Econometrics (Comparative Analysis between Islamic and Conventional Banks
1.0 Introduction
The 2008 global financial crisis has brought a sharp focus on the operations of the banking
systems worldwide. The functioning of the global conventional banks have been put in question
especially after the giant collapse of the Lehman Brothers bank that shook the entire banking
industry globally. The Islamic banking has also attracted some attention given its advantages on
the Shariah-compliant banking products. The Shariah-compliant banking products have been
popular with the Muslim population whose religious beliefs have been factored in the design of
these products. These paper looks at the fundamental similarities and the differences between the
asset quality, efficiency, stability and the business model of the Islamic and the conventional
banks. (Platt, 2008)
Steward (2008) considers banks to be the key players in most economies and a major factor in
the creation of wealth in the financial markets. This indicates that the banking sector plays a
significant role in financial intermediation and assists in the creation of wealth by supporting and
facilitating the establishment of several economic relations.
Most banks in the market are conventional banks (Shafi, 1997) which charge high interest as it’s
considered as the major source of revenue besides the other revenue sources. These makes most
financial markets and other financial institutions are very sensitive to any changes in the
financial interest rates. Interest rates are critical in revenue generation and also in the general
stability of the entire financial market.
Any changes in interest rates can influence the operations of the banking sector either positively
or negatively which can also have a great impact in the financial market and also in the general
economy. To avoid such situations, most banks have engaged elaborate processes to actively
manage the risk factors associated with the interest rates through the risk management and
resource allocation management techniques. The Islamic Banking system differs from the
conventional banking system in several important ways. (Shafi, 1997).
In the same way that the conventional banks charge interest rates, there are also other
unconventional banks that consist of several religious beliefs based products like the products in
the Islamic banks. The major feature of the Islamic banking system is that it’s mostly interest-
free. Shari‘ah-compliant financial institutions don’t charge interest. The Islamic faith, considers
interest as exploitative as it’s a charge on the use of money (Sole, 2007).
This simply implies that the Islamic banking has its own rules and regulations that are very
unique. However, with modern systems of banking operations, Islamic banking has to go hand in
hand with the development of modern technology in the banking systems and also to allow their
own unique operations to be integrated with the modern systems, for instance, the receivable
interest income is mostly replaced with cash inflows from the productive sources, like the returns
from active wealth generating investment operations and which include profits from trading
assets and other different types of cash inflows. (Platt, 2008) Milza et.al, (2003), points that
modern techniques in Islamic banking were developed initially in Muslim dominated countries
such as Malaysia, in Asia. After the mid-1990s, Islamic banking industry improved
tremendously and it was widely acceptable in the gulf region. Its reliable techniques significantly
influenced its faster growth in the oil region mostly as a result of the vast oil revenues that is
mostly related with this particular region in the world. Currently, Islamic finance is taking over
as an alternative to global conventional banks in most countries in the world. Islamic finance has
also attracted conventional investors who are seeking new investment opportunities. Islamic
banking is not restricted to the Muslim community only but it also provides moral and ethical
concept while also providing financial and investment services in Islamic banking. Islamic
banking is also acceptable to all communities living in the UK and also in most parts of the
world.
In most banks are the convectional banks, Islamic banking has made a mark in the UK financial
market. In the last 5 years for instance, HSBC Amanah, has taken measures to deal with any
form of segregation in all its divisions.
Given the differential forms of management between the Islamic banks and the standard
conventional bank, questions have been posed about their long run sustainability. The Islamic
banks depend entirely on their efficiency and optimum performance. The efficiency of the
conventional banks is being studied in these literature to assess their experiences in achieving
their objectives (Shafi, 1997).
2.0 Literature Review
The Islamic financial banking system in Muslim community has been in existence for some time
but in different forms according to different periods in history. Actually Islamic financial
banking system was invented to fulfill other requirements in the society in different but
respectable ways. The Islamic banking sector is a growing with a broad diversity that targets
different segments and also spectrum. It caters to all religious Muslims in all Muslim’s societies
and communities as well as in all countries where Muslims are either in minority or even
majority. It has a broad standard and applies to non-Muslim individuals as well as other
communities that seek the assistance of financial solutions and above all those who are interested
in Islamic banking (Bell, 2009)
Despite several considerable developments in the Islamic banking sector, there are still some
studies which explore and still research on the real efficiency of Islamic banks. Previous studies
have focused on mostly on the primary conceptual issues of the Islamic banking. The major
objective of this paper is really to substantiate this research concept. Our key contribution to the
literature and research is our undertaking in the first empirical research and analysis of the
efficiency in performance of the IBB, which is also considered as the initial stand-alone Islamic
bank in the Western world (Beck, 2010).
