, there
had been 132 securities lawsuits related to subprime and credit issues, of which 56 were filed
since January 2008. New York has the most filings, with 48%, while California follows with 14%
and Florida wraps up the top three with 7%. Filings in other states range between 1% and 5%
(lawsuits by state are shown in Figure 3 below). This is consistent with recent trends in
shareholder class actions, where the US circuit courts encompassing New York (Second Circuit),
California (Ninth Circuit), and Florida (Eleventh Circuit) have seen the most activity in recent
years.
Figure 3. Partial Count of Subprime-Related Lawsuits by State (through 21 April 2008)


The majority of the early lawsuits have been against mortgage lenders. As various other market
participants reveal the extent of their losses and exposure, they too are being dragged into
litigation. The plaintiffs include shareholders, investors, issuers and underwriters of securities,
plan participants, and others. Figure 4 gives a breakdown of securities defendants and plaintiffs.
Figure 4. The Players: Plaintiffs and Defendants (through 21 April 2008)

Scope of Fair Value Accounting

As depicted in Figure 6, the valuation attributes required by the accounting standards governing
the accounting for subprime positions can be subdivided into the following broad categories.
Some of these standards require or allow subprime positions to be fair valued on the balance
sheet (e.g., FAS 115 for trading and AFS securities, FAS 133 for derivatives, FIN 45 for guarantees
at inception, and FAS 159 for positions for which the fair value option is chosen). When fair value
is the valuation attribute, unrealized gains on the positions may be recorded either on the income
statement (e.g., FAS 115 for trading securities, FAS 133 for non hedge and fair value hedge
derivatives, and FAS 159 for financial instruments for which the fair value option is elected) or in
other comprehensive income (FAS 115 for AFS securities and FAS 133 for cash flow hedge
derivatives).
Other of these standards requires subprime positions to be recorded at amortized cost (possibly
zero) on the balance sheet. Assets accounted for at amortized cost generally are subject to
impairment write-downs if criteria specified in the standards are met. Assets deemed impaired
based on the relevant criteria are required to be written down to fair value under some standards
(e.g., FAS 115 for HTM securities and SOP 01-6 for held-for-sale loans) and to other valuation
attributes that generally are higher than fair value under other standards (e.g., FAS 5 and FAS 114
for held-for-investment loans). Similarly, under FAS 115 unrealized gains and losses on AFS
securities that previously were recorded in other comprehensive income are recorded in income
when the AFS are deemed impaired.
Critical Aspects of the Definition of Fair Value
FAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer
a liability in an orderly transaction between market participants at the measurement date. In this
section, we unpack and discuss the constituent elements of this definition, indicating the practical
difficulties involved in applying each element and the slippage among the elements given the
current market illiquidity for subprime positions. The definition reflects an optimal exit value
notion of fair value, that is, the highest values of assets and the lowest values of liabilities
currently held by the firm. This notion corresponds to firms solvency more than do the possible
alternative fair value notions of entry value (the price that would be paid to buy an asset or
received from issuing a liability) or value in use (the entity-specific value to the current holder
of an item). In particular, if all assets and liabilities on a firms balance sheet were perfectly
measured at exit value, then owners equity would equal the cash expected to remain if the firm
liquidated all of those items in orderly transactions between market participants at the
measurement date, that is, not in fire sales. Given the paramount importance of maintaining
solvency during the subprime crisis, this element of the definition of fair value is well suited to
users of financial reports current informational needs.
At the measurement date means that fair value should reflect the conditions that exist at the
balance sheet date. If markets are illiquid and credit spreads are at historically high levels, as is
now the case, then the fair values should reflect those conditions. In particular, firms should not
incorporate their expectations of market liquidity and credit spreads returning to normal over
some horizon, regardless of what historical experience, statistical models, or expert opinion
indicates. While one can question this element of the fair value definition, it has considerable
precedent in the accounting literaturenotably FAS 107, Disclosures about Fair Value of
Financial Instruments, and SEC enforcement actions20 and it is hard to imagine the FASB
proposing a definition of fair value without it.
An orderly transaction is one that is unforced and unhurried. The firm is expected to conduct
usual and customary marketing activities to identify potential purchasers of assets and assumers
of liabilities, and these parties are expected to conduct usual and customary due diligence. Each
of these activities could take months in the current environment, because of the few and noisy
signals about the values of subprime positions currently being generated by market transactions
and because of parties natural skepticism regarding those values. Hence, the earliest such an
orderly transaction might occur could easily be a quarter or more after the balance sheet date. At

that time, market conditions almost certainly will differ from those that exist at the balance sheet
date, for better or, as been the case lately, worse.
The Fair Value Hierarchy
FAS 157 creates a hierarchy of inputs into fair value measurements, from most to least reliable.
Level 1 input is unadjusted quoted market prices in active markets for identical items. While
some accounting academics, bank regulators, and others worry that market values might be
incorrect or their use in accounting might have undesirable incentive or feedback effects, in our
opinion pure mark-to-market measurements using such maximally reliable inputs are the rough
equivalent of accounting nirvana. Even in times of normal market liquidity, this nirvana does not
exist for most subprime positions, however, and so we can safely ignore such philosophical
disputes in this essay. Level 2 inputs are other directly or indirectly observable market data.
There are two broad subclasses of these inputs. The first and generally preferable subclass is
quoted market prices in active markets for similar items or in inactive markets for identical items.
These inputs yield adjusted mark-to-market measurements that are less than ideal but usually
still pretty good, depending on the nature and magnitude of the required adjustments. The
second subclass is other observable inputs such as yield curves, exchange rates, empirical
correlations, et cetera. These inputs yield mark-to-model measurements that are disciplined by
market information but that can only be as good as the models employed. In our view, this
second subclass usually has less in common with the first subclass than with better quality level 3
measurements described below.
In times of normal market liquidity, many subprime positions would be fair valued using level 2
measurements. For example, while most subprime MBS trade over-the-counter and rarely, in
normal markets dealers generally do their best to provide bid and ask prices for these securities.
There are also price and yield indices for portfolios of subprime positions available from Market
and other sources. The price transparency offered by these sources has substantially evaporated
during the subprime crisis, however. Dealers are reluctant to provide bid and ask quotes for
subprime positions, and when they do the bid-ask spread is very wide. Very few truly orderly
transactions are occurring, and those that do occur typically are privately negotiated principal-to-
principal transactions for which the terms and positions involved are largely opaque to market
participants. Market has announced that there will be no indices for the first half of 2008 vintage,
due to an insufficient number of securitizations.
Level 3 inputs are unobservable, firm-supplied estimates. While these inputs should reflect the
assumptions that market participants would use, they yield mark-to-model valuations that are
largely undisciplined by market information. Due to the declining price transparency described
above, many subprime positions that previously were fair valued using level 2 inputs must now
be fair valued using level 3 inputs. While many firms have been criticized in the popular press for
this migration of fair value measurements down the hierarchy, this migration is an inevitable
result of the deterioration of price transparency in the subprime crisis.
Level 3 inputs usually are based on historical data in some fashion. Historical data is only useful
for fair valuation purposes to the extent that the future is expected to be similar, or at least
capable of being related, to the past. For subprime positions, a critical level 3 input is house price
depreciation. Most of the historical data to date (and a fortiori up to earlier points in the subprime
crisis) reflect a period in which house price appreciation was robust and so defaults were few,
uncorrelated, and yielded small percentage losses given default. Hence, this historical data is of
little use for the purposes of determining this input and thus the fair values of subprime
positions. Instead, firms must forecast future house price depreciation, as well as other primitive
variables such as future interest rates and the time when subprime mortgagors will be able to
refinance again. These variables are critical determinants of the future number and correlation of
defaults and the percentage magnitude of losses given default.

4. REQUIRED DISCLOSURES
Subprime positions are subject to the disclosure requirements of the governing accounting
standards (e.g., FAS 115 for securities) that we do not mention here.22 Instead, we discuss three
overarching disclosure requirements of particular relevance to subprime positions during the
subprime crisis.
First, FAS 157 requires disclosures of fair value measurements by level of the hierarchy. The
required disclosures are considerably more detailed for level 3 fair value measurements than for
level 1 or 2 measurements. In particular, for level 3 measurements firms most provide
quantitative reconciliations of beginning and end-of period fair values, distinguishing total
(realized and unrealized) gains and losses from net purchases, sales, issuances, settlements, and
transfers. The line-item location of gains and losses on the income statement must be indicated.
Qualitative descriptions of measurement inputs and valuation techniques must be provided.
These disclosure requirements make the effects of level 3 measurements on the financial
statements considerably more transparent than they would have been under prior GAAP, and
users of financial reports are fortunate to have them available during the subprime crisis.
Second, SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties, requires disclosures
regarding an uncertain estimate such as a fair value when it is reasonably possible the estimate
will change in the near term (one year or less) and the effect of the change would be material to
the financial statements. The disclosure should indicate the nature of the uncertainty. Disclosures
of the factors that cause the estimate to be sensitive to change are encouraged but not required.
Neither FAS 157 nor SOP 94-6 requires quantitative disclosures of the forecasted values of the
primitive variables that underlie level 3 fair valuations or of the sensitivities of the fair valuations
to movements in those primitive variables. In the absence of such quantitative disclosures, during
the subprime crisis I have found level 3 fair values to be very difficult to interpret for a given firm

and to compare across firms. To enhance the interpretability of level 3 fair values, I/we suggest
the FASB consider requiring disclosures of firms forecasts of primitive variables when those
forecasts have material effects on their level 3 fair valuations.
Third, SAS 1 requires disclosures of type 2 subsequent events, i.e., events that occur between the
balance sheet date and the financial report filing date, if these events render the financial
statements misleading as of the filing date. Very significant type 2 subsequent events occurred for
many firms holding large subprime positions in the third and fourth quarters of 2007.
Specifically, the third and fourth waves of the subprime crisis described above hit after the end of
the third and fourth fiscal quarters of many firms, respectively, but before the filing dates for
those quarters. Citigroups previously discussed third quarter 2007 subsequent events disclosure
is a good example.
Fair Value Option
FAS 159 allows firms to elect to fair value individual financial instruments upon the adoption of
the standard or at the inception of the instruments. One type of exercise of the fair value option
with particular salience in the subprime crisis is the decision by many securities firms to fair
value the liabilities of their consolidated securitization entities. Securities firms have made this
choice primarily because they are required by industry or other GAAP to record the entities
assets at fair value, and so electing the fair value option for the entities liabilities yields
symmetric accounting. In general, such symmetry is a desirable thing, as offsetting gains and
losses on these economically matched positions are recorded in the same period.
A concern, however, is that these firms may have the incentive to provide moral recourse to the
securitization entities. When this is the case, the firms may bear the losses on the entities assets
without benefiting from offsetting gains on the entities liabilities. At a minimum, the fair values
of the entities liabilities would have to be adjusted for any expected provision of moral recourse,
a problematic valuation exercise given the non contractual nature of moral recourse.
Potential Criticisms of Fair Value Accounting
During the Credit Crunch
Unrealized Gains and Losses Reverse
There are two distinct reasons why unrealized gains and losses may reverse with greater than
50% probability. First, the market prices of positions may be bubble prices that deviate from
fundamental values. Second, these market prices may not correspond to the future cash flows
most likely to be received or paid because the distribution of future cash flows is skewed. For
example, the distribution of future cash flows on an asset may include some very low probability
but very high loss severity future outcomes that reduce the fair value of the asset.
Bubble Prices
The financial economics literature now contains considerable theory and empirical evidence that
markets sometimes exhibit bubble prices that either are inflated by market optimism and
excess liquidity or are depressed by market pessimism and illiquidity compared to fundamental
values. Bubble prices can result from rational short horizon decisions by investors in dynamically
efficient markets, not just from investor irrationality or market imperfections. Whether bubble
prices have existed for specific types of positions during the credit crunch is debatable, but it
certainly is possible.
In FAS 157s hierarchy of fair value measurement inputs, market prices for the same or similar
positions are the preferred type of input. If the market prices of positions currently are depressed
below their fundamental values as a result of the credit crunch, then firms unrealized losses on
positions would be expected to reverse in part or whole in future periods. Concerned with this
possibility, some parties have argued that it would be preferable to allow or even require firms to
report amortized costs or level 3 mark-to model fair values for positions rather than level 2
adjusted mark-to-market fair values that yield larger unrealized losses. If level 1 inputs are
available, then with a few narrow exceptions FAS 157 requires firms to measure fair values at
these active market prices for identical positions without any adjustments for bubble pricing.
However, if only level 2 inputs are available and firms can demonstrate that these inputs reflect
forced sales, then FAS 157 (implicitly) allows firms to make the argument that level 3 mark-to-
models based fair values are more faithful to FAS 157s fair value definition.
If we agree with the FASBs decision in FAS 157 that the possible existence of bubble prices in
liquid markets should not affect the measurement of fair value. It is very difficult to know when
bubble prices exist and, if so, when the bubbles will burst. Different firms would undoubtedly
have very different views about these matters, and they likely would act in inconsistent and
perhaps discretionary fashions. To be useful, accounting standards must impose a reasonably
high degree of consistency in application. It should also be noted that amortized costs reflect any
bubble prices that existed when positions were incepted. In this regard, the amortized costs of
subprime-mortgage related positions incepted during the euphoria preceding the subprime crisis
are far more likely to reflect bubble prices than are the current fair values of those positions.
Future Cash Flows
Fair values should reflect the expected future cash flows based on current information as well as
current risk-adjusted discount rates for positions. When a position is more likely to experience
very unfavourable future cash flows than very favourable future cash flows, or vice-versa
statistically speaking, when it exhibits a skewed distribution of future cash flowsthen the
expected future cash flows differ from the most likely future cash flows. This implies that over
time the fair value of the position will be revised in the direction of the most likely future cash
flows with greater than 50% probability, possibly considerably greater. While some parties
appear to equate this phenomenon with expected reversals of unrealized gains and losses such as
result from bubble prices, it is not the same thing. When distributions of future cash flows are
skewed, fair values will tend to be revised by relatively small amounts when they are revised in
the direction of the most likely future cash flows but by relatively large amounts when they are
revised in the opposite direction. Taking into account the sizes and probabilities of the possible
future cash flows, the unexpected change in fair value will be zero on average.
Financial instruments that are options or that contain embedded options exhibit skewed
distributions of future cash flows. Many financial instruments have embedded options, and in
many cases the credit crunch has accentuated the importance of these embedded options. Super
senior CDOs, which have experienced large unrealized losses during the credit crunch, are a
good example. At inception, super senior CDOs are structured to be near credit riskless
instruments that return their par value with accrued interest in almost all circumstances. Super
senior CDOs essentially are riskless debt instruments with embedded written put options on
some underlying set of assets. Super senior CDOs return their par value with accrued interest as
long as the underlying assets perform above some relatively low threshold (reflecting the riskless
debt instruments),but they pay increasingly less than this amount the more the underlying assets
perform below that threshold (reflecting the embedded written put options). As a result of the
embedded written put options, the fair values of super senior CDOs typically are slightly less
than the values implied by the most likely cash flows. During the credit crunch, the underlying
assets (often subprime mortgage-backed securities) performed very poorly, increasing the

importance of the embedded put option and decreasing the fair value of super senior CDOs
further below the value implied by the most likely outcome, which for some super seniors may
still be to return the par value with accrued interest. To illustrate this subtle statistical point,
assume that the cash flows for a super senior CDO are driven by home price depreciation, and
that the distribution of percentage losses is modestly skewed with relatively small probability of
large losses, as indicated in the following table.
Estimated loss on

Home price depreciation Probability occurs (Value of) super senior CDO
as a percentage of par value
<10% 20% 0% (100%)
15% 40% 5% (95%)
20% 25% 20%(80%)
25% 10% 40%(60%)
30% 5% 80%(20%)

In this example, the most likely percentage loss on the super senior is 5%, which occurs 40% of
the time. The expected percentage loss is a considerably larger 15%=(40%5%) + (25%20%) +
(10%40%) + (5%80%), because it reflects the relatively small probabilities of large losses. The
fair value of the super senior is reduced by the expected percentage loss and so is 85% of face
value. Over time, this fair value will be revised upward with 60% probability, to either 95% of
face value (with 40% probability) or 100% of face value (with 20% probability). The fair value will
be revised downward with only 40% probability, to 80% of face value (with 25% probability) or
60% of face value (with 10% probability) or 20% of face value (with 5% probability). The expected
change in fair value is zero, however, because the lower probability but larger possible fair value
losses are exactly offset by the higher probability but smaller possible fair value gains. The
difference between the most likely and expected change in fair value would be larger if the
distribution of cash flows was more skewed.
According to our findings it is more informative to investors for accounting to be right on
average and to incorporate the probability and significance of all possible future cash flows, as
fair value accounting does, than for it to be right most of the time but to ignore relatively low
probability but highly unfavourable or favourable future cash flows. Relatedly, by updating the
distribution of future cash flows each period, fair value accounting provides investors with
timelier information about changes in the probabilities of large unfavourable or favourable future
cash flows. Such updating is particularly important in periods of high and rapidly evolving
uncertainty and information asymmetry, such as the credit crunch.

