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Islamic Banking, Conventional Banking Systems and the Global Financial Crisis

Introduction

The Islamic Finance System is one of the rapid growing economic segments in the global financial market. Several factors encourage the elevated rate of growth mostly the requirement in Islamic countries to have Sharia compliant finance products and the need to strengthen the framework of Islamic finance. The Global financial market has the capacity to develop and fuse a number of financial systems and instruments especially given the dissimilarity of Islamic and Conventional banking systems during the international financial crisis. Islamic Banking Systems (IBS) with comparison performed better that Conventional Banking (CB). This is because of the large losses experienced in the European and Western markets as compared to Arabic markets. Despite the effectiveness of the Islamic systems, the global financial crisis has led to an analysis of the relationship between Islamic banks and financial stability. In detail, the emphasized point is the resilience of the Islamic system given another financial crisis. Though the IBS were more resilient to the financial crisis, losses experienced highlighted several weaknesses in the banking system. This research will take an in depth analysis of why Islamic banks did not face the financial crisis referencing the Kingdom of Saudi Arabia. In addition, the research will highlight why conventional banks suffered under the financial crisis and the weaknesses in the Islamic banking system. After analysis of the two banking systems, the paper will highlight how the IBS can incorporate several aspects of conventional banking in order to elevate economic stability.

Preliminary Statement of Issues

The Kingdom of Saudi Arabia in its economic planning is identified as one that serves both spiritual and temporal factions. The Kingdom in its constitution abides in its faith on Islam with all national laws leaning and following to the established religious guidelines (Ghassan and Fachin 3). The Sharia law is imperative on the interest charged on loans, stock exchange, and commercial insurance in finance. This represents the Kingdom’s alignment with the first faction that is religious. The KSA in its 2005 accession with the World Trade Organization represents the second alignment with the temporal faction. In the year, the country made an international treaty that committed it to liberal trade following the WTO policies, economic resolutions, and regulations. The treaty with the WTO is identified as the initial entry of conventional banking in the Kingdom.

Preliminary studies in the economic capacity of Saudi Arabia suggest that the Arabic nations cannot achieve its desired economic objectives or maximize its potential economic capability whilst following Sharia law (Ghassan and Fachin 3). If the Kingdom was to adopt global and commercial practices, it is more assured to achieve its long-term objectives. Conversely, adopting global and commercial practices infringe the teachings of Sharia law thus negatively affecting the established religious banking system. Despite the infringement, studies show that KSA is heading to its worst financial crisis if it does not modify its banking system (Ghassan and Fachin 3). The risk on pursuing global finance practices lies on the established reliance and guidance on Islamic Sharia laws. On the other hand, the risk of not pursuing banking modifications lie on the non-performance of the Islamic bank system that may result in a financial crisis for the kingdom.

The potential risks develop into a financial dilemma, which the research document attempts to address. Sharia law is strict thus prohibits and contradicts the operations under modern banking laws. Conventional systems are more flexible thus can easily adopt financial aspects of Islamic law (Ghassan and Fachin 4). The main issue is how to reverse the flexibility to allow the IBS to integrate CB without infringing Sharia law. This could lead to the birth of a banking system as it incorporates some successful features of conventional banking system as well as some successful features of Islamic banking systems. Islamic banks have the greatest capacity to affect positively conventional banks, studies after the global financial crisis revealed that IBs are not entirely safe and free of risk.

According to the International Monetary Fund, the Islamic banking System survived the global economic crisis because its backbone is asset based (Hasan and Dridi 23). In addition, the Islamic form of finance emphasizes on risk sharing. The conventional banking system employed an opposite approach emphasizing on risk allowance and debts thus its demise following the global crisis. Research by the IMF shows that the Islamic banking system is on the verge of a second wave of financial crisis (Hasan and Dridi 23). The economic turndown will be because of the inflexibility of the IBs rising from its strict risk management practices. These practices are associated with high degrees of concentration or exposure to either one sector of the bank or the borrower. Therefore, most banks using the Islamic system are exposed to the spillover implications of the international economy. The research that is proposed is carried under the assumption that the dynamicity developed between the Sharia law and steps taken by the Kingdom of Saudi Arabia eventually immerse the economic system into the international financial mainstream. The religious leaders of the Islamic faith cannot permit distortion of its principles by conventional approaches. In this, the banking system only permits a greater heretical financial policy. The circumstance begs the inquiry on the extent of conventional aspects that can be incorporated into the Sharia economic law. The Islamic system is a constant variable in such an equation. Both forms of banking have the capacity to learn from each other.

Hypothesis

“Integration of several conventional banking practices to Islamic banking systems will result into improved financial stability and efficiency for Saudi Arabian banks.”

For instance, the revised loan and insurance approaches under conventional banking will elevate the flexibility of Islamic banking systems, as they will remove the constraints of the established risk management practices. Following the American mortgage crisis, loaning and insurance models were revised having a standardized form of applicant evaluation, guarantee, and payment. The novel methods have lower probabilities of risk thus are suitable for the IBs.