We literally attempt to answer some of the following fundamental questions (two) that simply
arise after reviewing the literature on the IBB and the efficiency measurement, rules and
techniques. Does the IBB produce any superior efficiency when compared to the the
conventional banks in the United Kingdom? Can IBB outperform the Islamic banks in their own
Muslims countries (Ansari & Rehman, 2010)
Modeling the Performance of Convectional and Islamic Banks
According to Wikipedia, (2013), Econometric models are statistical models used
in econometrics . Econometric model defines and also specifies the exact statistical relationship
that holds between several other economic quantities that pertain to a specific economic
phenomenon that is under study. An econometric model is mostly derived from a
particular deterministic economic model that can allow uncertainty.
The current study suggest to use logit model as the econometric statistical tool, which is
essentially because the dependent variable is a binary variable which consist of the choice of the
respondents on the their favourite bank where the choice is between the Islamic and the
convectional banking system, such a formula may be expressed as
P (y=1| x) = G (β0+β1×1+…….…+βkxk)=G(b0 + xβ) (1) is
Given 0< G (z) <1
3.1 Logit Model
It is better to adopt the following econometric concept that assumes all the underlying response
as variable y* and can be expressed as an equation in the following regression form:
Ε β + = Σ = Kxy1× (2)
The dependent variable in the Logit model can be estimated in this particular paper as equal to 1
and if the bank is conventional as (iγ=1) = 0 and if the bank
is Islamic as (iγ= 0). The conditional probability that the bank is conventional and it’s on the
right side of the equation on regression and the independent which include the list of the
particular financial ratios.
If the coefficient of the Logit model βj >0, this indicates that increasing xj increases the
probability of a bank type to be conventional bank Pr(iγ=1).
On the other hand, if βj <0 this shows that increasing xj also decreases the probability of the
bank type to be conventional bank. βj = 0 indicates that increasing xj has no effect on Pr (iγ=1).
Six Models will be utilized to avoid the multi co linearity; and each of the six models which
includes different independent variables on the right side of the regression model.
4.4.0 ANALYSIS AND PRESENTATION OF DATA ON THE
The section consists of first describing the raw data which was used for the task and finally
describing the variables that were used for the study. The raw data consisted of dataset from
British banking system
Variables used in the study
The variables used in the study consist of profitability ratios, liquidity, leverage and structural
ratios
Profitability Ratios
Returns on Assets
Return on Equity
Dividend Payout
Liquidity Ratios
Cash to Assets
Cash to Deposits
Leverage Ratios
Debt to Assets
Equity to Assets
Structural Ratios
Deposits to Equity
Deposits to Assets
Loan to Assets
Loan to to Deposits
Loan to Equity
Invest & Deposits to
Assets
Other Measures
Table 1. Description of variables
Description of the data used in the research
The study borrowed data from policy research working paper 6556 by Thorsten Beck which
contain data about comparison between convectional and Islamic banks in many parts of the
world.
Individual or
Group banks
ROE ROA Personal
Exps
Liquidity Lending
Intensity
Capital
Adequacy
Leverage
IBB in UK 0.26 0.06 0.41 1.26 0.91 0.25 5.53
Conventional
Banks in UK
0.45 0.09 0.46 0.76 0.69 0.11 24.37
6 Major Findings
2.1 Financial Performance Ratios, figure 4.1
4.6 PROFITABILTY RATIOS
a) Return on Equity (ROE)
Islamic
Convectional
2010’2011’2012′
0%
5%
10%
15%
20%
25%
30%
35%
This ratio measures the returns company makes from the equity the shareholders have invested It
is a yardstick for financial performance used by senior managers and investors. It is a suitable
ratio to measure returns expected because:
-No artificial upper or lower bonus to bonus earnings capacity and therefore it eliminates
smoothing and manipulations of accounts
-It also provides a clear unambiguous earning goal i.e. share price improvement rather than one
artificial and politically derived through negotiation of interested parties (Hearly 1985).
