Efficiency in Islamic Banking During a Financial

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ISLAMIC BANKING

Efficiency in Islamic Banking during a Financial

Crisis-an Empirical Analysis of Forty-Seven Banks

Abstract

This writing will present an analysis of Islamic banking during the financial crisis of the late 2000’s. It will be an in depth look at this question by measuring efficiency by way of the on-parametric technique of DEA, Data Envelopment Analysis . The present paper explores this question further, suggesting that the Islamic banks displayed an efficiency increase during 2006 through 2009, especially the larger banks. Small and medium size banks, however, came from a beginning of a much less efficiency. The results of this study also demonstrate that the Islamic banks’ efficiency seems to increase during an economic crisis, whether operating in Middle Eastern or non-Middle Eastern Countries.

1 Introduction

In the 1970’s the first Islamic banking appeared—the Dubai Islamic Bank (DIB). Following that, the International Islamic Development Bank (IDB) was established in Jeddah, Saudi Arabia. After that both private and semi-private Islamic banks were established in various countries such as Bahrain, Kuwait and Egypt. Coinciding with that in the early 2000’s, Islamic banking was spreading in other Islamic countries. Iran, Bangladesh and Pakistan gained Islamic banks in 2005. During that time, the bank in Iran was forced to establish minimum and maximum rates of returns for various industries. The reason for this was that Islamic banks could then have the money for their own operations and also make a profit. This was possible even while observing the Shariah rule of charging no interest.

Profit and loss in Islamic banking can be shared by several different methods. One is to establish a partnership, called Musharaka. This is the sharing of investments while still not being involved in the management of a company. Another method is Mudrabah, which is making a provit by re-selling or leasing a contract with a profit (jiara). In Western banks this is done by a profit but in Islamic banking would be done by reselling at a higher price.

This type of banking is in reality a more stable system because banks tend to diversify the investments, which in turn, makes the risks much less, and the profits more. In turn, this tends to bring in more investors and again, increases the bank’s efficiency. The Shariah practice in banking involves four distinct laws of business.

First of all is the rule of the lender and the borrower shares in the profit or loss. Second is fixed charges established ahead of time. Third is charging no interest. And the Fourth rule is the lender and borrower collaborating in the transaction. Concerning profit and loss sharing, it involves two basic principles. Mudrabah, one of the principles, is the agreement between two groups. In banking, the two groups would be the group that provides the funds and the other would be the companies obtaining the funds. If a profit is made by the company, the two groups would share the profit, which would be agreed upon beforehand. If the business operated at a loss, the bank would have to “eat” the entire loss. While this does not seem fair, the business would have exerted time and effort and resources to try to make the business work successfully. In Western banks, this business arrangement would be similar to a venture where one group (bank) would provide funds and the other group (business) would provide the operation and business knowledge.

As was discussed previously, Musharaka is the second rule, which is a type of partnership between two groups or two parties. When applied to Islanic banking, the bank provides the money and the business uses the money to operate the business of course. But, if there is a profit, they both split the profit, and also split the loss if there is one. In Western banking, this would be considered a “joint venture” where profit or loss would also be borne by both parties to the agreement, which was decided upon prior to the venture.

Another principle of Islamic banking is “set” bank fees as opposed to charging interest. It is called Murabaha in Arabic, and is self explanatory. It is the adding of charges on to the cost of the goods or services in the transaction or business. It is a contract in which the cost of the desired products are discussed and set charges assessed by the provider of the financing, which in this discussion, is the bank. Murabaha is a type of transaction that could be compared to a “rent to own” type contract arrangement in Western banks. A deferred payment sale without extra fees or charges is called Bai-Mua’ jjal. In the “Western” banking this would be similar to a “90 days same as cash” or any other type of deferred payment sale with no money down. Leasing is the contract called Ijara, which is when the owner of the products allows their use by other parties. The Western “lease with option to buy” is a similar concept.

The same concept of no charges is the Qurad. This is when the borrower gives the financier the principle without any other charges. There are other categories as well, all of them having similar principles in Western banking. There are trusteeships (Wadiah) and pledges (Rhan) both of which are like types of savings accounts. Islamic banks follow the principle of Mudaraba when it comes to savings and investment products. The person or company that makes the money deposit does not know how much the money will make except the ratio of profit sharing upon which has been agreed to previously. Of course, repayment is only made to the Islamic bank when there is a profit.