5. MARKET ILLIQUIDITY
Together, the orderly transaction and at the measurement date elements of FAS 157s fair
value definition reflect the semantics behind the fair in fair value. Fair values are not
necessarily the currently realizable values of positions; they are hypothetical values that reflect
fair transaction prices even if current conditions do not support such transactions. When markets
are severely illiquid, as they have been during the credit crunch, this notion yields significant
practical difficulties for preparers of firms financial statements. Preparers must imagine
hypothetical orderly exit transactions even though actual orderly transactions might not occur
until quite distant future dates. Preparers will often want to solicit actual market participants for
bids to help determine the fair values of positions, but they cannot do so when the time required
exceeds that between the balance sheet and financial report filing dates. Moreover, any bids that
market participants might provide would reflect market conditions at the expected transaction
date, not the balance sheet date.
When level 2 inputs are driven by forced sales in illiquid markets, FAS 157 (implicitly) allows
firms to use level 3 model-based fair values. For firms to be able to do this, however, their
auditors and the SEC generally require them to provide convincing evidence that market prices
or other market information are driven by forced sales in illiquid markets. It may be difficult for
firms to do this, and if they cannot firms can expect to be required to use level 2 fair values that
likely will yield larger unrealized losses. In our view, the FASB can and should provide
additional guidance to help firms, their auditors, and the SEC individually understand and
collectively agree what constitutes convincing evidence that level 2 inputs are driven by forced
sales in illiquid markets. The FASB could do this by developing indicators of market illiquidity,
including sufficiently large bid-ask spreads or sufficiently low trading volumes or depths.
These variables could be measured either in absolute terms or relative to normal levels for the
markets involved. When firms are able to show that such indicators are present, the FASB should
explicitly allow firms to report level 3 model-based fair values rather than level 2 valuations as
long as they can support their level 3 model-based fair values as appropriate in theory and with
adequate statistical evidence. Requiring firms to compile indicators of market illiquidity and to

provide support for level 3 mark-to-model valuations provides important discipline on the
accounting process and cannot be avoided. Relatedly, we also believes that the FASB should
require firms to disclose their significant level 3 inputs and the sensitivities of the fair values to
these inputs for all of their material level 3 model-based fair values. If such disclosures were
required, then level 3 model-based fair values likely would be informationally richer than poor
quality level 2 fair values.
6. ADVERSE FEEDBACK EFFECTS AND SYSTEMIC RISK
By recognizing unrealized gains and losses, fair value accounting moves the recognition of
income and loss forward in time compared to amortized cost accounting. In addition, as
discussed in Section IV.A.1 unrealized gains and losses may be overstated and thus subsequently
reverse if bubble prices exist. If firms make economically suboptimal decisions or investors
overreact because of reported unrealized gains and losses, then fair value accounting may yield
adverse feedback effects that would not occur if amortized cost accounting were used instead.
For example, some parties have argued that financial institutions write-downs of subprime and
other assets have caused further reductions of the market values of those assets and possibly
even systemic risk.
These parties argue that financial institutions reporting unrealized losses has caused them to sell
the affected assets to raise capital, to remove the taint from their balance sheets, or to comply
with internal or regulatory investment policies. These parties also argue that financial
institutions issuance of equity securities to raise capital have crowded out direct investment in
the affected assets. It is possible that fair value accounting-related feedback effects have
contributed slightly to market illiquidity, although he is unaware of any convincing empirical
evidence that this has been the case. However, it is absolutely clear that the subprime crisis that
gave rise to the credit crunch was primarily caused by firms, investors, and households making
bad operating, investing, and financing decisions, managing risks poorly, and in some instances
committing fraud, not by accounting. The severity and persistence of market illiquidity during
the credit crunch and any observed adverse feedback effects are much more plausibly explained
by financial institutions considerable risk overhang10 of subprime and other positions and their
need to raise economic capital, as well as by the continuing high uncertainty and information
asymmetry regarding those positions. Financial institutions actually selling affected assets and
issuing capital almost certainly has mitigated the overall severity of the credit crunch by allowing
these institutions to continue to make loans. Because of its timeliness and informational richness,
fair value accounting and associated mandatory and voluntary disclosures should reduce
uncertainty and information asymmetry faster over time than amortized cost accounting would,
thereby mitigating the duration of the credit crunch.
Moreover, even amortized cost accounting is subject to impairment write-downs of assets under
various accounting standards and accrual of loss contingencies under FAS 5. Hence, any
accounting-related feedback effects likely would have been similar in the absence of FAS 157 and
other fair value accounting standards.
CONCLUDING REMARKS
Financial history contains many examples of the cycle characteristic of the subprime market
discovery of profitability, expansion of credit activity, weakening of credit standards as
competitive pressures to maintain volumes increase, followed by subsequent collapse. The
subprime cycle is unique mainly in the lack of clarity regarding the distribution of mortgage
default risks, especially in the failure to recognize that even the mortgage trusts might suffer
enough write offs that their own securities could be wholly or partially defaulted. The principal
lesson from each of these cycles is that risk control needs to be tougher during the upswing of the
cycle, just when everyone believes it to be unnecessary. If the industry cannot control risks on its
own regardless of how confusing the allocation of the risks might be then regulators must
ensure they do so. Sadly, in the many cycles where the foregoing effects have been observed,
regulatory corrective action is almost always too little and too late to offset some painful losses.
Like all of the severe crises that have periodically be/been(?) set our remarkably flexible economy,
the subprime crisis is not and could not be the fault of any one set of parties. The entire economic
system failed to appreciate the risks of the rapid growth in risk-layered subprime mortgages, the
inevitable end of house price appreciation, and unprecedented global market liquidity. These
factors combined to enable all-too-human undisciplined behaviours in lenders, borrowers, and
investors, all of whom were unquestioningly optimistic for as long as the sun shined upon home
equity. Economic policy, bank regulation, corporate governance, financial reporting, common
sense, fear of debt and bankruptcy, and all of our other protective mechanisms were insufficient
to curb these behaviours.
This passage also captures how divorced the process was from the economic and statistical
concepts, such as fair value, that underlie accounting.
Accounting, fair value or otherwise, will never eliminate such behaviours. It can only play two
roles. It can provide periodic financial reports that inform relatively rational and knowledgeable
market participants on an ongoing basis, thereby mitigating the adverse effects of these
behaviours. It can provide a common information set upon which market participants can
recalibrate their valuations and risk assessments when the economic cycle turns. In our view, fair
value accounting plays an essential part in both of these roles, but especially in allowing such
recalibrations to occur as quickly and efficiently as possible, as it is now doing in the subprime
crisis. By comparison, any form of historical cost accounting would drag out these recalibrations
over considerably longer period, likely worsening the ultimate economic cost of the crisis.
This is not to say that fair value accounting and other aspects of GAAP have worked perfectly
during the subprime crisis. The crisis has made clear that financial statement preparers need
additional guidance regarding how to calculate fair values in illiquid markets. Users of financial
reports need better disclosures about the critical estimates underlying level 3 fair values and how
sensitive fair values are to those estimates. Accounting standard setters need to consider what
guidance and disclosures to require. Preparers need to provide these disclosures in an
informative fashion, and users must analyze them carefully and dispassionately. Accounting
researchers and teachers can contribute to all of these processes. Indeed, for all of us who care
about accounting and its role in our economy, there is much work to be done.

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2 An Empirical Analysis of Credit Risk Management in
Islamic Banks of Pakistan
Asma Abdul Rehman
*
, Cardiff Metropolitan University

Abstract
The purpose of this study is to investigate the banks factors which have significantly
influence the credit risk of Islamic banks operating in Pakistan. Secondary data is
obtained from annual reports of the Islamic banks from 2007 to 2011. Data is analyzed
by using descriptive statistics, correlation matrix and multiple regression analysis.
Findings reveal that total debt equity ratio and capital adequacy ratio have positive and
significant relationship with credit risk whereas asset utilization has a negative and
significant relationship with credit risk. Considering the importance of credit Risk
management in Islamic banks, this research has determined the credit risk management
in Pakistani Islamic banks. This study would be helpful as a base study for future
conceptual model.
Keywords: Credit risk, Non-performing loan, capital adequacy, debt to equity ratio,
asset utilization ratio, Islamic banks, Pakistan
G21 : Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

1. INTRODUCTION
Islamic banking industry has been significantly growing over the last three decades and now has
total assets of around $1.2 trillion with annual growth rate over 20 percent.
Credit risk is considered the major risk in banking industry. Credit risk management is an
integral part of banks loan process. In developing countries, the development process depends a
lot on financial intermediaries. Empirical researches have shown that a good financial sector
contributes to the development of economy. Financial institutions should have a credit risk
management system in place to identify measure, monitor and control credit risk which in turn
prevents distress or collapse of the financial institutions. The concepts of a sound risk
management system in financial institutions and regulations provide a mechanism to strengthen
and improve the supervision and risk management system. A successful system for risk
management needs a positive risk culture.
The financial crisis of 2007 have provided a golden opportunity to Islamic banks for the
expansion in the other parts of the world because Islamic banks are considered as much safer as
they do not include risky products offerings (Lahem 2009, Cihak and Hesse 2008). Islamic banks
have managed to survive during financial crisis due to uniqueness of Islamic banking products
(Zeitun, 2012).
Today, there is unstable circumstances in Pakistan that has put banks both Islamic banks and
conventional banks to face numerous barrier to grow. Islamic banks are new to the industry that
is the reason they are more obvious to the unstable conditions. There is not a specific study that
has been conduct specifically on credit Risk management in Islamic banks of Pakistan. So, this
study will add value to literature and will be useful for Islamic Banks, practitioner as well as for
academic point of view.

*
Asma Abdul Rehman is at Cardiff Metropolitan University, Email: asmaabdul@hotmail.com
OBJECTIVES OF THE STUDY
The aim of this paper is to investigate empirically the internal factors that have an impact on the
capital risk ratio in Islamic banks operating in Pakistan.
The overall objectives of the current study are as follows:
1. To investigate the impact of total debt equity ratio on credit risk ration of Islamic banks
operating in Pakistan.
2. To examine the effect of NPL ratio on credit risk ratio of Islamic banks of Pakistan.
3. To determine the effect of capital adequacy ratio on credit risk of Islamic banks.
4. To investigate the effect of banks size on credit risk of Islamic banks.
5. To examine the impact of asset utilization ratio on credit risk of Islamic banks operating
in Pakistan.
The remaining paper has been organized as follows: Section 2 discusses the Islamic banking
system in Pakistan briefly, section 3 through light on previous studies related to Islamic banking
and credit Risk management, section 4 explains the Methodology in detail, Section 5 is related to
the Data Analysis and finally section 6 presents the conclusion of the study.
2. OVERVIEW OF ISLAMIC BANKING IN PAKISTAN
Islamic banking is growing significantly in Pakistan as it constitute of over 10% of banking
system in Pakistan with 903 billion rupees of assets and with 1115 branches of Islamic banks
operating all over Pakistan (SBP, 2013). Islamic banking is having profits of 4.3 billion rupees as
the end of June 2013. Islamic bankings share of assets in banking industry is reached to 9%. It is
estimated that with this growing trend Islamic banking industry will reach double of its market
share by 2020. There are 19 Islamic banks working in Pakistan out of these banks five banks are
full-fledge Islamic banks in Pakistan such as Meezan bank, Bank Islami, Dubai Islamic bank, Burj
bank and Al-Baraka bank and remaining are Islamic windows of conventional banks working in
Pakistan.
Following table shows the statistics of Islamic banking industry of Pakistan:
Table 1: Islamic banking industry
Industry progress (billion RS.) Share in industry
June 2012 March 2013 June 2013 June
2012
March 2013 June
2013
Total Assets 711 847 903 8.2% 8.7% 9.0%
Deposits 603 704 771 8.9% 9.7% 9.9%
Net Financing &
investment
543 666 700 7.9% 8.9% 8.8%
NPL 18.3 19.5 19.4 - - -
Branches 886 1100 1115 - - -


3. LITERATURE REVIEW
Credit risk is the most prominent risk in banking industry. According to Drzik et al. (1998), credit
risk is comprised of 60% of total risks in commercial banks. Credit risk refers to defaulting of
counterparty on debt payment or meeting contractual obligation. Fraser et al. (2001) pointed out
that credit risk is considered the major reason of banks failure in recent years, and it is most
evident risk that is faced by banks.
Khan and Ahmad (2001) states that the nature of the risk goes to change due to change in the
composition of its assets & liabilities as well as profit and loss sharing ratio. Their analysis
highlights that credit risk depends upon profit and loss sharing model of financing. The most
important risk that seriously affects the banks viability is credit risk. In order to maintain
sustainable growth of Islamic banking is to identify the key factors which influence Islamic
banking credit risk. They investigate that according to bankers point of view there is lack of
understanding the risk which is involved in the Islamic banks.
Brewer (1994) has studied the impact of loan activities on bank risk. He have used ratio of loan to
asset for banks risks because loans are illiquid and considered as higher default risk than any
other banking asset. Findings of the study reveal that there is a positive relationship between loan
to asset ratio and banks risk measure. Whereas Altunbas (2005) is of the view point that credit
risk management strategies suggest that there is negative relationship between loan to asset ratio
and bank risk.
Bashir (1999) examines the effects of scale (total assets) on the performance of Islamic banks. And
there findings revealed that there is negative and statistically significant relationship between
size of banks and the risk index indicates that large size is economically efficient.
Hayati et al. (2002) conduct a study on factors influencing credit risk in Islamic banking. This
study emphasis on that, operating side by side with conventional banks, Islamic banks are
equally vulnerable to risks. The future of Islamic financial institutions will depend to a large
extent on how well they manage risks. This ability could be enhanced if the factors affecting these
risks are systematically identified.
Ahmad and Arif (2007) investigate the key determinants of credit risk of banks. The study
compares the emerging economys credit risk with developed economies. Eight key factors are
taken as potential risk determinants in the two test models to find out which are the factors that
have major contribution in the credit risk. The study finds that regulatory capital, loan loss
provision, loan to deposit ratio are significantly related to the credit risk. In other words, these
are the key determinants of credit risk. Whereas, leverage is not a significant determinant of
credit risk. The study concludes that emerging economys banks are facing more credit risk as
compared to developed economys banks.
Martin and Hesse (2008) analyze whether small Islamic banks tend to be more financially strong
as compared to large Islamic banks, which may affect credit risk management issues of large
Islamic banks. The study uses z-score as a dependent variable to measure the banks risk
individually. The study conducts using data of 20 banks. The study finds that small Islamic banks
are stronger as compared to small commercial banks. Stability of small Islamic banks is high as
compared to large Islamic banks. Islamic banks are more stable when operating on small scale
and facing low risk than large Islamic banks.
Farida Najuna (2011) examines the relationship between bank specific variables and credit risk
and analyzes the financing structure. The study conducted using the data of Malaysian Islamic
banks. Five bank specific variables are used including financing expansion, financing quality,
capital buffer, bank size and capital ratio. Three dummy variables which are regressed against
credit risk. The findings show that four bank specific variables: capital ratio, capital buffer,
financing expansion and financing quality have significant relationship with credit risk.
Financing structure also has a significant influence on the level of credit risk.
Ahmed et al. (2011) conduct a comprehensive study to determine the firms level factors which
have significantly influence the risk management practices of Islamic banks in Pakistan. For this
purpose, the current study selects credit, operational and liquidity risks as dependent variables
while size, leverage, NPLs ratio, capital adequacy and asset management are used as explanatory
variable for the period of four years from 2006 to 2009. The results indicate that size of Islamic
banks have a positive and statistically significant relationship with financial risks (credit and
liquidity risk), whereas its relation with operational risk is found to be negative and insignificant.
The asset management establishes a positive and significant relationship with liquidity and
operational risk.
Nawaz et al (2012) have conducted research on credit risk and performance of Nigerian banks by
using secondary data from 2004 to 2008. Results showed that no-performing loan has a negative
relationship with return on assets.
Ogboi and Unuafe (2013) have studied impact of credit risk management of performance of
Nigerian commercial banks. They have used panel data for the years 2004 to 2009. They have
used return on asset as a proxy for credit risk in their study. Findings illustrate that NPL has a
negative relationship with credit risk whereas Capital adequacy ratio has a positive and
significant relationship with credit risk.
Masoud et al (2013) have studied risk management in Iranian banks. The purpose of their study
was to investigate relationship between banking ratio with credit, liquidity and operational risks.
They have used banks secondary data for the year 2006 to 2011. Their findings reveal that capital
adequacy have a negative relationship with credit risk whereas debt to equity ratio has a positive
relationship with credit risk.
4. METHODOLOGY
To comply with the objective of this research, the paper is primarily based on quantitative
research, which constructed an econometric model. This research paper attempts to investigate
the effect of specific factors on credit risk in Islamic banks. This study has used secondary data
that were taken from annual reports of Islamic banks operating in Pakistan. There are 5 full-
fledge Islamic banks operating in Pakistan such as: Meezan bank, Bank Islami Pakistan ltd., Burj
Bank, Dubai Islamic bank, Al-Baraka bank. This study has used data from year 2007 to year 2011.
E-views 5.0 are used for data analysis. Data is analyzed by applying descriptive and inferential
statistics. The descriptive statistics apply to find the mean and standard deviation of the
variables.
Pearson correlation is calculated to indicate the relationship between independent variables and
to examine if there is any problem of autocorrelation between independent variables. And finally
regression analysis is applied to derive the significance and relationship between dependent and
independent variables.
4.1. Research Models
Following table shows the dependent and independent variables, their abbreviations and their
proxies used in this study.