In Britain from 2009-2011 returns on equity was initially at high of 22% in 2010 and it improved
slightly 2011 indicating that convectional banks made more money per unit of shareholders
equity. Islamic banks on the other hand, had its ROE increasing by 16% from 2010 to 2011 .
b) Return on assets (ROA)
Islamic
Convectional
20112012
0
2
4
6
8
10
12
14
This ratio measures how well a company is generating income from its assets as shown in Figure
4.2 .It is calculated as ,ROA=Net Operating Income (NOI)*100, Convectional banks ROA has
been improving steadily from 2010 to 2012 mainly due to the booming business and controlled
cost but ROA declined sharply in 2012 mainly due to the economic crunch and increased
inflation
c) NET PROFIT MARGIN ((NPM)
This ratio shows how well accompany has controlled its overheads is calculated as and shown in
Figure 4.3
Net profit after Tax (PAT) X 100
Gross Income (G.I)
201020112012
0
10
20
30
40
50
60
Islamic
Convection
al
Convectional banks net profit margin seems to be stagnant with a small decline in 2012 .This is
mainly attributed to the tight controls put on costs .Islamic banks NPM is steadily improving
.This is quite impressive and it indicates that, Islamic banks has put more measures in operating
cost and overheads.
2.1.2: ASSET QUALITY RATIOS
These ratios give an indication of the company’s assets and thus its stability
Bank assets comprise mainly of loans and advances to customer’s .Main ratios include:
a) NON-PERFORMING LOANS TO OPERATING INCOME
Non Performing Loans are loans have defaulted to pay their loan within the stipulated time and
therefore have defaulted and the bank is still booking their interest due.
A lower NPL to be operating income is desirable which means less risk of bad debts.
It is calculated as follows: NPL X100, Convectional banks’ ratio of NPL to operating income
have been reducing significantly Islamic ratios have also done the same despite the fact that
they are still much higher. The reason for this decline and big difference for Islamic banks may
be the fact that it performs thorough credit checks and thorough security and guarantor valuation
before granting loans.
201020112012
0%
100%
200%
300%
400%
500%
600%
700%
800%
900%
1000%
2.1.3 LIQUIDITY RATIOS
Islamic
Convectional
Liquidity ratios indicates the company’s ability to pay their debts and possibility to meet
other demands for cash payments.
DEBT RATIO
This ratio measures a company’s total debts to total assets. A safe limit is 50% It is calculated as
Debt ratio =Total Debts *100
Total Assets
Both Banks have exceeded the 50% limit with Convectional banks having a high of 86% and
Islamic banks 91.6%. The main reason for this big percentages is due to the fact that customer
deposits which make up for the largest liabilities increased while loans and advances which are
the main assets remained stagnant or reduced due to the stringent measures taken before offering
loans. These ratios aren’t looking good because incase of liquidation very little will be left for
the shareholders.
201020112012
0%
1000%
2000%
3000%
4000%
5000%
6000%
7000%
8000%
9000%
2.1.4 EFFICIENCY RATIOS
a) TOTAL COST OF TOTAL INCOME
Islamic
convectioa
nl
This ratio measures how much it costs an entity to raise income from its operations. A low
ratio is desirable because it indicates that it minimizes costs to produce more income. A ratio
exceeding 100% means that a company is making losses and cannot cover its operating
expenses. It is calculated as follows:
Total cost x 100
Total income
Convectional banks ratio are quite high and stagnant but are much lower than Islamic Banks
ratios.
