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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

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.

The regression analysis was run on the comparisons between the Return on all total assets
between the conventional banks and the Islamic banks. The total number of observations or the
sample size was 11. The average net income of the banks is b= 0.0000104 and it’s not
statistically significant at 0.05 level (p = 0.072) The coefficient is positive and it indicates that
that the net income is affects the total assets. The next is the effect of the net loans b= 0.0054988,
p = 0.945 which is insignificant and the coefficient is positive and it’s not related to the net
Total assets b= 6.5, p = 0.906 which is insignificant and the coefficient is positive and it’s not
related to the net income.

The predicted Return on Average Assets is 0.0000104+0.0054988+6.5+109.1818 and it’s
expected to increase to 0.0054988 if the ratio of Net loans to total assets increases by one or
decrease by to 0.0000104 if the net income increases by one or its predicted to be 6.5 if both the
ROAA and the total assets are zero.
P, t and the standard error
The t- statistics usually arrived at by dividing the coefficient by the standard error as the standard
error is the estimate of the coefficient of the standard deviation. A large coefficient compared to
its standard deviation will probably be different from zero.
The t value is equal to 2.12+0.70+0.12+0.35 = 3.29 while the total p value is equal to
0.072+0.945+0.906+0.735= 2.658. The p value for the regression is 0.0472 as a whole and as
shown in the analysis. To t values determines the expected behavior of the 11 observations
regarding their return on average assets. 95% of the t distribution is actually closer to the mean
than the t value hence the p value is 5% which refers to a significance level of 5%. The p value is
less than 5% or 0.05.
The effect of the dependent variable is given by the size of each independent variable while the
sign shows the direction of the effect. The positive nature of the coefficient indicates that the net
income may increase by 0.0000104 million dollars if the net loans to the total assets increase by
1 million dollars.

R-Squared and the regression significance

The F test is statistically significant. The R-Squared of the regression is 0.6566 and it accounts
the fraction of the independent variable that affects the dependent variable. Approximately
65.7% of the variance has been accounted for the ROAA. Its test is 2.12 i.e. 2.12^2 = 4.46. The
p value indicates that the individual variables have some correlation together with the dependent
variable. The coefficient for net income is 0.0000104.
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. There is however no correlation between the Islamic banks and the
conventional banks.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 on average.
ROA doesn’t follow the same pattern or movement as the Islamic banks or the conventional
banks. ROE also follows the same trend. The average 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 average 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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