Table 2: Variables and Proxies
Variables Abbreviations Proxies
Credit Risk
CR Ratio of Total Debt to Total
Assets
Predictor variables
Total Debt equity ratio DER Total Debt/ Total equity
NPLs Ratio
NPL Non-Performing Loans/Total
Loans
Capital Adequacy Ratio
CAR Tier 1 Capital + Tier 2 Capital /
Risk Weighted Assets
Bank's Size BS Logarithm of Total Assets
Asset Utilization Ratio
AUR
Operating Income/Total Assets

Following Regression Equation is to be estimated in this research study:
CRit = 0 + 1 (DERit) + 2 (NPLit) + 3 (CARit) + 4 (BSit) + 5 (AURit) + it (1)

4.2. Variables and hypothesis development:
1. Credit Risk
Credit risk refers to delayed, deferred and default in principal amount or interest amount by
counterparties which it is obligated to do. In this study the ratio of total debt to total assets is
used as a proxy to depict credit risk. Because the higher the ratio the greater risk will be
associated with banks operation. This ratio is an indicator of financial leverage of banks.
2. Bank's Size
Bank size is the major issue in calculating the risk about the banks. In this study, Log of total
assets is used as a proxy for estimating banks size.
H1: There exists a relationship between banks size (BS) and credit risk of Islamic banks.
3. NPLs Ratio
Non-performing loans are credits which are perceived as possible losses of funds due to loan
default by banks. In this study, NPL ration is calculated through non-performing loans /total
loans. It is expected that NPL has negative relationship with credit risk ratio (Ahmad et al., 2011;
Ogboi and Unuafe, 2013)
H2: There exists a relationship between non-performing loans (NPL) and credit risk of Islamic
banks.
4. Capital Adequacy ratio
CAR refers to a percentage of a bank's risk weighted credit exposures. The formula to calculate
CAR is as follows:
Tier 1 Capital + Tier 2 Capital / Risk Weighted Assets
This ratio is used to protect depositors and promote the stability and efficiency of financial
systems around the world. It is expected that CAR has a positive relationship with Credit risk
ratio (OGBOI and UNUAFE, 2013)
H3: There exists a relationship between capital adequacy ratio (CAR) and credit risk of Islamic
banks.
5. Debt to Equity Ratio
It is a measure of financial leverage of a bank which is calculated by dividing its total liabilities
with stockholders' equity. It is an indication of the proportion of equity and debt the bank is
using to finance its assets. Literature illustrates that debt to equity ratio has a positive relationship
with credit risk (Masoud et al., 2013)
H4: There exists a relationship between debt to equity ratio (DER) and the credit risk of Islamic
banks.
6. Asset utilization ratio
In this study, asset utilization ratio is calculated through by dividing Operating Income with total
Assets of banks. Literature suggests that there is a negative relationship between credit risk and
asset utilization ratio (Ahmed et al., 2011).
H5: There is a relationship between asset utilization ratio (AUR) and credit risk of Islamic banks
operating in Pakistan.
5. Data analysis
Descriptive Statistics
Table 3: Descriptive Statistics
Variables Mean Standard deviation
Credit Risk (CR) 0.7818 0.2766
Total Debt Equity Ratio (DER) 4.1817 4.3208
NPL Ratio (NPL) 0.0292 0.0341
Capital Adequacy Ratio (CAR) 0.3424 0.2786
Bank size (BS) 6.7892 2.1986
Asset utilization ratio (AUR) 0.0088 0.0445

Table 3 shows the descriptive statistics (mean and standard deviation) of data variables. Mean value
tells us about the central tendency of the data whereas standard deviations gives idea by measuring
data that how much a typical data value differs or deviate from the mean value. It can be seen from
the table that banks size has a greater mean value of 6.7892 with a standard deviation of 2.1986. Total
debt equity ratio has a second highest mean value of 4.1817 with standard deviation of 4.3208. Credit

risk has a mean value of 0.7818 with a standard deviation of 0.2766 followed by NPL has mean value
of 0.0292, capital adequacy has 0.3424 mean value, and asset utilization ratio has 0.0088 as mean value.
Table 4: Correlation Matrix
Table 4: Correlation Matrix
Total Debt
Equity Ratio
(DER)
NPL Ratio
(NPL)
Capital
Adequacy
Ratio
(CAR)
Bank size
(BS)
Asset
utilization
ratio
(AUR)
Total Debt Equity Ratio
(DER)
1
NPL Ratio (NPL) 0.310* 1
Capital Adequacy Ratio
(CAR)
-0.422** 0.44 1
Bank size (BS) 0.525** 0.281* 0.316* 1
Asset utilization ratio
(AUR)
0.544* -1.11** -3.88** 0.125** 1
* Correlation is significant at 5% level (2-tailed).
** Correlation is significant at 1% level
Table 4 shows the correlation matrix of the research variables in order to determine the problem of
multi-co-linearity among variables. Results exhibits that NPL and DER; BS and NPL; BS and CAR; and
AUR and DER are significant at 5% level whereas CAR and DER; BS and DER; AUR and CAR; AUR
and BS are significant at 1% level. Moreover, CAR and DER; AUR and NPL; AUR and CAR are
negative correlated. Overall, results showed that there exists no correlation among predictor variables.
Table 5: Regression Analysis
Model Unstandardized Coefficient T Significance (p-
value)
B Standard
deviation
Constant -0.070 -0.76 -0.211 0.833
Total Debt Equity
Ratio (DER)
0.066 0.013 5.110 0.000**
NPL Ratio (NPL) -3.40 1.111 -0.308 0.759
Capital Adequacy
Ratio (CAR)
0.411 0.200 2.111 0.041*
Bank size (BS) 0.040 0.014 2.222 0.321
Asset utilization
ratio (AUR)
-5.112 2.223 -2.441 0.021**

R-Square 0.89 F-Statistics 29.11
Adjusted R2 0.87 Significance 0.000**
Durbin Watson 1.693
Dependent Variable: Credit Risk (CR)
** Coefficient is significant at 1% level
* Coefficient is significant at 5% level
Table 5 illustrates the regression analysis results of research variables. R-square value shows that
model is good-fit as 89% of the variation in dependent variable i.e. Credit risk can be explained
by predictor variables i.e. total debt equity ratio, NPL ratio, capital adequacy ratio, bank size and
asset utilization ratio and remaining 11% variation is due to other factors. Durbin Watson value is
1.693 which means there is no problem of serial-correlation between data because rule of thumb
about Durbin Watson test says that if value is below 2 then there seems no problem of auto
correlation. F-statistics show the goodness of the model. F-value (29.11) is significant at 1% level.
So, it can be said that this model is a good fit.
T-statistic shows that hypothesis 1 is accepted as DER has a positive and significant relationship
with credit risk ratio at 1% level. This means, the higher the debt equity ratio, the higher will be
the credit risk ratio of Islamic banks operating in Pakistan. Hypothesis 2 is rejected because p-
value is more than 0.05 significance level. But NPL ratio shows a positive relationship with credit
risk ration of Islamic banks. Hypothesis 3 is significant and accepted because CAR has a positive
and significant relationship with CR ratio. This means that credit risk ratio will be more when
capital adequacy ratio of bank is more. Hypothesis 4 is rejected as bank size shows positive but
insignificant relationship with credit risk ratio of Islamic banks. Hypothesis 5 is accepted as AUR
has a negative and significant relationship with CR ratio of Islamic banks. This means credit risk
will be more when asset management of Islamic banks operating in Pakistan is weak.
Calculated Regression Equation
CR = -0.070 + 0.066 (DER) - 3.40 (NPL) + 0.411 (CAR) + 0.044 (BS) - 5.112 (AUR) --- ---- (2)
Table 5 also illustrates the values of beta used in regression equation. Constant value is -0.070
which means credit risk ratio will decrease by 0.07 degree considering all other explanatory
variables constant. Beta value of DER is 0.066 which means CR ratio will increase by 0.066 units
when DER increases by 1 unit. NPL beta value is 3.4 which mean CR ratio will increase by 3.40
units with 1 unit decrease in NPL ratio. CAR beta value is 0.411 which shows that CR ratio will
increase by 0.411 units when CAR increases by 1 unit. BS beta value is 0.040 which means CR
ratio will increase 0.04 units with every single unit increase in banks size. And lastly, AUR beta
value is -5.112 which means that CR ratio will decrease by 5.112 units with every single unit
increase in AUR.

6. CONCLUSION

The aim of this study is to investigate the firm level variables that are affecting credit risk of
Islamic banks operating in Pakistan. For that purpose secondary data is taken from annual
reports of Islamic banks for the period of 2007 to 2011. This study has employed credit risk as a
dependent variable whereas debt equity ratio, NPL ratio, bank size, asset utilization ratio and
capital adequacy ratio is taken as independent variables. Results show that credit risk has a
positive and significant relationship with debt equity ratio and capital adequacy ratio. Besides,
asset utilization ratio has negative and significant relationship with credit risk.
The current study was conducted on credit risk management of Islamic banks operating in
Pakistan. This study can be conduct on different countries using the same methodology. It is
expected that different countries will have different findings which will be interesting to know.
Future studies can also be conducted by comparing credit risk of conventional and Islamic banks
of a country or different countries.

REFERENCES
Ahmad, N. H. and Arif, M. (2007). Multi-country study of bank credit risk determinants. The
International Journal of banking & finance, Volume 5, pp. 135-152.
Ahmed, N., Akhtar, F. M., and Usman, M., (2011). Risk Management practices and Islamic banks:
As Empirical investigation from Pakistan. Interdisciplinary Journal of Research in Business, 1(6),
pp. 50-57.
Altunbas (2005), Mergers and Acquisitions and Bank Performance in Europe- The Role of
Strategic Similarities. European Central Bank, working paper series, No. 398.
Brewer, Elijah III, and Thomas H. Mondschean. (1994). An Empirical Test of the Incentive Effects
of Deposit Insurance. Journal of Money, Credit, and Banking, 26(1): pp. 146-164.
Bashir, A. H. M. (1999). Risk and Profitability Measures in Islamic Banks: The Case of Two
Sudanese Banks. Islamic Economic Studies, 6(2), pp: 1-24.
Cihak, Martin & Hesse, Heiko (2008) Larger Islamic Banks Need Prudential Eye IMF Working
Paper, European Department
Drzik, J. 1998. CFO Survey: Moving Towards Comprehensive Risk Management. Bank
Management, Vol. 71, pp.40.
Faridah, N.M. (2005). Financing structure, bank specific variables and credit risk: Malaysian
Islamic banks. Journal of Banking and Finance, 4(2), pp. 36-41.
Fraser, D., Gup, B. and Kolari, J., (2001). Commercial Banking: The Management of Risk. 2nd Ed.
Cincinnati, Ohio: South-Western College Publishing.
Hayati, N.A. and Shahrul N.A. (2002). Key factors influencing credit risk of Islamic Banks: A
Malaysian Case. University of Utara Malaysia. Working Paper Series 4012.
Khan, T. and Ahmed, H., (2001). Risk Management An Analysis of Issues in Islamic Financial
Industry. Islamic Development Bank-Islamic Research and Training Institute, Occasional Paper
(No.5), Jeddah.
Martin. C. and Heiko hesse, (2008). Islamic banks and financial stability: an empirical analysis.
IMF working paper 2008.
Masoud, B., Iman, D., Zahra, B., and Samira, Z., (2013). A study of risk management in Iranian
Banks. Research Journal of Recent Sciences 2(7), pp. 1-7.
Ogboi, C., and Unuafe, O. K., (2013). Impact of credit Risk Management and Captal Adequacy on
the Financial Performance of Commercial Banks in Nigeria. Journal of Emerging Issues in
Economics, Finance and Banking, 2(3, pp. 703-717.
State Bank of Pakistan, Islamic Banking Department (June, 2013). Islamic Banking Bulletin (June)
2013.


3 How do the historical perspective and systemic effects of
house price movements help to explain the pattern of
consumption in the U.K?

Priya Darshini Pun Thapa
*
, South London College, Equitable House

Abstract

The purpose of this research paper is to investigate whether the historical perspective of
house price movements can help to explain the recent pattern of consumption in the
UK. In addition to this, the document evaluates how strong the correlation between
those variables within a specific period of time can be. This paper also attempts to
investigate to which extent the current crisis, well-known as the subprime market crash,
could have affected future expectations about house prices and consumer habits,
considering the following three housing market hypotheses: 1) The wealth effect: an
expected increase in house prices raises the desired level of expenditure; 2) the lower
credit constraints, the higher consumption and 3) common causality model: factors such
as changes in expected income growth, tax changes or changes in credit market
conditions lead to increases in both household expenditure and house prices. Its
findings about the coincidence of house prices and consumption during the last two
decades have corroborated the hypothesis that an increase in house prices movements
can help to explain the followed pattern of consumption.
JEL Classification: C3, E3
Key words: House prices, consumption, wealth effect, housing
market.

