Question

Awareness about Islamic finance in the UAE or Gulf from the perspective of an islamic bank and a conventional one, how do they differ from each other ?

Answer 1

The discourses of Islamic and conventional finance differ according to the principles of Islamic finance there is no separation of the spiritual and the secular. Islamic finance is explicitly concerned with spiritual values and social justice, in contrast to conventional finance, which is based on the maximization of individual utility, welfare and choice, as expressed for example in the shareholder value model. Islamic and conventional banks respond differently to financial shocks. The below inference analyses the performance of Islamic and conventional banking systems in the UAE/Gulf. The study will comprise of two stages, first a comparative analysis .Secondly, a cross sectional analysis, between the Islamic banks and conventional banking sector that operated in the UAE/Gulf.

The discourse of Islamic banking involves: (a) equity rather than debt, (b) financing in strict relation to assets rather than leverage, (c) transparency and information sharing between investor and the manager, (d) diversification of risk by risk sharing. In contrast, the discourse of conventional finance failed as a result of: (a) too much debt, (b) overleveraging of assets and (c) excessive securitization and creation of new assets that were neither transparent nor understood.

This will alllow you to understand the two banking sectors, in terms of; capital adequacy, profitability, liquidity and leverage.

Islamic Financial System

One of the key differences between conventional and Islamic banking is the ban on Riba (usury); riba is any return/addition/increase for the use/rent of money. Islamic financial institutions must “trade” in real assets or services. There are several reasons for the prohibition of riba such as Unjust; a contract based on interest involves injustice to one of the parties, the lender or the borrower. Penalizing someone for default is unjust; a judge should decide the amount of any compensation for a default, not the party to whom the debt is owed. Qur’an (2:279) “clearly states that taking an amount in excess of the principal would be unjust”. And Implies Unlawful Appropriation of Other People’s Property; Interest on money is regarded as representing an unjustified creation of instantaneous property rights. It is unjustified, because interest is a property right claimed outside the legitimate framework of recognized property rights. Some key features as:

Money verses real market:

Money creation in a system of debt finance is based on lending, which makes it prone to oversupply, as there is no direct linkage between additional production and additional money supply.

Public sector:

Public sector borrowing, when it is not backed by tangible assets, raises a debt burden for future generations. Islamic asset-backed financing does not constitute a debt burden as assets are available which can be liquidated to repay the debts.

Price level:

Inflation will be minimal (under an Islamic finance system) as the money supply will be correlated to economic activities. Islamic finance encourages individuals to share business risks in return for reward with the understanding that the level of the expected reward is related to the level of risk. What is condemned in Islamic banking is the notion of a risk free reward or return which is in contrast to conventional banking principles. Islamic banking principles do recognize the time value of money but provided that profits are earned through trade and not on lending money. The distinguishing factors between Islamic from conventional banking are:

Gharar (uncertainty): Any contract based on a future of uncertain event within Islamic banking is not generally allowable this includes dealing in conventional derivatives and options.

Maysir (gambling): Speculative mentality transactions creating towers of debt based on speculation.

Halal business: Islamic (Sharia) law prohibits dealing in some products or activities e.g. pork, interest based finance, debt, gambling, alcoholic liquor...etc.

Comparison between conventional and Islamic banks on five performance parameters; capital adequacy, efficiency, profitability, liquidity and leverage:

Their analysis suggests that during the crisis Islamic banking, were impacted more in terms of capital adequacy and leverage while conventional banking more in terms of return on average assets and liquidity. For full year analysis the study found that Islamic banks performed better than conventional banks for the period 2006-2009. The study suggests that Islamic banks did suffer during crisis in terms of lowering of The study found no significant differences in terms of profitability.

However, the key differences found were; Islamic banks are less exposed to liquidity risk, and conventional banks depended more on external liabilities than Islamic banks.

Also, the following two interrelated research issues: Identifying and explaining the determinants the financial turmoil in the UAE’s financial markets and evaluating the impact of the UAE’s government bailouts on the UAE’s economy in the short and long run. The findings were that the government saved the troubled banks through bailouts and drawing down FXRES (Government economic activity). The timing of the increase in the ratio of leverage risk measures of the banking system and reserve adequacy (liquidity risk) of the UAE’s economy is consistent with the model’s prediction that the government’s bailouts and foreign reserve policy played a crucial role in reducing the adverse reaction to the financial crisis in 2007 - 2008. These developments significantly contributed to the positive expectations in the market. The result was survival of the banking sector with the confidence of market participants intact.

Also, it is observe that Islamic banking have lower overhead costs and cost-income ratio and higher returns over asset but capital asset ratios is smaller. Islamic banks have higher fixed asset ratio and lower non-interest earning asset ratio. Maintaining a high fixed asset ratio implies that the Islamic banks are managing their assets more efficiently and profitably than conventional banks.