Literature Review

Islamic Banking and the Global Financial Crisis

According to the IMF, Islamic banks have experienced a growth rate of ten to fifteen percent per year (Hasan and Dridi 24). By the end of year 2008, the Islamic form of banking was present in fifty-one countries worldwide. The global crisis did not only reveal shortfalls of conventional banking but shifted the attention to Islamic banking. IBs play the role of an informant in the global economy thus addressing the asymmetric information concern (Hasan and Dridi 24). The systems mitigate transaction costs facilitating growth for small entrepreneurs. During the global crisis, the IBs controlled risk through mitigation of operational, liquidity and information risks. Mitigation was done through the core concept of Islamic banking which is Justice. The concept involves the sharing of risks where shareholders share equally losses and profits. Though justice is a religious norm, ethical finance is a modern concept in risk management (Hasan and Dridi 24). In Islamic risk sharing, investors source their funds from Profit Sharing Investment Accounts (PSIA) where both returns and risks are equally distributed. In such scenarios, returns are not guaranteed and are dependent on the general performance of the bank. Investors share the risks through Mudharabah and Musharakah contracts binding the results to them.

In the 2008 financial crisis, the Islamic financial market experienced a shortfall of foreign investors mostly in the real estate resulting in elevated housing prices. Stock price volatility from the mortgages increased due to the financial distress of investor declines (Habibi 3). To address the effects of the crisis, Islamic banks retained and maintained large investments mostly in stocks (Hasan and Dridi 25). The stocks were then loaned to private entities solely for the purpose of investment within the Islamic market. Given the little exposure to international markets, the large investments were sufficient to hold the Islamic system through the first wave of the financial crisis. The banks remained well capitalized having a capital adequacy ratio of 16% with high liquidity and asset percentages (Habibi 3).

Conventional Banking and the Global Financial Crisis

Conventional Banking runs entirely on manmade principles, policies, and regulations. The investor is guaranteed always of a constant rate of interest despite the performance of the bank (Hasan and Dridi 28). The banking system’s sole purpose is to increase the rate of profit without any limitations. Through this, loaning is done with the basis of compound interest. Loaning is the fundamental operation of conventional banks (Hasan and Dridi 28). Compound interest and secondary fines on defaulters represent a vast pool of profit generation. During the global financial crisis, conventional banks were the most affected given their reliance on debts and credits. Lack of investors, elevated real estate costs, and product inflations meant that the banks were not well capitalized and had low asset and liquidity percentages. Lack of investors equally meant that the sizes of conventional banks reduced. Banking size is a determinant of profitability because of diversification, reputation, and economies of scale (Habibi 3).

Introduction of Conventional Banking to Islamic Banks

The global financial crisis highlighted several gaps in the Islamic form of banking. For instance, it was noted that the size of an IB determined its stability towards the first wave of the crisis (Hamif 169). In the KSA, small banks did not experience a stable asset and profit growth as compared to big banks. The difference was mainly associated with the inability to retain, lure, and maintain large investors thus lack of investment capital. In addition, all Islamic banks were identified to have weaknesses in their risk management practices. The justice approach of IB and strict loaning and insurance policies meant that the banks were exempted from concentration limits in the global market (Hamif 169). Exemption from the economic concentrations resulted in poor profit performance despite the financial stability during the crisis. The identified niches in IBs in KSA emphasize on the significance of an impartial regulatory structure for both CBs and IBs.

According to the IMF, IBs have the capability to double their profit and asset growth if risk management practices steer from the loaning restrictions of Sharia law. Risk control approaches implemented by CBs can allow small Islamic banks to cushion adverse economic conditions through debt and credit interests. CBs have an emphasis on liquidity risk that IBs do not incorporate thus have a more efficient resolution framework. Islamic banks run overly their liquid balance sheet thus in the process destroy shareholder value and sacrifice profitability (Hamif 170). The banks suffer either from excess liquidity that results in foregone investment opportunities or liquidity shortages that result in lack of investment capital. Liquidity risks allow IBs to loan small entrepreneurs with elevated support asset and credit growth. This in turn results in a greater solvency and improved external ratings.

Research Questions

This research document makes an analysis on the actual performance of conventional banks and Islamic banks in nations or markets that have significant financial shares. The analysis on the banking performance is done for the year 2008 when most financial systems were adversely affected by the global financial crisis. To address the evaluation, the research will focus on five broad inquiries:

1. Has the Islamic banking system fared better than the Conventional banking system in the year 2008?
2. What are the main reasons behind the identified answer in (1) above?
3. What challenges or weakness did the global financial crisis reveal concerning the Islamic form of Banking?
4. Why is it advisable for the Islamic banking system to consider several aspects of the Conventional form of Banking? What are the advantages?
5. How will the Conventional banking system be incorporated to the Islamic system? The steps or phases required to effectively attain this objective.

To answer the first inquisition, the research focuses on the performance of the two banking systems in two specific countries (KSA and USA) in order to control heterogeneity including macro shocks, regulatory frameworks, and policy reactions to the crisis. The second question utilizes an examination of bank specific macro and micro variables in order to explain the reasons behind the found answer in the prior question.