1. INTRODUCTION
The global financial downturn in 2007 has remarkably affected the historical perspective of house
price movements in the UK. Since then, this financial turmoil which had its origins in a previous
credit crisis called the sub-prime mortgage market crash, can be considered to be the first domino
in a whole chain. This type of lending practice, which presumably has changed the relationship
between house prices and consumption, has not only clearly marked a historic turning point in
the UK economy, but it has also set in motion fundamental changes in the credit market in terms
of consumer habits, peoples expectations and government regulations.
It is often believed that this phenomenon, accompanied by a strong fluctuation in house prices,
has also helped to multiply its devastating snowball effects on the economy, especially for those
household victims of the credit crunch, who saw their consumer spending fall as a cascade after
2006.
Therefore, the subprime market crash, led by financial institutions in the mortgage market such
as HBOS, nationwide, Northern Rock etc, could be the most recent explicative fact that
presumably could have changed the connection between house prices and consumption in the
UK since the 1980s according to Pricewaterhousecoopers[20]). However, and based on previous
downturns in the UK economy as seen in 1991, it has not yet occurred. Arguably, one may tacitly

*
Priya Darshini Pun Thapa is Lecturer at South London College, 10 Woolwich New Rd, London SE18
6AB, pdpthapa@gmail.com
suggest that the magnitude of this lending practice can only have a major impact on countries
where the credit market is weak and not well developed; unlike the UK where financial
institutions are more concerned about financial stability and the well-being of the economy
through regulation.
Bearing this in mind, the following three housing market hypotheses will be considered: 1) a
wealth effect [16]: an expected increase in house prices raises the desired level of expenditure; 2)
the lower credit constrains, the higher consumption [13] and 3) common causality model: factors
such as changes in expected income growth, tax changes or changes in credit market conditions
lead to increases in both household expenditure and house prices [13]. In addition, a historical
perspective of two decades will also be used to investigate how some observable facts from the
past have led and influenced the relationship between house prices and consumption, and also
how some endogenous variables have accentuated the crisis effects to a larger extent. Finally, the
analysis will run a test on the response of household consumption to house prices; considering
both housing as a major component of wealth and credit access as a source of liquidity.
2. LITERATURE REVIEW
According to the literature there are three main key housing market hypotheses that could
explain the link between house prices and consumer spending: 1) a wealth effect
[16] i. e. an expected increase in house prices raises the desired level of expenditure; 2) the lower
credit constrains the higher consumption [13]; and 3) common causality model: factors such as
changes in expected income growth, tax changes or changes in credit market conditions, could
lead to increases in both household expenditure and house prices [13]
Recent studies show that consumer expenditure is not only the dominant component of
aggregate demand, but is also the key factor for understanding the behaviour of the housing
market. In recent years there has been increasing interest in the role of housing and its interaction
with consumption. Benito and Haroon *4+ point out that houses are a significant part of
household wealth and this higher wealth is typically associated with higher consumption, at
least among those who own houses.
In the same way *20+ remarks the importance that houses bring to the market by quoting an
increase in house price arguably makes non-home owners worse off via higher rents or the higher
savings required for future house purchases. Hence the consumption of this group may
decrease and the overall wealth effect may be insignificant as a result of being non-home owners.
Secondly, households may borrow vastly more cheaply if they own housing equity which may be
used as collateral. Then an increase in house price raises housing equity and cheaper borrowing
typically results in increased consumption. Thirdly, both house prices and household
consumption tend to be positively related to household expectations of future earnings.
Additionally, [4] and [17] assert another view that there is an important causal effect of housing
in providing collateral which allows credit to be obtained on more favourable terms to finance
consumption. That role may be particularly strong, or only exist at all, for those who might well
be less constrained by the availability of easy access to credit as a source of liquidity.
For example: Data in the US estimates that the marginal propensity to consume out of wealth
range vary from 4 to 7 cents, depending on the amount at which aggregate wealth can positively
change [9] and [7].
According to Belsky and Prakken *3+, changes in aggregate consumer spending are more
sensitive to changes in home values, at least in the short run, than to changes in the value of
other types of wealth. They believe that over the past decade housing expenditure has comprised

more than one fifth of the national domestic product. They also affirm that when housing
wealth increases, consumers spend more as a result of both capital gains from home sales and
borrowing as collateral. In another study Case, Quigley and Shiller *6+ estimate that the elasticity
of consumption with respect to housing wealth is 0.06, as compared to 0.03 for financial wealth.
Subsequently, in the work of Aoki, Proudman and Gertjan, [2] it is assumed that if house prices
are growing rapidly, consumption growth will be affected in the same way. Not far from that,
recent minutes of the Monetary Policy Committee meetings in the United Kingdom stated: the
continuing strength in house prices would tend to underpin consumption . . . Correspondingly,
the Fed Chairman, Alan Greenspan, stated: And thus far this year, consumer spending has
indeed risen further, presumably assisted in part by a continued rapid growth in the market
value of homes[11].
Aokis research *1+ stresses the importance that housing market brings to the owners for access to
the borrowing sector as collateral. He suggests that the value of housing in the UK accounts for
almost 40% of total households, i.e. approximately 80% of all household borrowing can be
secured with their homes. As a result of that, owners are more able to get easier access to credit
by financial institutions and make use of it in order to augment their Marginal Propensity of
consumption.
As one can expect, the authors do not deny the possible effects between house prices and
fundamentals; not surprisingly they support the idea that house prices and consumption move
together and synchronously. One of the reasons that might explain these movements is that
consumers are optimistic enough about the economic prospect, and secondly, because house
prices in the UK are included within the retail price index which determines both the level of
house prices and wealth.
Coincidentally, the model proposed by Orazio, Andrew and Matthew [18] provides more
evidence about the strong correlation between house prices and consumer spending. Their
findings show that over the past thirty-five years the correlation between those variables has
been relatively stronger than other countries, even during boom and bust periods.
3. AN OVERVIEW OF UK HOUSING MARKET
Historically, the UKs housing market has evidenced a long history of booms and slumps. Since
the 1980s the performance of the UK housing market was clearly marked by a period of economic
transformation, where the changes in credit availability during that period could likely have
contributed to enlarge the boom and subsequent retrenchment in consumption. The evidence
shows that in the late 1980s the UK experienced an inflationary boom which led house prices to
increase dramatically at an increasing rate of 30% and general inflation rising to over 10%.
According to Samter [21] the British government in the 1980s cracked down on inflation and
unemployment in order to control the negative effects caused by the turmoil in the economy after
the liberalization process. Despite the failure in the policy action taken during that time to reduce
inflation, the British economy started experiencing an economic downturn, which then became
intertwined with falling house prices by up to 13% between 1990 and 1993. Analysts of that time
affirm that as a consequence, many lost their homes or faced negative equity because those who
owned houses were unable to resell their properties as the high cost of outstanding debt on their
mortgage exceeded the present value of their home. After that they stabilized for approximately
18 months before falling by a further 4% between mid-1994 and the end of 1995.
Following that, the development of the credit markets allowed the British economy to live
continuous periods of economic growth and positive house prices movements as a result of the
boom. Since 1996 nominal house prices have risen by approximately 180% and by approximately
150% after accounting for general inflation, whereas economy growth reached levels of 5% since
1992.
According to Michael Ball [14] there have been two major UK house price downswings in history
apart from the current one. The first one was recorded in the 1970s and the second one in the
1990s. Both coincidentally lasted for four and six years respectively and preceded major general
economic recessions; they featured significant accelerations in general price inflation and
persisting periods of downturn associated with low consumption. This may suggest that major
housing market downswings, as last recorded in 2008 and 2009, could have long-lasting negative
impacts on consumer spending and house price expectations, which can then also affect the
entire economy.
Parallel to that, and indisputably, many believe that the boom of 1997 to 2007 has only brought
subsequent problems related to market activity. The Bank of England in its review of 2008
indicates that the most recent boom has not only brought to the economy devastating effects, but
has also brought forward long period of low economic growth, low interest rates accompanied by
low inflation, intense competition in the mortgage market, and tougher access to credit funds.
In part, one may propose that the timing and characteristics of those particular booms and
slumps from the past not only reflect changes in macroeconomic fluctuations, GDP,
unemployment, interest rates, or shifts in credit conditions, but can also reflect some changes in
peoples expectations as seen in 1991 with the decline in consumption. Undoubtedly, such
fluctuations are not straightforward to control, because the developing of the mortgage markets,
new lending practices and the amount of housing supply, can increase the chances to boost more
and more spending. Furthermore, it can also limit the responsiveness towards the market for
readjusting opportune changes in demand and supply.
Finally and most recently the UK landscape has noticeably shown signs of change as a result of
the longest on record economic downturn and the overvaluation of house prices at the end of
2007. By comparing previous booms with the recent downturn, one may tacitly identify that the
behaviour in house prices has been commonly followed by a response in consumption since 1989.
Primarily there is a sharp increase in house prices, which is followed by a period of decreasing
house prices along with consumption, GDP, consumer confidence and consumption - see graphs.
Secondly, there is a short stage in which house prices are adjusted within a period of two to three
years, where those significant negative changes are diminished by the governments
intervention, price controls and financial assistance. Finally, and more importantly, there is a
strong tendency to reduce interest rates along with inflation and a major alarm in the
unemployment rate.
4. RESEARCH METHODOLOGY
4.1 Data
These were mainly collected from governments and their various agencies, bureaus, and
departments such as: Office of National Statistics and treasury HM. The analyzed period for the
study is from 1989-2008.
4.2 Econometric Model
Generally, the following model maintains the basics of previous studies as has been noted in
Benito et al. [5]. However, this one differentiates from others, because this model does not only
include and focus on recent facts post-2007 financial crisis, but it also takes into account several

key indicators for the current financial crisis, such as: consumer confidence, unemployment rates
and net mortgage lending rates.
4.2.1 A linear regression
Between consumption and house prices, in which the database corresponds with a period of
economic crises characterized by high volatility and financial instability, from 1998 to 2008.
SPEND = C(1)*HP + C(2) (1)
4.2.2 A multiple regression
Between consumption and house price, GDP, consumer confidence, net lending mortgage,
household disposal income and unemployment, considering the same assumptions from the
previous regression in terms of time. This, in due course, will bring more consistency among the
theory and reality based on previous event.
SPEND = C(1)*HP + C(2)*CONFCONS + C(3)*GDP + C(4)*NETLENDING + C(5)*RHDI +
C(6)*UNEMP + C(7) (2)
where,
SPEND = Final consumption expenditure annual % growth
HP= House prices annual % growth
GDP = Grow Domestic Product annual % growth
CONCONFS =Consumer confidence index balance annual
NETLENDING = Net mortgage lending growth
RHDI= Real household Disposable Income annual % growth
UNEMP= Claimant unemployment rate annual % growth
C= Constant
In essence, the model will be developed from the basis of the IS-LM model where the
consumption variable is determined by changes in the current income, personal wealth and
expectations [19].
Figure 1. IS-LM Model

Source: (Piana, 2002)
4.3 The choice of explanatory variables
The model considers the following six variables to reveal the relationship behind the housing
market and consumer spending during the period comprehended between 1989 and 2008.
4.3.1 Dependent variable
SPEND=Household final consumption expenditure (Consumer Prices Index). It is the
dependent variable of the model.
4.3.2 Independent variables
HP= House prices It has often been said that increase in house prices leads to boost consumption.
In general this variable is considered as a major source of personal wealth in the UK. According
to Muellbauer [15] the more gross housing wealth, the greater the available collateral for
mortgage debt and thus the greater the consumption. Recently this variable has been recovering
its significance and magnitude as an economical indicator since the last boom of house prices in
2007, and therefore this variable will be the main independent variable for the model.
GDP: Gross Domestic Product: This important variable, which has historically been used as
economic indicator, has made it known that there is a strong association between house prices,
GDP and consumption. A recent IMF cross-country study [12] in the UK on housing booms and
busts, calculated that roughly 40 per cent of all housing booms are followed by large changes in
consumption associated with very high GDP declines.
CONFCONS: Consumer Confidence GFK: According to Garratt [10] the consumer confidence
indicator can explain up to two-thirds of the variation in the annual growth of house prices.
Equally, it does have an important role for influencing the willingness of households to
undertake secured borrowing.
RHDI= Real Household Disposable Income: This indicator is used to compare living standards
and development in the UK.
NETLENDING= Net Mortgage Lending: This variable constitutes great theoretical explanation
for the research because it can help to explain previous booms and busts in the UK. For example:
the historical perspective shows that the following crises after the 1980s boom have been
characterized by high interest rates periods; low household income and low GDP growth. This,
added to sudden movements in house prices, could have had negative effects on the
consumption demand in the UK.
UNEMP= Claimant Unemployment Rate: This rate is considered to be one of the most principal
unemployment indicators in Great Britain. To some extent it determines the propensity to
consume as a result of the discrepancy between incomes and saving rates. In other words, this
macroeconomic indicator has an inversely proportional effect on the consumption function by
diminishing the level of personal wealth.

4.4 Time Series
The time period chosen for the analysis is based on annual series from January 1989 to April 2008.
This period includes critical facts associated to house prices and consumption in which the UK
economy has been particularly sensitive. Those several historical incidents can significantly help
to test the response and accuracy of the model. Moreover, some other critical periods will be
contained and summarized in the time series analysis.

Figure 2. Historical Perspective Of Global Events

Source: (UK Recession analysis 2008)
4.5 Pair wise Granger Causality test
It indicates if the past of each variable affects the present of the other variables, in this case, for
example: compare the GDP historical perspective with the present consumer confidence. The
theory suggests that causality does not exist when the past of each one of those variables does not
affect the present endogenous or exogenous variables.
4.6 Chow test
This test allows finding out if there is any structural break point in the dataset by changes in
policies or shocks in the economy on time series. This test can lead to huge forecasting errors and
unreliability if those breaking points are not detected in the model.

5. DATA ANALYSIS AND MAJOR FINDINGS
5.1 Linear Regression
SPEND = 0.1294815893*HP + 1.734138565
Table 1. Results of linear regression analysis
Variable Coefficient t-statistic Probability
HP 0.129482 4.910000 0.0001
C 1.734139 6.011047 0.0000
R-squared 0.572529 Durbin-Watson stat 1.114232

5.2 Multiple Regressions
SPEND = 0.05692718216*HP + 0.0670272835*CONFCONS + 0.3258144702*GDP +
1.22270418*NETLENDING + 0.2582495352*RHDI - 1.640080882*UNEMP + 1.121331821
Table 2. Results of multiple regression analysis
Variable Coefficient t-statistic Probability
HP 0.056927 4.106836 0.0012
CONFCONS 0.067027 2.454181 0.0290
GDP 0.325814 2.259945 0.0416
NETLENDING 1.222704 2.525740 0.0253
RHDI 0.258250 2.621411 0.0211
UNEMP -1.640081 -1.993198 0.0677
C 1.121332 1.890362 0.0812
R-squared 0.951625 Durbin-Watson stat 2.134600
The variable with more significance in the model is HP (4.106836) followed by RHDI (2.621411),
NETLENDING( 2.525740), CONSCONF (2.454181) , GDP (2.259945), and in the last instance by
UNEMP(-1.993198); which means that House Prices and Household Disposable Income are
highly representative in the UK for considerably affecting the variable of consumption.
5.3 Pairwise Granger Causality TestsThe results are shown in the Table A in Appendix section.
The test shows that NETLENDING causes the variable HP, or, the past of the variable
NETLENDING (Net Mortgage Lending) affects the present of the variable HP (House prices). On
the other hand, the past of the other remaining independent variables HP, GDP CONSCONF,
RHDI and UNEMP, do not affect the present of the dependent variable SPEND.
5.4 Chow Breakpoint Test
Table 3.Chow Breakpoint Test: 2001
F-statistic 1.213429 Probability 0.414761
Log likelihood ratio 17.63951 Probability 0.013707

Table 4. Chow Forecast Test: Forecast from 2002 to 2008
F-statistic 0.929149 Probability 0.543993
Log likelihood ratio 14.68585 Probability 0.040244
According to the Chow test, there are no significant signs of structural changes in the model.
Moreover, the probability associated to the statistic was lower than 5% indicating no structural
changes in the sample.
6. FINDINGS
According to the test the following conclusions were obtained:


6.1 Linear Regression
By taking just the house prices variable, 57.25% of the variations in the SPEND are a consequence
of the independent variable in the model. Since 1989 there has been a strong relationship between
house price and consumption as a result of the credit market liberalization and the psychological
wealth effect from house prices movements. According with the model, changes in house prices
by 2 units produces increases in consumer spending by 0.2589 units. The analysis suggests that
when house prices go up, there is a strong consumer response adjusted by the housing market
expectations.
6.2 Multiple Regressions
95.16% of the variations in Consumer spending are a consequence of the independent variables in
the model: House prices, GDP, Household Income, consumer confidence, net lending and
Unemployment. According to the main equation (2), changes in HP house prices by 1 unit
produces increases in consumption by 0.056 units, and it also increases in consumer confidence.
GDP, household disposable income and net lending have the same effect but in a lower
proportion. This is unlike the unemployment rate, which if increases by 1 point, decreases
consumption by 1.64 points. The sensitivity at which consumer spending is exposed by changes
in other variables is highly representative. Between 1980 and 2004, the chow test did not show
structural changes in house prices and consumption. However, the period comprehended
between 1991 and 1992 considerably affected the scale at which consumption is measured as a
result of the crisis (but by default the chow test includes this period as one of no structural
change). The following period after 2004 when house prices started increasing did also not
show signs of stability problems as the chow test suggested. According to the causality test, the
past of the variable Net Mortgage Lending (NETLENDING) affected the present of the variable
HP (House Prices). This observable fact can be attributable to past lending practices in 2004,
which considerably affected present house prices. When the subprime market started growing, as
a result of a large number of mortgages approved, house prices began to increase dramatically
along with the risk and the psychological wealth effect from lending. This, linked to the capacity
to spend, brought higher expectations about house prices and interest rates. These findings, along
with the proximity at which other variables were tested to the consumption variable, highlight
the importance of considering house prices as a barometer for both the economy and the market.
7. CONCLUSION
The present study has been an analysis of the housing market and its influence on consumption
in the UK. Its findings about the coincidence of house prices and consumption during the last
two decades have corroborated the hypothesis that an increase in house prices movements can
help to explain the followed pattern of consumption. According to the outcomes from the main
equation (2), changes in house prices by 1 unit produce increases in consumption by 0.056 units,
due to the fact that in the UK approximately 75% of the population owns a house. These results of
housing wealth effects were also compared with other previous studies developed by Belskey &
Prakken [3] and Case Quigley & Shiller [6] where those results showed also similar responses in
consumption.
Moreover, increases in consumer confidence, GDP, household disposable income and net lending
have the same effect on consumer spending but in a lower proportion; unlike the unemployment
rate, which if increases by 1 point, decreases consumption by 1.64 points.
The theories along with the model have not contrarily found that the effects of any potential
decline in house prices could negatively affect UK stability by decreasing the marginal
propensity to consume, which intrinsically comes with the housing wealth effect. It is believed
that when house prices fall, people are more concerned about their psychological wealth.
Therefore, they tend to be more reluctant to spend, because their equity turns negative as result
of those lower expectations and less availability of credit confirming the assumption about credit
constraints.
Moreover, the phenomenon of lowering consumption through house prices effects can also be
explained by the recent subprime market crash which originally could have affected housing
wealth and consumption since 2005 in the UK. According to the subprime market review, large
amounts of mortgage products provided by banks during 2005 and 2006, unquestionably
initiated a wave of consumption, but it also brought panic and then recession as a result of the
unsustainable bubble of house prices and wealth.

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[15] Muellbauer, J., Housing, credit and consumer expenditure in: Housing, housing finance, and
monetary policy, A Symposium Sponsored by the Federal Reserve Bank of Kansas City, Jackson
Hole, Wyoming, August 30 - September 1, 2007, 267-334.
[16] Muellbauer, J. and Murphy, A. ' Is the UK balance of payments sustainable', Economic
Policy, 11, (1990), 345-83.
[17] Nickell, S. 'Household Debt, House Prices and Consumption Growth', Bank of England
Monetary Policy Committee Glasgow speech, (2004), 23.
[18] Orazio, A., Andrew, L. and Matthew, W. (2008) 'The Coincident Cycles of House Prices and
Consumption in the U.K. Do House Prices Drive Consumption Growth', NBER and CEPR, 3.
[19] Piana, V. ' A Graphic Representation Of A basic Macroeconomic Scheme the IS-LM Model',
Economics Web Institute, 2, (2002), 11.
[20] Pricewaterhousecoopers 'How much do prices affect consumption ', UK Economic Outlook ,
November, (2008) p. 19.
[21] Samter, P. 'UK Housing and the Economy', Council of Mortgage Lenders, 3 (2007).
Appendix :
Table A:
Pair wise Granger Causality Test
Sample: 1989 2008
Lags: 1

Null Hypothesis: Obs F-Statistic Probability

HP does not Granger Cause SPEND 19 0.34273 0.56642
SPEND does not Granger Cause HP 2.51299 0.13248

GDP does not Granger Cause SPEND 19 0.88166 0.36171
SPEND does not Granger Cause GDP 0.12010 0.73344

CONFCONS does not Granger Cause SPEND 19 1.18841 0.29180
SPEND does not Granger Cause CONFCONS 1.01681 0.32828

RHDI does not Granger Cause SPEND 19 0.17087 0.68483
SPEND does not Granger Cause RHDI 0.62565 0.44052

NETLENDING does not Granger Cause
SPEND 19 1.15299 0.29885
SPEND does not Granger Cause NETLENDING 4.56593 0.04840

UNEMP does not Granger Cause SPEND 19 3.12385 0.09622
SPEND does not Granger Cause UNEMP 2.39780 0.14106

GDP does not Granger Cause HP 19 1.24368 0.28123
HP does not Granger Cause GDP 0.19933 0.66125

CONFCONS does not Granger Cause HP 19 3.00970 0.10199
HP does not Granger Cause CONFCONS 0.40800 0.53202

RHDI does not Granger Cause HP 19 0.11657 0.73722
HP does not Granger Cause RHDI 0.01375 0.90811

NETLENDING does not Granger Cause HP 19 9.85233 0.00634
HP does not Granger Cause NETLENDING 0.65166 0.43136

UNEMP does not Granger Cause HP 19 0.03463 0.85472
HP does not Granger Cause UNEMP 0.37788 0.54738

CONFCONS does not Granger Cause GDP 19 0.42067 0.52580

GDP does not Granger Cause CONFCONS 1.52761 0.23431

RHDI does not Granger Cause GDP 19 2.53554 0.13087
GDP does not Granger Cause RHDI 0.16406 0.69081

NETLENDING does not Granger Cause GDP 19 1.23660 0.28256
GDP does not Granger Cause NETLENDING 3.47073 0.08093

UNEMP does not Granger Cause GDP 19 2.94382 0.10550
GDP does not Granger Cause UNEMP 6.58514 0.02072

RHDI does not Granger Cause CONFCONS 19 0.34530 0.56499
CONFCONS does not Granger Cause RHDI 0.51393 0.48378

NETLENDING does not Granger Cause
CONFCONS 19 0.01909 0.89183
CONFCONS does not Granger Cause NETLENDING 2.90458 0.10767

UNEMP does not Granger Cause CONFCONS 19 7.95910 0.01229
CONFCONS does not Granger Cause UNEMP 3.47776 0.08065

NETLENDING does not Granger Cause RHDI 19 0.85506 0.36886
RHDI does not Granger Cause NETLENDING 1.02311 0.32684

UNEMP does not Granger Cause RHDI 19 0.31770 0.58081
RHDI does not Granger Cause UNEMP 0.08638 0.77261

UNEMPdoesnotGrangerCause
NETLENDING 19 1.04285 0.32235
NETLENDING does not Granger Cause UNEMP 0.13594 0.71719


4 Significant role of derivatives in islamic capital market

Shahid Muhammad Khan Ghauri
*
, Faysal Bank Limited, Lahore, Pakistan

ABSTRACT
Purpose: this paper is designed to identify the current status of implementation of
Islamic Capital Market (ICM), to highlight key implementation issues and challenges on
ICM faced by the regulatory and supervisory authorities; and to propose
recommendation on how can regulatory and supervisory authorities implement ICM.
Design/methodology/approach: paradigm of this paper is structured through dual
methodology using both, primary and secondary data. Primary data is collected from
survey conducted through questionnaire, while secondary data is collected from annual
reports of five Islamic and five conventional banks operating in Pakistan.
Findings: it is observed that Islamic capital market has a significant role in the earnings
of banks. Tools of these capital markets help in promotion of economic activities of the
country. These tools of capital market contribute in expanding the profits of Islamic
financial institutions.
Practical implications: recommendations of this research are addressed to the regulators
and market players to develop innovative products for Islamic capital markets and
derivatives. This research can be implemented for designing new products and
expanding the income from derivatives.
Key words: Islamic derivatives, Islamic capital markets, Islamic finance
JEL classification: E 40, E44, E 58, E59

1. INTRODUCTION
Islamic finance is a closed financial system with the aim of fulfilling the teachings of the Holy
Quran as opposed to earning maximum returns on financial assets (Zaher and Hassan, 2001).
Islamic finance is based on five main principles: the prohibition of interest (riba), excessive
uncertainty (Gharrar), speculation (Maysir), sharing on the basis of risks and returns, and the
prohibition of investing in unethical industries (Shanmugam and Zahari, 2009). These principles
have far reaching outcomes for Muslim investors. For example, these principles imply that
Muslims are not allowed to invest in products based on futures, options and other speculation
based derivatives, and they do not have access to conventional credit. These principles also limit
the scope for many other structured financial products. It entails the following financial criteria
firms must adhere in order to be classified as halaal (permissible according to Islamic law):
Total debt divided by the trailing 12-month average market capitalization has to be less
than 33%;
Cash plus interest-bearing securities divided by the trailing 12-month average market
capitalization has to be less than 33%; and

*
Shahid Muhammad Khan Ghauri is Assistant Vice President at Faysal Bank Limited, Lahore,
Pakistan
Accounts receivable divided by the 12-month average market capitalization has to be less
than 33%.
Nowadays most Islamic Equity Funds (IEFs) are standard open-ended mutual funds, offering
medium to long-term growth based on capital appreciation rather than dividend income.
(Kraeussl et al, 2011). Some of the researchers have identified that investment in equity funds is
restricted with involvement of 5% earning from non-Islamic assets. For instance, income of a
hotel is permissible if proportion of income from sale of alcohol or other prohibitive activities is
less than 5%.
According to Monger and Rawashdeh (2008), there are more than 300 Islamic Financial Institutes
(IFIs) serving 1.2 billion Muslims or one-fifth of the global population. Islamic finance is not
restricted to Muslims only (Monger and Rawashdeh, 2008) or to the regions of Middle East or
Southeast Asia as Muslims population in Great Britain is more than 2.5 million and 19 IFIs are
operative in the USA (Shayesteh, 2009).
Majority of the countries are following floating exchange rate or variations of floating exchange
rate system, due to which estimated cash flows from their international operations are exposed to
higher exchange rate risk and thus highlights the importance of employing different risk
management techniques for hedging firms uncovered positions (Afza, 2010).
Derivatives are defined as off-balance sheet financial instruments whose values are
hypothetically derived from other financial assets, and are widely used by the firms to hedge
their foreign exchange risk (Afza, 2010). Derivatives are financial contracts on a pre-determined
payoff structure, whose value derives from underlying reference assets, such as securities,
commodities, market indices, interest rates, or foreign exchange rates (Jobst, 2008). Derivatives
offer gains from risk transfer at low transaction cost. They improve market liquidity, aid price
formation, and complete financial markets by facilitating the unbundling, transformation and
diversification of financial risks, which can be customized to the risk preferences and tolerances
of agents, improving the capacity of the overall financial system to bear risk and intermediate
capital (Jobst, 2008).
Islamic banks are prohibited to pay or receive any interest in their lending and investing
transactions. They also face a supply side shortage of appropriate Islamic instruments which can
serve the liquidity, risk management and hedging needs of customers or the banks themselves.
Such instruments are offered by traditional banks in the form of derivatives (forward and futures
contracts) and options (put and call). Under various (though not all) interpretations of Islamic
law all such instruments are forbidden as they include the element of risk (Gharrar). The risk of
these futures instruments is that at the time of execution of contract, which is the current period,
the object/commodity to be sold does not usually exist. Insurance is also ruled out both on the
grounds of risk and also as it includes an element of riba (interest) because insurance companies
invest their funds in a number of fixed income securities which earn interest. Insurance also has
an element of gambling in the sense that the insured party could collect a large amount of money
after paying a few or just one installment of insurance premium or on the other hand they may
make many payments without ever getting the state contingent return from the insurance
company. Islamic financial instruments are based on the principles that they exclude interest
(riba), not possess major uncertainty (Gharrar) and not have gambling like features (Maysir)
(Siddiqui, 2008).
Purpose of this paper is to determine the current status of implementation of Islamic Capital
Market (ICM), to highlight key implementation issues and challenges of ICM faced by the

regulatory and supervisory authorities; and to propose recommendations on how can regulatory
and supervisory authorities in implementation of ICM.
Later parts of this paper include literature review, methodology, data collection and analysis and
conclusion.
2. REVIEW OF THE RELATED LITERATURE
Financial globalization facilitates greater diversification of investment and enables risk to be
transferred across national financial systems through derivatives. The resulting improvement in
allocation of risks has made overall capital markets more efficient, while the availability of
derivatives to both limit and leverage risk exposures has increased market capitalization and
liquidity in the underlying cash markets. But emerging derivative markets also pose important
challenges to financial stability, particularly in areas where vulnerabilities to changes in risk
extend across institutions and national boundaries. Emerging market regulators recognize the
necessary importance of developing derivative markets; they remain concerned about potentially
excessive risk-taking, particularly in the context of rapid evolution of products, inadequate
understanding of risk management techniques, and limited supervisory capacity. (Jobst, 2008)
Islamic banks are not involved in trading of debt securities due to prohibition of interest in Islam.
One of the major causes for the current financial crisis is the use of Mortgage based securities
(MBS). These derivatives are issued based on subprime mortgages that earn interest. Islamic
banking is distinguished by the fact that it is prohibited from buying debt securities under
Islamic Sharia law; therefore, Islamic banks are safer from the direct effect of the global financial
crisis. Second, Islamic banking distances itself from investing in projects with excessive
uncertainty due to the prohibition of Gharrar. MBS and other securities are packaged and
repackaged to sell in tranches with a high rating though they were issued based on subprime
loans. Therefore, there was a high amount of risk associated with these derivatives. Thus, the
prohibition of interest and Gharrar provides a protection wall to the Islamic banks and inherently
they were able to avoid the direct brunt of financial crisis. Whatever negative effect we see in the
Gulf countries, is more of a psychological nature. Islamic banks will be affected to a certain
degree as they are part of the wider global financial system and consequently will be affected by
all global financial dealings, even if only in an indirect manner. (Chazi & Syed, 2010).
Derigs and Marzban (2008) have shown that different opinions and inconsistencies exist among
the Shariah scholars and their compliance strategies. These can mainly be attributed to the
different Shariah perceptions of the scholars and to the complexity of transforming the historical
and verbal Shariah sources into quantifiable and formal guidelines to be used within a modern
guideline evaluation and portfolio management system (Derigs and Marzban, 2008). The use of
derivatives by non-financial firms has grown rapidly over the last two decades, yet to date there
is little consensus regarding both why firms use derivatives and what the effect of derivatives use
on the market value of the firm. Therefore, the determinants and the value effect of derivatives
use are issues calling for additional empirical investigation (Khedri, 2010).The main difference
between Bai Salam and the futures contract is in the timing of payment (Ebrahim & Rahman,
2005). An Islamic bank faces a number of risks in its banking operations: credit risk, benchmark
risk, liquidity risk, operational risk, legal risk, withdrawal risk, fiduciary risk, displaced
commercial risk, return risk, exchange rate risk, systematic risk, performance risk. In traditional
(non-Islamic) banks, interest rate swaps are used as a hedging instrument against illiquidity
which can arise if payment liabilities against deposits exceed receipts against loans and other
assets. In Malaysia, 85% of the Islamic banks assets are based on fixed rates of return as
measured through profit rates, while 90% of the liabilities are on floating profit rates. Traditional
banks use forward contracts and futures contracts to hedge price risks. Futures contracts were an
improvement over forward contracts in that counterparty risk (risk of default by a party) is
eliminated by the futures exchange by means of the margining process and by daily marking to
market. The incentive to default is reduced as the futures exchange requires the contracting
parties to make an initial deposit (another name for initial margins) and requiring the losing
party to pay up (adjusting the margins) as losses occur. Through this method of margining and
marking to market the counterparty risks (defaults) have been reduced to negligible rates.
Traditional banks have also used another derivative instrument, that is, of options, to manage
contingent liabilities or contingent claims. Since call and put options allow one to purchase the
right to act or not to act (non-obligation) such non-obligation to exercise the buying or selling of
the asset allows more flexibility and allows further hedging, risk management and improving
cash flows. Islamic scholars have some reservations on options especially pertaining to the part
relating to trading of call and put options and the charging of premiums, which are viewed as
interest (riba), and are forbidden. Kamali (1996) and Bacha (1999) give arguments in favor of
options and contend that its premiums and its trading are an extension of the basic trading model
allowed in Islam. Islamic banks do not have a large portion of their assets in fixed income interest
bearing assets, as conventional banks do, they should theoretically budget for a larger capital
adequacy ratio and a larger liquidity ratio. Based on this logic, the Basel Committee has
stipulated higher minimum capital requirements for Islamic banks (Siddiqui, 2008).
The viable use of derivatives as means to facilitate risk transfer and efficient price discovery
hinges on transparent pricing in liquid cash markets and essential economic, infrastructural and
regulatory conditions, whose consistent and measured integration ensures systemic integrity and
sound market practice. The rationale for derivatives originates from three main sources: (1)
economic incentives, including the need to share and hedge risk as well as efficient price
discovery; (2) restrictions and constraints on financial activity, including regulation, investment
restrictions (e.g. limited or prohibited short-selling), and taxation of financial transactions; as well
as (3) financial globalization and associated technological and methodological advances, which
require more complex and comprehensive cross-border risk management strategies (Jobst, 2008).
According to Modigliani and Miller (1958) under perfect capital market conditions, it is useless
for a firm to reduce risk by using derivatives (Afza, 2010). By considering investment and
financing decisions in accordance with firms hedging policies, Froot et al. (1993) had proved
mathematically that derivatives will be beneficial for firms in two different situations: firstly,
when external financing cost exceeds opportunity cost of internal financing and secondly, when
correlation between investment expenditures and firms cash flows were negative. Purnanandam
(2008) had empirically tested the relationship between financial distressed firms and corporate
risk management activities on 2000 non-financial U.S firms and found that firms decision to use
derivatives was positively influenced by leverage whereas highly leveraged firms had lower
tendency towards derivative usage.
Derivatives were institutionally accepted as a marker of good health to the extent that (with
exceptional irony) by 2004 the credit default swap (CDS) market was becoming increasingly
accepted as an accurate measure of credit quality, for instance in a special analysis produced by
the Bank for International Settlements (BIS) in its Quarterly review of June 2004 (Cloke, 2009).
The development of derivative markets in emerging economies plays a special role in this context
as more institutional money is managed on a global mandate, with more and more capital being
dedicated to local capital markets (Jobst, 2008).
The economic rationale for derivatives assumes gains from efficient price discovery and risk
shifting. Derivatives supplement cash markets as unfunded alternatives to trading underlying