The bank uses two things in order to apply the profit/loss rule. The first would be the Musharaka, where both the bank and business agree on a specific division of profit. Some of the banks investments are high risk matters so being careful about such ventures is very important. Islamic banks must find business schemes that are much less risky. They are constantly in competition with the Western style banks.

Islamic law forbids interest because it would be bringing in money without any actual effort on the part of the bank. According to that law, income must be from an investment, physical labor, or such related activities but not just someone else using the money from a lender. In the Islamic banking industry then, both the bank and the investor or business owner share in the profit and loss, instead of the bank collecting interest whether or not the business is successful.

In the manner of the Islamic banks, they assess a set charge for the service they provide, which is the money of course and the processing of the loan itself. By charging this set price, they can recoup the cost of “doing business” from the charges, without charging interest. For the most part, Islamic banks get a higher percentage of profit that those that borrow from the bank since the banks are furnishing the money and therefore, more of the risk. In the long term loans, the funds must be kept ready to lend out until the end of the period of the contract. In Islamic bank, this makes a great exposure to high risk should this investment fall through.

More recently, Islamic banks were growing consistently. The International Monetary Fund (IMF) reported in 2005 that the number of Islamic banks had grown from a previous 75 to approximately 300 in total. By 2007 the assets of the entire industry were about $250 billion and the rate of growth was reportedly a yearly 15%. That is triple what the growth rate was in the Western banking industry.

Parker & Arnold reported that the asset increase in Islamic banking was up to 40%. There were approximately 300 Islamic banks with a minimum of $500 billion in assets in the year 2007. Sharia Calling reported that Islamic Bank institutions have grown 29% during the year 2009. Also in 2009 the assets of those banks were said to be $882 billion. Little wrote that by the year 2015 the Islamic banks will have assets of close to $4 trillion US dollars.

2 Research Question and Hypotheses

During an economic crisis, are Islamic banks efficient and stable?

H1: No differences in the efficiency of Islamic banks operation in Middle Eastern and non-Middle Eastern countries during an economic crisis.

H1a: There are differences in the efficiency of Islamic banks operation in Middle Eastern and non-Middle Eastern countries during an economic crisis.

H2: There are no differences in the efficiency of Islamic banks operation between small and large Islamic banks during an economic crisis.

H2a: There are differences in the efficiency of small and large Islamic banks

Are Islamic banks stable and efficient during a financial crisis?

3 Literature Review

Few actual studies have been done concerning the efficiency of the Islamic banking system. Of course many studies have been done about the same thing in Western style banks. A profitability study was done by Samad and Hassan, who also studied liquidity, risk, and solvency. Their hypotheses were (1) that the liquidity ratio in Islamic banks would be increased during the opening stages of the banks’ operations and (2) the increase in assets of Islamic banks would depend on the general public’s knowledge about these banks and how they use tools to operate.

Two different time periods were studied—1984 to 1989 and 1990 to 1997—in order to compare the financial information. Accounting rations compared profits, liquidity, risk and solvency. Also measured was
the banking institutions’ loyalty to the Islamic community. It showed that the studied institutions were more liquid than Western banks when it came to cash deposits. Islamic banks reported a cash deposit ratio of .02 compared to .01 for the Western style banks. Hassan pointed out that later in the development of the banks, there was a slightly greater risk, yet still was at less of a financial risk than Western style banks.

A study by Yudistira looked at the efficiency of 18 Islamic banking institutions over the course of 3 years, from 1997 to 2000, and used the DEA to measure and compare the efficiency of the banks. He scored the banks between one and zero, using one as a completely efficient bank. That does not, however mean that a bank with a score of one has the most profits from a given input, but rather used as a mere scoring system. This particular study collected information from nonconsolidated income and financial statements obtained from the International Bank Credit Analysis, Ltd in London, England. The time studied was 1998 and 1999, a period of financial crisis globally. This information was all exhibited in U.S. dollars and in conjunction with the consumer price index (CPI) of each particular country to take into account economic changes. Three different inputs and outputs were studied. The inputs used for this study were the cost of staff, fixed assets, and the total deposits. The outputs were loans in total, miscellaneous income and the amount of liquid assets. Those banks analyzed were determined to be less efficient in the years of 1998 and 1999 than they were from 1997 to 2000. Yudistira also found that those banking institutions in the Middle East were much less efficient than those in the rest of the world. One important finding from Yudistira was that the Islamic banks were much more efficient than Western style banks, sometimes as much as 10% more efficient. In addition, the reason for the study conclusions was to show that the Islamic banks did very well during all periods of time, not just during a financial crisis. The data showed the importance, for the small and medium Islamic banks, of mergers and acquisitions. Finally, the Middle Eastern market was not determined to be significantly important in the study.