201020112012
0%
10%
20%
30%
40%
50%
60%
Table 4.3: Descriptive Statistics of the convectional and Islamic Banks in Britain
Ratio Banks Types Obs Mean Std Dev Min Max
Profitability Convectional 18 0.4646 0.0900 0.459000 3.7800
Islamic 10 0.2560 0.0550 0.409000 1.2600
Returns on
Assets
Convectional 18 0.4780 0.0911 0.459000 3.7890
Islamic 10 0.3780 0.0922 0.467890 3.5600
Return on
Equity
Convectional 18 0.3580 0.0912 0.489000 3.6788
Islamic 10 0.4560 0.0946 0.459000 3.8900
Dividend
Payout
Convectional 18 0.5670 0.0922 0.459000 3.8900
Islamic 10 0.4674 0.0923 0.469000 3.8900
Returns on Convectional 18 0.5670 0.0923 0.459000 3.8999
Islamic
Convectional
Assets Islamic 10 0.4678 0.0933 0.459900 3.9000
Liquidity Ratios Convectional 18 0.2345 0.0456 0.409000 1.1222
Islamic 10 0.2346 0.0345 0.409990 1.2345
Cash to Assets Convectional 18 0.2135 0.0345 0.349000 1.2354
Islamic 10 0.2345 0.0345 0.468000 1.2346
Cash to Deposits Convectional 18 0.1233 0.0233 0.349000 1.2490
Islamic 10 0.3456 0.0390 0.409000 1.3590
Structural Ratio Convectional 18 0.3456 0.0234 0.459000 1.2391
Islamic 10 0.3456 0.0345 0.439000 1.2233
Deposits to
Equity
Convectional 18 0.2335 0.0233 0.459000 1.1222
Islamic 10 0.2335 0.0244 0.459000 1.2333
Convectional 18 0.4646 0.0900 0.459000 3.7800
Islamic 10 0.2560 0.0550 0.409000 1.2600
Deposits to
Assets
Convectional 18 0.4780 0.0911 0.459000 3.7890
Islamic 10 0.3780 0.0922 0.467890 3.5600
Loan to Assets Convectional 18 0.3580 0.0912 0.489000 3.6788
Islamic 10 0.4560 0.0946 0.459000 3.8900
Loan to to
Deposits
Convectional 18 0.5670 0.0922 0.459000 3.8900
Islamic 10 0.4674 0.0923 0.469000 3.8900
Loan to Equity Convectional 18 0.5670 0.0923 0.459000 3.8999
Islamic 10 0.4678 0.0933 0.459900 3.9000
Invest & Deposits
to Assets
Convectional 18 0.2345 0.0456 0.409000 1.1222
Islamic 10 0.2346 0.0345 0.409990 1.2345
Deposits to
Equity
Convectional 18 0.2135 0.0345 0.349000 1.2354
Islamic 10 0.2345 0.0345 0.468000 1.2346
Deposits to
Assets
Convectional 18 0.3580 0.0912 0.489000 3.6788
Islamic 10 0.4560 0.0946 0.459000 3.8900
Correlation Matrix between types of the banks and the independent variables
The Correlations coefficient shows a strong association between the independent variables
which consist of liquidity, efficiency, leverage and profitability ratios and the type of bank
whether Islamic or convectional .The Pearson correlation coefficient shows the linear association
between two of the scale variables. The correlation reported in the table is positive amongst all
the variables which indicate that there is a strong difference between the overall performance of
the Islamic and convectional banks in Britain.
Correlations
type of
bank
ROE ROA Structural
ratios
Liquidity Lending
Intensity
Capital
Adequacy
Leverage
type of bank Pearson
Correlation
1 -.850 ** -.970 ** -.589 ** -.998 ** -.725 ** -.912 ** -.999 **
Sig. (2-tailed) .000 .000 .006 .000 .000 .000 .000
ROE Pearson
Correlation
-.850 ** 1 .841 ** .610 ** .869 ** .588 ** .744 ** .840 **
Sig. (2-tailed) .000 .000 .004 .000 .006 .000 .000
ROA Pearson
Correlation
-.970 ** .841 ** 1 .532 * .970 ** .630 ** .934 ** .969 **
Sig. (2-tailed) .000 .000 .016 .000 .003 .000 .000
Personal
Interest
Pearson
Correlation
-.589 ** .610 ** .532 * 1 .576 ** .567 ** .514 * .567 **
Sig. (2-tailed) .006 .004 .016 .008 .009 .020 .009
Liquidity Pearson
Correlation
-.998 ** .869 ** .970 ** .576 ** 1 .730 ** .901 ** .996 **
Sig. (2-tailed) .000 .000 .000 .008 .000 .000 .000
Lending
Intensity
Pearson
Correlation
-.725 ** .588 ** .630 ** .567 ** .730 ** 1 .572 ** .722 **
Sig. (2-tailed) .000 .006 .003 .009 .000 .008 .000
Capital
Adequacy
Pearson
Correlation
-.912 ** .744 ** .934 ** .514 * .901 ** .572 ** 1 .914 **
Sig. (2-tailed) .000 .000 .000 .020 .000 .008 .000
Leverage Pearson
Correlation
-.999 ** .840 ** .969 ** .567 ** .996 ** .722 ** .914 ** 1
Sig. (2-tailed) .000 .000 .000 .009 .000 .000 .000
4.2.4 Using the Logit Model to analyze the Financial Ratios for the Convectional and Islamic
Banks in Britain
The model used is the logit model to analyze the financial ratios of the Islamic and convectional
banks in Britain, the dependent variable which is the type of bank has been coded as a binary
variable where it take two values 1 or 0.