The performance of Islamic compared to conventional banks in Indonesia. Different ratios were used and they found that the cost efficiency ratios were lower in Islamic than the conventional banks in addition the revenue and profit efficiency ratios were higher in Islamic banking. Also the Islamic banks net interest margin (NIM) have maximum of 0.182, while conventional banks have 0.097. Furthermore, the operating income to average asset in conventional bank was 0.006 while in the Islamic bank the mean was 0.013. Islamic banking is generating higher income from its asset, which is a positive indicator of revenue efficiency performance in Islamic banks.  

Also, it was studied the top 10 Islamic and conventional banks performance during the financial crisis, they found that the aggregate net profit for the conventional banks observed a drop while Islamic banks experienced an increase in their net profit in the same period. Moreover, the leverage ratio (asset/equity) for conventional banks increased from 16.6% in 2006 up to 18.2 in 2008, however, Islamic banks leverage ratio was 5.8 in 2006 boosted to 6.6 in 2008. The leverage ratio measures the firm’s long term solvency, the ability to meets its obligation, as the leverage ratio is smaller it means that the firm is using less debt.

The performance of Islamic and conventional banks from 2007 to 2009 in terms of return on asset and on equity, net loan to total asset and loan loss reserve to gross loan. They used data from 46 Islamic banks and found that Islamic outperformed conventional bank in 2007, but in 2008 there was no significant difference between the two banking systems. However, conventional outperformed Islamic banks in 2009. they summarized that although there was no significant difference in terms of performance in 2008, the financial crisis impacted both banking systems, yet the impact on Islamic banks was limited to a decline in returns.

The performance of Islamic and conventional banks in the period 2004 - 2009 in terms of profitability, leverage ratios, return on asset/equity, net margin, dividend payout, total debt to common equity, long term debt to common equity, total debt to total asset and the size of the bank asset they used a sample of 50 Islamic and 59 conventional banks from 18 countries. Their findings is that Islamic have lower debt to equity ratio than conventional banks, 7.8 times and 11.48 times for Islamic and conventional banks respectively. Islamic banks rely more on shareholder capital, unlike conventional banks which relies more on debt to structure the bank. Moreover, in terms of profitability, they found that Islamic have higher ROA than conventional banks and lower debt to asset ratio than conventional banks, in terms of long-term debt to common equity. The study found significant difference between Islamic and conventional banks; Islamic banks have lower debt to asset ratio than conventional banks. The findings can be interpreted that Islamic banks have lower leverage than conventional banks.

The financial crisis has impacted the global banking system around the world, yet Islamic banking has been displaying better performance. Particularly in the UAE, the performance of Islamic banks has shown competitive enhancement compared to conventional banks in the period 2007-2008. The study finding reveals the following: Firstly; on macro level analysis both banking sectors were impacted negatively by the crisis as evidenced by the decrease in terms of ROA and ROE.  

In terms of the cross sectional analysis, the market share and total asset of the Islamic banking industry maintains a higher percentage compared to conventional banks. Secondly; this reveals that Islamic banks preserve a higher percentage of liquidity than conventional banks in the UAE/Gulf during the financial crisis. Thirdly; in terms of non-performing loans, Islamic banks maintain a lower percentage than conventional banks, which can be translated as a good quality, credit screening conducted by Islamic banks.

Overall, the effect of the financial crisis was limited on Islamic banks; Islamic banks were affected in terms of ROA and ROE mostly. In terms of mitigating liquidity risk and insolvency, Islamic banks were outperforming conventional banks as Islamic banks managed to have a high percentage of liquid asset. As a result the Islamic banks were less likely to have liquidity problems and bankruptcy declarations, because they are not allowed practicing banking activity that was directly linked with debt instruments.

The Islamic approach emanates from a foundation set of ethical principles. therefore discussion of Islamic finance in connection with global financial practices introduces an ethical dimension that is welcome. Khan (1986) believes that Islamic finance potentially has appeal for the mainstream as well as Muslim consumers because of its ethical basis: "Islam teaches us that money should be channeled toward the 'real' economy, the production of real goods and services and not the 'financial' economy such as hedge funds and derivatives," he argues, "It keeps us in touch with the real economy and away from speculation and Islamic system of finance might create a more stable world financial market.

The real roots of the financial crisis are in the attempt to construct a financial system, a materialist heaven, in denial of limitation and mortality that are the realities of living in time and space. The promise was unbounded exponential growth, extending infinitely to a paradise of consumption.

This emphasizes that since the current architecture of the conventional financial system has existed for a long time, radical structural reform of the kind that the Islamic financial system is unlikely. This suggests some movement in that direction may be possible but does not discuss inertial factors which we think are likely to be overwhelming in the near future. Current discourse is dominated by what we have called Chicago thinking: the lure of bonuses and the political power of the financial sector is immense and destructive.