The third question utilizes bank level information covering the period 2007 and 2008 in several countries using the Islamic system of banking. The countries of choice will equally have a little percentage of conventional banking already in use. The percentage of conventional banking will allow deriving the advantages of fusing the two systems of banking as inquired by the fourth research question.

Research Methods

In order to answer the first inquiry on the performance of IB and CB systems, the research can either carry an analysis of independent banks or generalize the KSA and USA market. Despite the approach chosen, financial stability is measured using the Z score (Čihak and Hesse 31). The score is a method of financial analysis using the formula

K_t is the variable for the ratio of equity capital with total asset reserves. U_t is the mean return to asset ratio while σt represents the standard deviation of the return to assets ratio. The Z score is preferred over other stability analysis methods such as Stress tests and Value at Risk because it is not influenced by unique variables such as bank operations (Čihak and Hesse 31). In addition, the method examines the solvency risk. Basing the research on an assumption that bank returns are not abnormally distributed, the default probability of the Z score will highlight the number of standard deviations necessary for returns to fall to deplete the equity (Čihak and Hesse 31).

Standard models and past research associate the Z score with sector level, bank specific and macro variables. Therefore, in this research, variables will include the credit to asset ratio (CA), total assets (A), income diversity (ID), and the operating cost income ratio (CI). The CA for Islamic banks is measured by the ratio of bank activities to assets while in conventional banks it is measured by loans to asset ratio. Since Islamic banks do not have an interest rate, the income diversity (ID) in the equation is replaced by the finance charges from the PSIA. Replacement of the variables is the shortfall of the Z score method as it results in understating the financial strength of the Islamic institutions.

Given capture of the Z scores, the research will employ regression analysis of the results in order to answer the first, second and third inquisitions. In the regression analysis, the Z score is the dependent variable. A dummy variable is necessary in order to balance the equation with reality. For instance, if the conventional bank being measured is weaker than its comparative Islamic bank, the dummy variable should have a negative sign in order to expound on the dependent variable. In addition to regression analysis, data interpretation will employ pair wise comparisons where a bank in CB is put head to head with another in IB. Conversion will use graphical representations such as tables and graphs to simplify representation. To eliminate bias, banks put head to head will be of similar financial size. The research with its high variability will emphasize on the existence of outliers that have a significant effect on the mean Z scores. In order to elevate accuracy of the mean Z scores, both a complete sample and one without the first and last percentile in the score distribution is shown.

Secondary socioeconomic research will be done to highlight how the two banking systems were affected by the global crisis. The socioeconomic research is done because the Islamic form of banking follows the Sharia law, which is religious, thus the study must have basic comprehensions of the spiritual guidelines. Understanding is derived through cause and effect brainstorming, reduction of variables and observations. This phase of the research will enable the derivation of the best approaches in the integration of CBs in IBs with minimal conflict. Equally, the phase of the study is meant to ease the relationship between the Sharia law within the Kingdom of Saudi Arabia and the World Trade Organization policies.

Conclusion

The Islamic Banking System compared to the Conventional banking System has a greater growth rate and potential to stand through economic hardships. In order to achieve the said potential, the form of banking has to incorporate smoothly conventional bank approaches that might conflict with Sharia law. The same applies to conventional banks that equally stand to benefit from fusion of Islamic financial aspects with their approaches. This proposal is an overview of the upcoming dissertation paper that will address the foundation, challenges, and advantages in fusing IBs and CBs. To do this, similarities, differences, advantages and disadvantages will be derived and compared. The research will more so derive a set of recommendations that may act as a framework in the development of the novel hybrid system. The globalization and standardization of economic activities suggests that both forms of banking need to borrow from each other in order to align with the modern trend and to improve the output results of their operations.

 

Outline

Table of Contents

Introduction. 1

Preliminary Statement of Issues. 1

Hypothesis. 2

Literature Review.. 2

Islamic Banking and the Global Financial Crisis. 2

Conventional Banking and the Global Financial Crisis. 3

Introduction of Conventional Banking to Islamic Banks. 3

Research Questions. 4

Research Methods. 4

Conclusion. 5

 

 

Works Cited

Hamif, Mohamed. Similarities and Differences in Islamic and Conventional Banking. Edward Elgar Publishing Ltd, n.d. 2010.Print.

Čihak, Martin, and Heiko Hesse. “Islamic Banks and Financial Stability: An Empirical Analysis.” Islamic Banking and Finance. 3. (2010): 26-50. Print.

Ghassan, H. B., and Stephan Fachin. Financial Stability of Islamic and Conventional Banks in Saudi Arabia: a Time Series Analysis. University of Rome. 2013. Print.

Hasan, Maher, and Jemma Dridi. The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study. Washington, D.C.: International Monetary Fund, 2010. Print.

Habibi, Nader. The Impact of the Global Economic Crisis on Arab Countries: A Year-End Assessment. Middle East Brief. 40. (2009). 1-10. Print.