reference assets by providing hedging and low-cost arbitrage opportunities. They improve
market liquidity and complete financial markets by facilitating the unbundling, transformation
and diversification of financial risks, which can be customized to the varying risk preference and
tolerance of agents, and, thus, improving the capacity of the financial system overall to bear risk
and intermediate capital (Jobst, 2008). Equity derivative trading tends to be associated with high-
trading volumes in deep and wide cash markets, mainly because equity derivatives necessitate
liquid collateral (including pricing benchmarks) to ensure efficient price formation (Jobst, 2008).
The (Bank of International Settlement) BIS estimates for total monitored trade in derivatives
some $680 trillion for 2007-2008 (Haas, 2008). When this is compared with CIA estimates for the
total world capital base ($53 trillion) it is theoretically possible that a loss of just 7.87% of total
derivatives exposure could wipe out the worlds capital base (Haas, 2008). Financial crisis 2008
revealed that financial institutions relied on optimum value of their assets instead of fair value
which burst the balloon of intermediation and financial giants sink into it. In the light of $680
trillion worth of global trade in derivatives, $700 billion to rescue the perpetrators of this
market looks not only feeble but pointless (Cloke, 2009).
Researchers show that financial derivatives (futures) lead stock market (spot). In other words,
futures market has a stronger lead effect (Floros, 2011). Derivatives are structured under Money
market, FX market and commodity markets through Repo, Reverse Repo, Interest Rate swaps,
forward contracts, futures, FX swaps, etc.)
2.1. Challenges & Limitations
Nance et al. (1993), Fok et al. (1997) and Geczy et al. (1997), leverage depicts a significant negative
effect on firms likelihood of derivative usage. Hence, proving that high debt leads firm to more
financial distress and increases its cost of hedging, therefore making it difficult for a leveraged
firm to bear higher risk management costs. Dividend payout ratio shows a negative effect on
firms derivative usage, supporting signaling theory. Firms having volatility in cash flows are
more likely to cut dividend amounts in advance so that at the end of fiscal year lower dividend
payout ratio signals a weak financial position of firm; consistent with Haushalter (2000).
Generally, large size financially distressed firms, having lower leverage, dividend payout ratio;
liquidity, managerial ownership, profitability and tax convexity are more likely to use derivative
instruments for hedging purpose.
Three themes vital to the present financial crisis (Cloke, 2009):
1) The development of financial derivatives;
2) The subversion of risk analysis; and
3) The co-opting of fair value.
The main infrastructure-related challenges involve market practices conducive to market
stability: (1) the implementation of a modern trading system, which executes clearing and
settlement through a single central clearing counterparty (CCP) and multilateral close-out netting
(so that derivative positions can be considered jointly when assessing margin requirements for
mark-to-market (MTM) valuation and good faith deposits), (2) surveillance systems to detect
improvident behavior especially in areas that straddle the cash and derivative markets (3) sound
risk management and centralized mechanisms for the mitigation of counterparty risk, which
prevents individual failures from creating systemic stress, and (4) contract standardization
consistent with ISDA documentation and contract sizes which applies more to exchange-based
trading of derivatives rather than OTC (Jobst, 2008).
Some of the challenges face by Islamic banks related to their treasury operations are:
Open Market Operations cannot be used through purchase and sale of interest based securities
Islamic banks cannot borrow overnight from central bank therefore have to maintain more non-
earning liquidity reserves
Specific prudential regulations are not in place especially in countries having binary banking
system.
Gharrar, Qiyas, ownership of commodity/assets, prohibition of deferred liability transaction
(Kamali, 1999).
Another obstacle Islamic Equity Funds (IEFs) face is that there is no real consensus regarding the
financial criteria used to screen halaal stocks (Kraeussl et al, 2011). Since IEFs are not allowed to
invest in companies with high debt to total asset ratios, they are prone to investing in sub-
optimally leveraged companies. (Kraeussl et al, 2011)
2.2. Shariyah constraints
Islamic law prevails with a simple code of life, proved by teachings of Holy Quran, Holy
Ahadithes of Prophet Muhammad (S.A.W.W.) and thus preaching of various scholars. Bestowed
tools of conventional banking treasury involve some prohibited practices; therefore, Islamic
treasury requires purification of its products, tools and services.
2.2.1. Repo and Reverse Repo
Shariyah confirms any contract with an obligation of transfer of value from the buyer to seller
and transfer of possession from seller to buyer. Repo, Reverse Repo and Tri Repo agreements
lack these features of Valid Bai (Sale deed). Secondly, Bai Sarf is not allowed by Shariyah, there
should be an involvement of some halaal (permissible) mubai (commodity of trade) to
authenticate such transaction.
2.2.2. Futures
The Futures transactions, as in vogue in stock and commodities markets today are not
permissible for two reasons. Firstly, it is a well recognized principle of Shariyah that sale or
purchase cannot be effective for a future date; therefore, all Forwards and Futures transactions
are void. Secondly, in most of the Futures transactions, delivery of the commodities or their
possession is not intended. In most cases, the transactions end up with the settlements of
difference of prices only, which is not allowed in Shariyah.
2.2.3. Options
According to the principles of Shariyah, an option is a promise to sell or purchase a thing on a
specific price within a specific period. Such a promise in itself is permissible and is normally
binding on the promisor. However, this promise cannot be the subject matter of a sale or
purchase. Therefore, a promisor cannot charge the promisor a fee for making such a promise.
Since, the options transactions as in vogue and the options market are based on charging fees on
these promises, they are not valid according to Shariyah. This ruling applies to all kinds of
options, no matter whether they are Call Options or Put Options. Similarly, it makes no
difference if the subject matter of the option sale is a commodity, gold, silver or a currency; and
as the contract is invalid ab-initio, the same cannot the transferred. If the options of selling back
the stocks to seller have been made a pre-condition for the original sale transactions, the whole
transaction will be invalid because, according to Shariyah, a sale transaction cannot accept such a
transaction. If the option is an independent promise without being a pre-condition for the

original sale, no fee can be charged for such a promise as mentioned earlier. Although a
complementary promise of this kind is permissible in the Shariyah, it cannot serve the purpose of
the option market.
2.2.4. Swaps
It is one of the principles of the Shariyah that two financial transactions cannot be tied together in
the sense that entering into one transaction is made a precondition to entering into the second.
Since, both the parties use deposits for their own benefit, they are termed in Shariyah as loans
(Qardh) and not as trust (Wadeeah). Therefore, advancing one loan has been made a pre-
condition for receiving another which means that two financial transactions are tied together.
2.2.5. Bai-al-Dain
Dain means debt and Bai means sale. Bai-al-Dain, therefore, donates the sale of debt. If a
person has a debt receivable from a person and he wants to sell it a discount, as normally
happens in the bill of exchange, it is termed in Shariyah a Bai-al-Dain. Traditional Muslim jurists
are unanimous on the point that Bai-al-Dain is not allowed in Shariyah. However, some
Malaysian scholars allowed this kind of sale. They normally refer to the Shafites school of
thought where it is held that sale of debt is allowed, but they do not pay attention to the facts that
Shafites jurists have allowed it only in case where a debt is sold on its par value. In fact, the
prohibition of Bai-al-Dain is a logical consequence of the prohibition of Riba. A debt receivable in
monetary terms corresponds to money, an every transaction where money is exchanged from the
same denomination of money; the price must be at par value. Any increase or decrease from one
side is tantamount to Riba and can never be allowed in Shariyah. Some scholars argue that the
permissibility of Bai-al-Dain is restricted to a case where debt is created through a sale of a
commodity. In this case, they say the debt represents the sold commodity and its sale may be
taken as a sale of commodity. The argument, however, is devoid of force. For, once the
commodity is sold its ownership is passed on to the purchaser and it is no longer commodity of
the seller. What the seller owns is nothing other than money, therefore if he sells the debt, it is no
more than a sale of money and it cannot be termed by any stretch of imagination as the sale of
commodity. That is why; this view has not been accepted by the overwhelming majority of the
contemporary scholars. The Islamic Fiqh Academy of Jeddah which is the largest representative
body of Shariyah scholars and is represented by all Muslim countries, including Malaysia, has
approved the prohibition of Bai-al-Dain unanimously without a single decent.

3. METHODOLOGY
Hedging derivatives have always outperformed the firm value whether its core business is
financial or non-financial activities (Allayannis and Weston, 2001; Pramborg, 2004; Bartram et al.,
2004; Nelson et al., 2005; Allayannis et al., 2009; Ameer, 2009). Some of researchers have observed
variant results like Jorion and Jin (2006) and Nguyen and Faff (2007).
Authors Period Sample Results
Foreign
Currency
Derivatives
Interest Rate
Derivatives
Commodity
Derivatives
Allayannis and
Weston (2001)
1990-1995 720 US firms + * *
Bartram et al.
(2004)
2000-2001 7,292 firms from
48 countries
NS + *
Pramborg (2004) 1997-2001 455 Swedish firms + * *
Nelson et al. (2005) 1995-1999 1,308 US firms + NS NS
Jorion and Jin
(2006)
1998-2001 119 US oil and
gas producers
* * NS
Nguyen and Faff
(2007)
1999-2000 428 Australian
Firms
NS - NS
Allayannis et al.
(2009)
1990-1999 378 firms from
39 countries
+ * *
Khedri (2010) 2000-2002 250 French firms NS - *
Table-I: Research conducted on derivatives (source: Authors collection form literature)
Notes: *, it is a blank (means that the relation is not tested); +, positive effect of derivatives use on
market value; -, negative effect of derivatives use on market value; NS, not significant.
According to International Accounting Standards (IAS) 32 and 39, it is mandatory for firms to
disclose their usage of hedging instruments and their respective fair value in the notes of annual
reports in a uniform manner.
Further various models are discussed by different researchers like logit model of non-parametric
univariate test was used Afza (2010); another similar model used by Mian (1996), Lin et al. (2008),
Bratam et al. (2009) and Afza (2010); Tobins Q regression model by Khedri (2010); and CAPM
performance model by number of researchers.
We have used an identical method to complete our study which is further testified through
secondary data. A questionnaire is designed to determine the significance of derivatives in
Islamic capital market. This questionnaire has of 5 components:
(i) Development of Islamic capital market; (ii) Legal, Tax and Regulatory Framework; (iii) Shariah
Governance Framework; (iv) Human Capital Development; and (v) Products and Services. Each
part contains number of questions.

4. DATA ANALYSIS AND FINDINGS
Instrument was distributed through electronic means to the professionals associated with Islamic
financial institutes operated in different regions of Pakistan and 115 were returned which were
selected as sample for study. Questionnaire which were not properly filled or where filling
instructions were not properly followed was set aside and good sample of 100 instruments were
selected for study.
Factors Response n f Proportion
I
C
M

d
e
v
e
l
o
p
m
e
n
t

Willingness to develop
ICM
Yes 95 95 95%
No 4 99 4%

Neutral 1 100 1%
Major obstacle
Legal & Regulatory 13 13 13%
Shariah 17 30 17%
Tax neutrality & other incentives 7 37 7%
Secondary Market 51 88 51%
Shortage of skills and expertise 6 94 6%
Lack of awareness 6 100 6%
L
e
g
a
l

r
e
g
u
l
a
t
o
r
y

a
n
d

T
a
x

f
r
a
m
e

w
o
r
k

Legal system in country
Civil law 64 64 64%
Common Law 21 85 21%
Shariah 12 97 12%
Others 3 100 3%
Route of ICM
development
Strategic plan 21 21 21%
Parliamentary legislation 23 44 23%
Market forces 41 85 41%
Others 15 100 15%
Unique ICM framework
than conventional
market
Yes 96 96 96%
No 4 100 4%
Necessary legal
framework
Land law 2 2 2%
Tax Law 36 38 36%
Institutional laws 9 47 9%
Corporate laws 49 96 49%
None 1 97 1%
Others 3 100 3%
Tax benefits
Yes 61 61 61%
No 13 74 13%
Under consideration 19 93 19%
Not at all 7 100 7%
Most tax benefits on
products
Sukuk 19 19 31%
Islamic Mutual Fund 27 46 44%
Fund Management services 5 51 8%
Islamic stock broking services 7 58 11%
Others 3 61 5%
S
h
a
r
i
a
h

G
o
v
e
r
n
a
n
c
e

Framework for ICM
Yes 96 96 96%
No 3 99 3%
Neutral 1 100 1%
Shariah governance is
part of
regulatory framework 46 46 48%
Shariah advisory services 38 84 40%
legal framework of Shariah related
matters
12 96 13%
Component of Shariah
compliance
Shariah advisory committee 37 37 39%
Shariah advisory firm (including
banks)
39 76 41%
external Shariah advisor 12 88 13%
internal Shariah advisor 6 94 6%
Others 2 96 2%
Most effective tool
Internal Shariah review 12 12 13%
Shariah review by external
independent parties
27 39 28%
International Shariah board
member representation
16 55 17%
Continuous professional
development programmes for
Shariah scholars
23 78 24%
Standardization of Shariah
practices to facilitate
harmonisation
18 96 19%
Mitigate conflict of
interest
Restriction on multiple
appointment
48 48 50%
Disclosure for Shariah boards
information
37 85 39%