In the study by Samad, the performance of the Islamic banking system as compared to the Western system was compared in the country of Bahrain. Samad studied the information from six Islamic banks and 15 Western style banks from 1991 to 2001, a ten year study. Samad looked at bank statements and balance sheets using a set of ratios to determine each bank’s specific profitability, liquidity and credit-risk performance.

In Samad’s research, it showed that no significant difference exist between the Western banking systems and the Islamic banking systems in the country of Bahrain in reference to profitability and deposit risk. The Islamic banks showed higher equity ratios than the conventional bans. It also showed that the Western style banks used less discretion in the loan decisions than did the Islamic banks. In addition the reason for the ratios was to show that Islamic banks usually have more liquidity than Western style banks, which would suggest that the Islamic banks had lower liquidity risk that the comparable banks.

Ariff et.al researched 80 banks. Of those, 43 were Islamic and the rest were Western style banks. The information in this study was gathered between the years 1990 and 2005, which was long enough to make a valid comparison. This showed the Islamic banking institutions fared during the 1990 financial crisis. The results also showed past indicators that could be utilized to predict future trends for both banking systems. The information was changed to U.S. dollars and also adjusted for inflation.

Arrif et al. made use of the DEA since there were no forms such as functional or distributional that were necessary. Efficiency equals the weighted total of the inputs was the was efficiency was measured in this study. It showed that Islamic banks and Western style banks were the same re efficiency in the use of resources proportional to their capacity to create profit. Management had control of their internal resources, but less influence re the external factors such as governmental rules and regulations.

That same study suggested the conventional banks were less efficient that the small Islamic banks due to the capital structure of each. The other reason was that small Western style or conventional banks were up against more competition, which resulted in negative to their income. Moreover, this study pointed out the need for Islamic banks to be more attentive to how they use their resources to match the efficiency of the Western banks. The cost and profit efficiency of older Islamic banks was not as good as the older Western banks. The reason was determined to be that the Western style banks had more business experience and obtained it over a longer period of time.

Ariff also wrote that the Islamic banks that were considered “newer” were much less efficient than the “older” banks. Older Western banks fared better with cost and revenue efficiency than the new Western banks. Ariff surmised that the relative size of the assets of the banks, plus the experience advantage, were the reasons behind the findings. Smaller sized Western style banks had a higher profit and cost efficiency than the large Western banks.. The researchers further found that both smaller and larger Islamic banks should watch their cost and profit efficiency in order to remain competitive.

Ariff et al. also looked at geography as a factor in banking efficiency. The report showed that Western banks had better performance in Africa. But, in Asia, Western style banks fell down in the area of profits compared to Islamic banks. Not surprisingly, Islamic banks did better with cost, revenue, and profits in the Middle Eastern countries.

Al-Tamimi researched into what might have had an effect on Islamic banking and Western style baking in the United Arab Emirates from 1996 through 2008. The study used the regression, ROE and ROA as variables, and the independent were Gross Domestic Product per capita, financial development indicators, concentration, cost, and the branches per bank. The reason for the results were to demonstrate that liquidity and concentration actually were the most important factors for the Western banks’ performance, while the cost and branches were the most important determinants for the Islamic banks’ performance.

A number of other researchers noted that those Islamic banks had the same risks as the non-Islamic banks. Ariffin, Archer, and Karim studied 28 Islamic banks in a number of different countries by questioning the risk management teams about the risks faced by those banks. This was compared to banks in the Western system. They used less technical risk measurement tolls than the Western banks.

According to Srairi due to a lack of experience and being less familiar with the financial tools available, Islamic banks assumed more risk than their Western counterparts. This resulted in Islamic banks needing more capital to take care of the risk.

A study done by Johnes, Izzeldin, and Pappas was for the purpose of measuring the efficiency of Islamic banks in comparison to Western banks through the Cooperation Council of the Arab States. They used two tools to determine their results—the DEA, and the financial ratios analysis. Six banks in the GCC area provided information on their financials from 2004 to 2007. Western banks were more cost efficient, but less revenue and profit efficient than Islamic banks.