If the bank type equals 1, that means the bank is conventional bank. On the other hand, if the value of
bank type is zero that means the bank type is Islamic bank. Each model contains an array of financial
ratios as independent variables that helps in predicting the kind of bank on the left side of the equation.
Summary of the model Number of obs = 8
LR chi2(7) = 27.53
Prob > chi2 = 0.0003
Log likelihood = -5.884e-15 Pseudo R2 = 1.0000
Coef. Std. Err. z P>z [95% Conf. Interval]
Islamic Bank
78.01738 7.40e+08 0.00 1.000 -1.45e+09 1.45e+09
ROE -6.587879 3.00e+08 -0.00 1.000 -5.88e+08 5.88e+08
ROA -45.23721 . . . . .
PERSONAL .8909975 5.70e+08 0.00 1.000 -1.12e+09 1.12e+09
LIQUIDITY 9.095113 2.69e+08 0.00 1.000 -5.27e+08 5.27e+08
CAPITALADE~Y 9.560226 3.10e+08 0.00 1.000 -6.08e+08 6.08e+08
Leverage -1.551246 4.00e+07 -0.00 1.000 -7.83e+07 7.83e+07
_cons -41.89813 4.63e+08 -0.00 1.000 -9.07e+08 9.07e+08
(Type==Convectional is the base outcome)
The likelihood that the ratio is a chi-square of all the six models that have a p-value of 0.003 which
means that each of the six models as a whole that fits significantly better than an empty model (a
model with no predictors). The results show that all parameters in all the Eight variables are
statistically significant at 5% significance level which is also consist through the model. This shows
that the results are very robust indicating that all the significant parameters are employed models that
can explain the type of bank’s behavior.
5.0 Conclusion
Based on the above information that shows similarities and differences that were found while
compiling and comparing the information on conventional and Islamic banks in UK, profitability
of the conventional banks has definitely increased at a higher rate in than the growth of the
Islamic banking system. Though there are several differences in the movement of the operating
profit, the trend that has been followed is significantly correlated. The NPR ratio, on the contrary
shows a very different trend. The conventional banks have a higher growth rate in profitability.
NPR doesn’t follow the same pattern or trend of movement between the conventional banks and
also the Islamic banks. The analysis indicates that the ROA is one of the critical indicators of a
bank’s profitability. Islamic banks reported a higher ROA compared to conventional banks. ROA
doesn’t follow the same pattern or movement as the Islamic banks or the conventional banks.
ROE also follows the same trend. The total profit as a percentage of the total customer deposits
is relatively higher in most Islamic banks. It may be noted from the analysis that the total profit
as a percentage of all the customers’ deposits differ greatly between the Islamic banks and the
conventional banks. The study or research supports the view that Islamic banks are financed
mostly by equity funds while the conventional banks are financed through debt capital.
The total equity in Islamic banks registered a higher proportion in the value of total assets than
the conventional banks. There is a significant relationship between the movement of the Total
Equity among Islamic banks as a percentage on the Total Assets and also the conventional banks.
The total assets grew by 21.53% during 2005-10, while the growth rate is 18.42% for the Islamic
and conventional banks respectively. The performance indicators included the total operating
profit, the operating expenses, the operating income, the net profit, the total assets, total equity
capital and the customer deposits The study concluded that Islamic banks occupy a more
favorable position where the operating income increased at a higher rate than the operating
expenses.
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