Declaration in writing 9 94 9%
Others 2 96 2%
H
u
m
a
n

C
a
p
i
t
a
l

D
e
v
e
l
o
p
m
e
n
t

Shortage supply of
talent
Yes 7 7 7%
No 91 98 91%
Neutral 2 100 2%
Most affected area
Banking 52 52 52%
Takaful 18 70 18%
Capital Market 19 89 19%
Legal 9 98 9%
Others 2 100 2%
Need for development
of human capital
Yes 87 87 87%
No 7 94 7%
Neutral 6 100 6%
Qualification base of
experts from
Local 36 36 36%
Overseas 64 100 64%
Overseas qualification
from
Malaysia 24 24 38%
Bahrain 14 38 22%
UAE 4 42 6%
UK 18 60 28%
Others 4 64 6%
Islamic finance
education in your
country
Entry level 18 18 50%
Certificate level 12 30 33%
Fellowship and advanced level 6 36 17%
P
r
o
d
u
c
t
s

a
n
d

S
e
r
v
i
c
e
s

Most effective ICM
product
Sukuk (Islamic Bond) 22 22 22%
Shariah-compliant securities/stocks 16 38 16%
Islamic Mutual Funds 20 58 20%
Islamic Real Estate Investment
Trusts
2 60 2%
Islamic Structured Products &
Derivatives
19 79 19%
Islamic Private Equity 7 86 7%
Islamic Exchange Traded Funds 9 95 9%
Others 5 100 5%
Most effective ICM
service
Islamic bank/investment bank 54 54 54%
Islamic fund management 19 73 19%
Islamic stock broking services 4 77 4%
Islamic private equity and venture
capital
7 84 7%
Shariah advisory 5 89 5%
Legal advisory/expert specializing
in Islamic finance
9 98 9%
Others 2 100 2%
Cross-border issue
faced by supervisory
authorities
Supervision of cross-border
offerings of products and services
46 46 46%
Cross-border enforcement 21 67 21%
Lack of Islamic infrastructure to
facilitate international Islamic
finance transaction e.g. legal
framework, Shariah governance,
taxation etc
23 90 23%
Others 10 100 10%
Most effective initiative
to enhance ICM product
and services
Collaborate with other regulators
to enhance market accessibility
68 68 68%
Implement international standards
relating to market and transactions
29 97 29%
Others 3 100 3%
Table-II: Analysis from survey (Source: authors data analysis from survey)
Analyzing the above finding in table-II, we can discuss individual response of each question
asked in instrument. All findings with respect to each component can be discussed as appended.

i. Development of Islamic capital market: it is observed that 95% of professionals are willing to
develop Islamic capital market in the country as it is basis for growth of Islamic finance in the
country. 51% professionals think that non-availability of secondary market in the country is the
major obstacle to develop Islamic capital market in the country, followed by Shariyah and legal
framework for growth of Islamic capital market in the country.
ii. Legal, regulatory and tax framework: it is observed that civil law is implemented in the
country as opined by 64% professionals in the survey, so 41 % of the professionals suggest that
requisite framework for development of ICM should be designed according to market forces like
in US and EU nations, 23% suggest that its framework should be structured through parliament
and 21% suggest that it should be implemented by regulatory authorities through strategic
planning. 96% of the respondents believe that framework for Islamic capital market is unique
than conventional one, as its theoretical foundation is totally different from conventional market.
With respect to required amendment in legal framework in the country, 49% professionals
believe that corporate laws should be reviewed, 36% suggest that tax laws should be revisited so
corporate firms may be diverted to Islamic capital markets from their conventional through tax
benefits, and 9% suggest that institutional laws should be amended for promotion of Islamic
capital market. As tax benefits are always a convenient tool for monetary and regulatory
authorities so 61% professionals believe that tax benefits should be provided to the corporate
firms to divert them to Islamic capital market products and services, while 19% believe that tax
benefits are already in consideration by regulators. Out of these 61% professionals, 44% believe
that Islamic mutual funds are the most benefitted product among ICM products while 31% name
sukuk certificates as most benefitted.
iii. Shariah governance: Shariah governance is the key element in development of Islamic
financial setup. Shariah governance is required at every stage of product life cycle and is an
ongoing process for the institution. 96% professionals believe that Shariah governance setup is
available in the country for Islamic capital market. Out of these 96% professionals, 48%
professionals believe that Shariah governance is part of regulatory framework while 40% believe
that it is part of Shariah advisory services provided to institutes providing Islamic products and
services. 41% professionals of above 96% believe that Shariah compliance is part of Shariah
advisory firm while 39% believe that it should be dealt by Shariah advisory committee. 28%
professionals of 96% consider that Shariah review should be conducted by external parties for
transparency of the process, while 24% believe that it should be conducted through Shariah
scholars for authenticity, while 17% name it for board members committee and 13% suggest for
internal Shariah review process. To cover the risk of conflict of interest, 50% professionals of 96%
believe that it should be managed through restrictions on multiple appointments while 39%
believe that it should be informed through disclosure of Shariah board.
iv. Human capital development for ICM: development of human capital is essential step to
promote a particular area of interest. So, we have included it as an integral part of our research.
In relation to availability of qualified talent related to Islamic capital market, 91% professionals
believe that adequate supply of human capital related to Islamic capital market is available in the
country. 52% professionals believe that banking is the most benefitted area of Islamic finance
where most of human capital is available, while 19% believe its capital markets and 18% consider
its takaful companies. 87% professionals still believe that there is still room for further
development of human capital related to Islamic capital market. 64% of professionals believe that
most of this human capital is qualified from overseas while 36% think that it is raise from local
institutes. Among the 64 % professionals who believe that human capital is qualified from
overseas, 38% think that these are qualified from Malaysia while 28% from UK and 22% from
Bahrain. Among 50% professionals, who believe that this human capital is raised locally, 28%
believe that the education available in local institutes is of entry level only while 33% believe that
this available education is related to secondary level while only 17% believe that this education is
of advanced level.
v. ICM products and services: last component of instrument is based on available products and
services in the country related to Islamic capital market. 22 professionals believe that sukuk is the
most effective ICM product while 20% consider Islamic mutual funds as most effective product
and 19% believe derivatives and Islamic structured products as most effective products of Islamic
capital market. Similarly, 54% professionals consider Islamic banks as most effective service in
Islamic capital market while 19% think Islamic funds management is the most effective service in
ICM. 46% professionals believe that supervision of cross-border offerings is the major issue faced
by supervisory authority, while 23% believe its lack of Islamic infrastructure to facilitate
international Islamic finance transactions. In the end, 68% professionals suggest that Islamic
capital market can be promoted through collaboration with other regulators while 29% believe it
can be possible through implementation of international standards in the country.
4.2. Analysis from financial data
Data for this part of methodology is extracted from the audited annual reports of 10 banks
working in Pakistan. These banks are selected on the basis of same size range with respect to
assets and branch networks. These banks are categorized into two groups, Islamic and
conventional banks. Group of Islamic banks comprises of Al-Baraka Bank, Burj Bank, Dubai
Islamic Bank, Bank Islami and Meezan Bank. While group of conventional banks comprises of
Askari Bank, Bank Al-Habib, Habib Metropolitan Bank, Faysal Bank and Soneri Bank. Financial
data is extracted for the period of four years from 2009 to 2012. Financial values of earnings from
capital market tools like derivatives and hedging was taken and its contribution in total earnings
of banks.
Yea
r
Islamic banks Conventional banks
Burj
Bank
Dubai
Islami
c Bank
Bank
Islami
Al-
Barak
a Bank
Meeza
n Bank
Askar
i Bank
Bank
Al-
Habi
b
Habib
Metropolita
n Bank
Faysa
l
Bank
Soner
i
Bank
200
9 3% 6% 13% 7% 8% 7% 6% 11% 6% 6%
201
0 3% 5% 4% 8% 10% 4% 5% 12% 7% 5%
201
1 2% 1% 3% 6% 6% 6% 5% 11% 8% 8%
201
2 3% 9% 4% 6% 5% 6% 5% 11% 8% 7%
Table-III: Contribution of earnings from capital market tools in total earnings (source: authors
calculations)
Above table-III shows the net contribution of earnings from capital market tools like derivatives,
forex, hedging, etc. in total earnings of banks. It shows that this contribution varies from 3% to
13% where conventional banks rely more on these earnings as compared to Islamic banks. Major
reason for this variation may be the available opportunities to invest through products and
services of capital markets. Conventional banks have good variety of products and services
related to capital markets including hedge funds, swaps, options, futures, etc. while Islamic
financial institutes have a limited choice comparatively in REITs, sukuk, Islamic mutual funds,

etc. non-availability of secondary market related to Islamic capital market product is the major
obstacle in the promotion of Islamic capital market tools.

5. CONCLUSION AND RECOMMENDATIONS
Islamic capital markets play an important role in development of Islamic financial institutes.
Financial institutes earn most of their earnings from these secondary markets. Earnings from
such markets are popular because these earnings bear comparatively low cost and less time than
core earnings of the financial institutions. Islamic capital markets play vital role in risk
management for the institution. Liquidity, market and credit risks management are completely
dependent of Islamic capital markets. Financial institutions cannot proceed without risks
management in these categories. Basel-II accord implementation for the financial institutions
requires the meeting of risks management, for which Islamic financial institutions require Islamic
capital market tools and secondary markets for the operation of these tools.
Above analysis conclude that Islamic capital markets are vital for the development of Islamic
financial institutes in the country. These capital markets require some other infrastructures like
secondary markets, commodity markets, legal framework and intermediate companies to operate
such tools through the Islamic financial institutes. Though, Islamic finance relies on real assets
and ventures and considers the value of assets, instead of value of money. Conventional financial
institutes consider money as commodity for trade and financial dealings while Islamic financial
institutes strictly follow teachings from the Holy Quran and Sunnah of Prophet Muhammad
(S.A.W.W.).
Finally, it can be recommended to the regulators to develop secondary market and commodity
markets for the development of derivatives and other financial products. Financial market of
Pakistan has an adequate human capital and financial base to develop the Islamic derivatives and
capital markets in the country.

REFERENCES
Abdelaziz Chazi and Lateef A.M. Syed (2010), Risk exposure during the global financial crisis:
the case of Islamic banks, International Journal of Islamic and Middle Eastern Finance and
Management Vol. 3 No. 4, 2010 pp. 321-333
Andreas A. Jobst (2008), The development of equity derivative markets, International Journal
of Emerging Markets Vol. 3 No. 2, 2008 pp. 163-180
Anjum Siddiqui (2008), Financial contracts, risk and performance of Islamic banking,
Managerial Finance Vol. 34 No. 10, 2008 pp. 680-694
Bakri Abdul Karim, Mohamad Jais and Samsul Ariffin Abdul Karim (2011), The Subprime Crisis
and Stock Index Futures Markets Integration, Emerald Group Publications
Cloke, Jon, An economic wonderland: derivative castles built on sand, critical perspectives on
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Floros, Christos, Dynamic relationships between Middle East stock markets, International
Journal of Islamic and Middle Eastern Finance and Management Vol. 4 No. 3, 2011 pp. 227-236
Haas, D. (2008), The crushing potential of financial derivatives, available at:
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Karim Bin Khedri, Do investors really value derivatives use? Empirical evidence from France,
The Journal of Risk Finance Vol. 11 No. 1, 2010 pp. 62-74
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Islamic financial system help?, The Journal of Risk Finance Vol. 12 No. 1, 2011 pp. 15-25
Mohammad Zakir Hossain (2009), Why is interest prohibited in Islam? A statistical
justification, Humanomics Vol. 25 No. 4, 2009 pp. 241-253
Muhammed Hashim Kamali (1999), Prospects For An Islamic Derivatives Market In Malaysia,
Thunderbird International Business Review, Vol. 41 (4/5) 523-540 (July-October 1999)
M. Shahid Ebrahim & Shafiqur Rahman, On the pareto-optimality of futures contracts over
Islamic forward contracts: implications for the emerging Muslim economies, Journal of
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Raphie Hayat & Roman Kraeussl (2011), Risk and return characteristics of Islamic equity funds,
Emerging Markets Review 12 (2011) 189203
Talat Afza and Atia Alam (2010), Corporate Derivatives and Foreign Exchange Risk
Management: A Case Study of Non-financial Firms of Pakistan, Emerald Group Publications
Limited.
Turkhan Ali Abdul Manap & Salina H. Kassim (2011), Long Memory Properties and
Asymmetric Effects of Emerging Equity Market: Evidence from Malaysia, Emerald Group
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Ulrich Derigs and Shehab Marzban (2009), New strategies and a new paradigm for Shariah-
compliant portfolio optimization, Journal of Banking & Finance 33 (2009) 11661176
William Marty Martin & Karen Hunt-Ahmed (2011), Executive compensation: the role of Sharia
compliance, International Journal of Islamic and Middle Eastern Finance and Management Vol.
4 No. 3, 2011 pp. 196-210


5 The Stability Estimation and Growth Analysis of Islamic
Banks: The case of OIC countries
Omar Masood
*
, Royal Docks Business School, University of East London, London, United
Kingdom
Muhammad Ashraf
, Management Sciences, University of Gujrat, Gujrat, Pakistan

Abstract:
Purpose- The objective of study is to investigate factors responsible for the
growth of Islamic banks for the 2007-2012.
Design/Methodology/Approach- To analyze the growth of Islamic banks,
banks are divided in two categories (Small and large) and Z-score analysis
used as dependent variable.
Findings- The study results shows higher z-score than of larger banks which
indicates that small banks are more stable than of larger banks. For large
Islamic banks z-score increase and for small Islamic banks z-score decrease.
The regression results confirm that larger banks have higher income diversity
and smaller banks have lower.
Originality/value-The interesting features are exemplifies by the Islamic
banking from the view point of corporate governance are profit-and-loss
sharing and risk, participation of equity on the basis of Islamic financing.
These features become the main cause of Islamic banking departure from
conventional banking. The study provides important acumens regarding
Islamic banks stability and growth by using of statistical techniques.
Keywords: Islamic Banks, Stability estimation, Growth, Country-specific
factors, Z-score.

1. INTRODUCTION
The study examined the condition or factors that changes the regulation and over all banking
system of Islamic banks. To examine this, an empirical analysis conducted on the growth of
Islamic banks by using the econometric techniques. The Islamic banking financing methods
differs from the conventional banking. Loans on based of interest or financing instruments are
not offered by the Islamic banks. The Islamic banking financing methods based on risk and profit
and loss sharing and participation of equity from both parties.
Under the Islamic banking financing arrangements, investors are considered as partners and will
be given predetermined ratio of profits when the used funds yield profit. In addition, the
investors are also given profit returns for willingness to assume risk
The very important is that few empirical analyses are on Islamic banks role in financial stability.
The Islamic financial institutions risk discussed by few studies in form of theoretical rather of

*
Omar Masood is at Royal Docks Business School, University of East London, London, United
Kingdom
Muhammad Ashraf is at Management Sciences, University of Gujrat, Gujrat, Pakistan,

Ashraf.iub@gmail.com

data analysis, but on the other hand efficiency related issues are focused by empirical research on
Islamic banks such as, Yudistira, (2004); and Moktar, Abdullah, and Al-Habshi, (2006).
The thrust of our research is to tackle and fill up the gap of limited literature on the structure of
market in the Islamic banking sector. As per our knowledge, few studies are conducted to
analyze the cross-country empirical analysis to review the role of Islamic banks in financial
stability. To analyzing the issue in the context of cross country, very important is cross country
data which distinguish impact of Islamic banks from the numerous other factors that have impact
on financial stability. For country-specific factors, cross-country data entails adjustment. The
adjustment is possible for the reason that in this paper employed methodology significantly
increases observations for the analysis.
This study contributes in the Islamic banking systems literature on market structure through use
of large scale banks sample over a momentous time frame. By using a larger sample of banks
over a significant amount of time. Our data collection based on 30 Islamic banks for the time
period of 2006 to 2011. The research objective is to analyze the financial stability and growth of
Islamic banks over the selected time period.
The division of paper is as follows. Section-I of this paper reviews the previous studies related to
this study. The Islamic banking overview provided in Section-II and in Section-III, Methodology
and variables used for research are discussed. the empirical results and findings are presented in
Section-IV. Finally, In section V conclusion is summarized and for further research topics are
suggested.
2. Literature review
The Islamic banks credit risk shifted to funds depositors due to Profit and Loss sharing (PLS)
modes. These modes may also augment the level of risk of assets side of banks balance sheet
even though the PLS mode assets are considered uncollaterised.In principles, the deductive
instinct is that, the riskier assets to total assets ratio should usually be higher in an Islamic bank
than in conventional bank, Sundararajan and Errico (2002).
The Islamic financial institutions working scenario is not prevented from risk. However, in the
monitory view and by relevant literatures it is cleared that Islamic banks risks pose scenario to
financial system in many regards differ from conventional banks. The Islamic banks Risks arise
from the Islamic contracts specific features and the liquidity, governance and legal infrastructure
of Islamic finance.
The Islamic product examined by number of studies introduces by (Islamic and commercial)
banks but on the other hand, Islamic banking regulatory and supervisory features remain in
focus, Ainley et al. (2007).
Choong and Liu (2006) stated in his research about the practice of Islamic banking which deviates
from the paradigm of profit and loss sharing (PLS) and in practice not very different from
conventional banking. For analysis of financial sector, the authors as a result suggest that Islamic
banks and conventional banks should be treated in the same way.
Cihak and Hasse, (2008) suggested in his study that Islamic banks are more stable base on a small
scale operations, and are less stable on a large scale operations. The authors also found that small
Islamic banks likely to be financially healthier than smaller commercial banks and on the other
larger commercial banks are financially healthier than larger Islamic banks. They also found that
Islamic banks do not have a significant impact on market share and strength of other banks.
A relative banking efficiency examined in Bahrain by employing 31 banks pannel data for the
period 1999-2000. In study, he concludes that the inefficiency main cause is technical factor not
allocative factor. The researchers also investigate the efficiency measures differences between
domestic and foreign banks of Bahrain. The study unveils the fact that in banks, efficiency scales
terms are different, Hassan et al. (2003).
The studies from non-US, investigate that Hungarian Banks mean to say foreign banks are most
efficient than Domestic banks Hasan and Marton (2003). Another study conducted by Zaim and
Isik and Hassan (2002) for banks of Turkish and found the similarity in results as the results
obtain by Hasan and Marton (2003) for Turkish banks.
While, a study Growth and rise of smaller Islamic banks by Sathye (2001) divulge that accruing of
comparative advantage is not seen to foreign banks. A study conducted by Al-Jarrah and
Molyneux (2003) in which they include banks from Bahrain, Egypt, Saudi Arabia, and Sudanand
examined that in their sample; the Islamic banks are the most efficient.
The study conducted by Hussein (2004) in which he observed facts regarding funds cost which is
cheaper for Islamic banks in comparison to the other financial institutions. The researcher also
finds that performance of Islamic banks is better than conventional banks because the Islamic
banks gain is higher than of conventional such as 75 and 66 percent of profit respectively. The
difference between Islamic and conventional banks profit efficiency is because of commercial
banks performance difference instead of investment banks.
The researcher argue on the efficiency is that more superior efficiency profit efficiency rather of
cost efficiency, even though the profit efficiency accounts for the errors on the output side, i.e.
revenues as well as the input side, i.e. cost, Berger and Mester (1997).The further argue by Berger
and Mester is that it can be possible for bank to minimize cost and become more successful in
comparison to other firm, but the bank yet make less profit then other firm. The reason exist
behind this is that they are unable to make appropriate selection while choosing its output mix.
Even though Islam has high regard for efficiency, but relatively few literatures have embarked on
the efficiency of Islamic banking. Most of the production efficiency studies of banks tend to focus
on the conventional banks.

2. METHODS
2.1. Data

Panel data of selected sample is used to analyze the financial stability and growth of Islamic
banks. The panel data set is used for this purpose, and the selected sample is based on 30 Islamic
banks from 15 countries and the selected countries are member of Organization of Islamic
Countries (OIC). The six years data for the said period 2007 to 2012 is used for the purpose of
analysis. The countries are chosen from different regions where awareness among consumers
about Islamic financial products and services growing. This condition makes more pertinent to
check the financial stability and growth of selected Islamic banks.
For each Islamic bank, the annual frequency data is collected for analyzing growth and financial
stability and data obtained from profit and loss and balance sheet statements. On the other hand
macro-economic variables, the data on economic activity and annual inflation rate are obtained
from: CIA world fact book. The data collected from fifteen different countries such as; Bahrain,
Bangladesh, Indonesia, Kuwait, Malaysia, Pakistan, Qatar, Saudi Arabia, Sudan, Turkey, United
Arab Emirates, Yemen, Iran, Egypt and Manutrian.
2.2. Measures
Stability estimation of Bank
The method z-score utilized in the study to measure the stability of stability of smaller and larger
Islamic banks. To estimate the stability of smaller and larger Islamic banks, the Z-score used by C
ihak and Hesse (2008).

The stability estimator Z-score computed as:

Where,

is equity capital and reserves as percent of assets.
is average return as percent of assets.
is standard deviation of return on assets as a proxy for return volatility.

The normal distribution is considered here and assumed z-score is a stability measure. The
higher z-score indicate better financial position of bank and lower z-score indicate higher chances
of bankrupt or insolvent for the bank.
The investments made on the base of Mudarabah principle, the two parties involvement, one
finance provider and the 2
nd
investor of finance in commercial dealing. The both parties (investor
or capital provider) in return will get profit that was pre-determined. The same can be seen that
the lots of financial liabilities of Islamic banks are made up with different pre-agreed maturities
of investment accounts of different nature.
The z-score computation is used for the banks that have different strategies for returns like (I)
high risk/high return (II) low risk/low return strategy. On the other hand, z-score can also be
used to measure the soundness of banks which have higher capitalization but adjusted for lower
risk returns.
2.3. Dependent Variable
Z-score: the Z-score is defined as z= (k+)/, where k is equity capital as percent of assets,
is average return as percent of assets, and is standard deviation of return on assets as
a proxy for return volatility. Measure the number of standard deviations a return
realization has to fall in order to deplete equity, under the assumption of normality of
banks' returns.The dependent variable, Z-score is used to measure individual bank risk.
The z-score has become a popular measure of bank soundness (see, e.g., Boyd and
Runkle, 1993; and Maechler, Mitra, and Worrell, 2005). Its popularity stems from the fact
that it is inversely related to the probability of a banks insolvency, i.e., the probability
that the value of its assets becomes lower than the value of the debt. A higher z-score
therefore implies a lower probability of insolvency risk.

2.4. Independent Variables
Total assets: The total assets of the bank in USD
Loans to assets: Ratio of loans to assets (percent). The ratio loans to total assets measure
the banks income source and expected to affect the bank profitability positively except the
bank is at unbearable level of risk. Aydogan, (1990)
Expenditure to income: Ratio of total expenditure to total income
Income Diversity: 1-I (Net operating income-other operating income)I Total operating
income
Islamic Bank Dummy: Equals 1 for large Islamic banks; and 0 for small
Market Share: The share of the bank amongst various paramount Islamic banks in the
dataset
Herfindahl Index: Sum of squared market shares of banks in the dataset

2.5. Regression analysis
The z-score is used as a function of variables to estimate the stability of smaller and larger Islamic
banks stability. This regression equation used in this study replicate the equation used to
compare the stability of commercial banks against Islamic banks by the Cihak and Hesse
(2008). However, this study sample based only on Islamic banks and will estimate the stability of
smaller and larger selected Islamic banks from OIC countries.

(I)

The model-I is rewritten below in the functional form as:
Growth and Financial Stability
=
(II)
Where the growth and financial stability is measured by Z-score in model-II, used proxies are
expanded in the following model.

The Islamic banking dummies are calculated through yearly market share of Islamic banks by
assets for the purpose to investigate the large Islamic banks impact on smaller Islamic bank. For
Islamic banks market share, a positive or negative sign interact to work of banks stability and on
the other hand higher or lower Islamic banks share implied by Islamic bank dummy which
increase or reduce the banks stability measured by z-score.
The control variables are measured through the use of asset size in US dollars billions of banks,
loans-to-assets ratio and the cost-to-income ratio, respectively. The banks are differentiated based
upon size, structure of assets and the efficiency regarding costs, because of this the control
variables are used in the regression equation. For control of banks income composition, the
income diversity is also used (Laeven and Levine, 2005). Through the income diversity is a way
to determine the diversification from traditional to other activities. There are differences in these
variables so that controlling of these variables is essential between large and small Islamic banks.
To measure the financial stability variation of cross-country, Herfindahl index used because of
market concentration. The sum of squared market share (total assets) used to measure Herfindahl
index for all banks. Variables like bank-specific market share, macroeconomic, Herfindahl index
are used on the study. The regression applied on these variables and their lagged Islamic
dummies to measure the individual banks risk. At the same time, variables are used to analyze
the lagged effect of explanatory variables are robust.
To analyze the sensitivity of results, the Ordinary Least Square regression applied. The fixed
effect regression method applied. Robustness of the results also estimated through applying of
regression separately on the sub-sample of large and small Islamic banks. The banks are
categorized in large and small sample. The large banks are having their assets above the average
and small having their assets below the average.
The list of variables and their descriptions are listed in the table-I and the. The used variable
proxies in the study are similar to Cihak and Hesse (2008).
Table-I Variables and their descriptions
Variable Description
Z-score
Z-score is defined as z= (k+)/, where k
is equity capital as percent of assets, is
average return as percent of assets, and
is standard deviation of return on assets
as a proxy for return volatility. Measure
the number of standard deviations a
return realization has to fall in order to
deplete equity, under the assumption of
normality of banks' returns.
Total assets The total assets of the bank in USD
Loans_assets Ratio of loans to assets (percent)
Exp_inc Ratio of total expenditure to total income
Income Diversity
1-I(Net operating income-other
operating income)I Total operating
income
Islamic Bank Dummy
Equals 1 for large Islamic banks; and 0
for small
Market Share
The share of the bank amongst various
paramount Islamic banks in the dataset
Herfindahl Index
Sum of squared market shares of banks
in the dataset
GDP Growth
Inflation
Source: Cihak and Hesse (2008)

3. EMPIRICAL ANALYSIS
The table-II, presents the summary statistics for Islamic banks of the data sample over the sample
period of 2007-2012.
The study results show the higher z-scores (22.38) for Islamic banks which indicate that small
banks are more stable than of large banks. The outliers treatment are also illustrated in the table
because of importance. On the other hand, the small banks outliers still have higher z-score
which indicate for higher stability. In the both cases of means comparison suggests that the
difference is significant at 1 percent level.
Table II Large Islamic Banks Small Islamic Banks
Z-score 15.96 22.38
Z-score excel. Outliers 11.07 13.09
Loans/assets 0.61 0.58
Income Diversity 0.67 0.63
Note:
The results reveal that loan to assets ratio for small banks are lower than the larger Islamic
banks. The ratio indicates the Islamic banking investment prohibition in treasury bills or
conventional bonds. The appearance of large Islamic banks loans to asset ratio is an average
than of small Islamic banks. The results of income diversity for large and small Islamic banks
are insignificant, even though the large Islamic banks have higher income diversity.
On the pooled data set, the regression analysis is employed and the results are presented
through the Tables III and IV. The Ordinary Least Square estimation results are shown in
table III and the Table IV provide the results of robust estimation technique.
Table III, Dependent variable Z-score, Regression Results: Ordinary Least
Squares
Variable All Banks Small Banks Large Banks
C 21.643 18.467 22.844
Assets 0.266 (0.084)** -0.950 (0.073)** 0.637 (0.045)*
Loans/assets -1.928 (0.731) -1.950(0.089)** -6.438(0.467)

Exp-inc -0.065 (0.063)** -0.817(0.285) -0.681(0.545)
Income Diversity 1.021(0.288) 2.389(0.087)** 7.551(0.096)**
Market share

34.446(0.200) -0.238(0.033)*
Islamic Dummy -6.901(0.024)* 15.923 (0.008)* -30.773(0.203)
Herfindahl Index -0.059 (0.010)* -0.005(0.005)* -0.005(0.056)**
R-squared 0.264 0.241922 0.415915
Note: Significance levels are *1 and **5 percent, respectively; parenthesis values
are of P-values.
The regression results also explain that small Islamic banks are more stable than large Islamic
banks. These results also confirmed by the variable Islamic dummy, the results of variable are
negative for large Islamic banks but it is positive for small Islamic banks.
The banks stability measured by the z-score and loans to asset ratios are negatively related to z-
score for large and small Islamic banks.
Table IV, Dependent variable Z-score, Regression Results: robust estimation
Variable All Banks Small Banks Large Banks
C 14.473 09.467 16.844
Assets 0.399 (0.070)** -0.317 (0.042)* 0.423 (0.066)**
Loans/assets -1.003 (0.319) -3.652 (0.063)** -5.352 (0.029)*
Exp-inc 0.479 (0.065)** -0.645 (0.094)** -0.462 (0.098)**
Income Diversity 0.037 (0.162) 0.979 (0.016)* 0.109 (0.172)
Market share

24.020 (0.200) -0.176 (0.033)*
Islamic Dummy 0.065 (0.461) 56.137 (0.012)* -14.598 (0.099)**
Herfindahl Index -0.061 (0.659) -0.009 (0.050)* -0.005 (0.828)
R-squared 0.379 0.174 0.398
Note: Significance levels are *1 and **5 percent, respectively; parenthesis values are
of P-values.
However, the small banks estimated coefficient is significant and for large insignificant. Further
stated that z-score tend to increase with bank size for large Islamic banks but decrease with size
for small Islamic banks.
The study results of descriptive statistics and regression show that income diversity of large
Islamic banks is greater then of small Islamic banks. According to Cihak and Hesse (2008), this
is expected since larger banks usually do not rely much on income bearing assets.

We find that the Herfindahl index had a negative impact on both type of Islamic banks which is
associated with lower stability. Our findings are in accordance with previous literatures of
Schaeck et al. (2006) and Cihak and Hesse (2008).
The regression results of robust analysis are similar with our earlier findings that small Islamic
banks are more stable than of large Islamic banks because Islamic dummy is positive for small
Islamic banks while negative for large banks.

The regression results for the herfindahl index are negative in robust analysis but significant for
small banks and insignificant for large banks but there is still confusion about impact that it leads
towards lower or higher stability. Several checks applied to estimate our results robustness but
no major change found in our results.
Table IV; List of Selected Banks and respective countries from OIC
Sudan
1-Arab Bank Sudan
2- Faisal Islamic Bank
Indonesia 3-Bank Syariah Mandiri
Malaysia
4-Affin Islamic Bank
5-Bank Islam
Bahrain
6-Al-Salam Bank
7-Bahrain Islamic bank
8-Gulf Finance House
Kuwait
9-Boubyan Bank
10-Kuwait Finance House
Qatar
11-Qatar International Islamic Bank
12-Qatar Islamic Bank
Saudi Arabia
13-Al-Rajhi Banking
14-Riyadh Bank
United Arab
Emirates
15-Dubai Islamic Bank
16-Emirates Islamic Bank
17-Sharjah Islamic Bank
Yeman 18-Tadaman International Islamic Bank
Bangladesh
19-ICB Islamic Bank
20-Islami Bank
Pakistan
21-Al-Baraka Bank
22-Bank Islami
23-Meezan Bank
Turkey
24-Bank Asya
25-Trkiye Finans Bank
Egypt
26-Egyptian Saudi Finance Bank
27-Faisal Islamic Bank of Egypt
Iran
28. Bank Maskan
29. Bank Mellat
Mauritania
30. BAMIS Banque Al Wava Mauritanienne
Islamique


4. CONCLUSIONS
In this changing pattern of environment, stability estimation and the causes for growth of large
and small Islamic banks becomes the lust feature. The large and small Islamic banks stability
tested through regression using z-score as dependent variable and as a function of number of
variables. For regression analysis, the ordinary least squares (OLS) technique used on the selected
data sample for the time period of 2007-2012.
The study results shows that banks stability (z-score and loans to asset) ratios are negatively
related to z-score for large and positively for small Islamic banks. However, the small banks
estimated coefficient is significant and for large insignificant. Further stated that z-score tend to
increase with bank size for large Islamic banks but decrease with size for small Islamic banks.
The descriptive statistics and regression results of study show that income diversity of large
Islamic banks is greater then of small Islamic banks. The results indicate that small banks are
more in strength than of large banks. This is expected since larger banks usually do not rely much
on income bearing assets. The Herfindahl index had a negative impact on both type of Islamic
banks which is associated with lower stability.

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EURO-MEDITERRANEAN

ECONOMICS AND FINANCE

, University of Cergy and ISC Paris Business School, Paris, France

, Management Sciences, University of Gujrat, Gujrat, Pakistan

Muhammad Ashraf is at Management Sciences, University of Gujrat, Gujrat, Pakistan,

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