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Increasing Demand For Shariah Products In Islamic Countries

Introduction

Islamic banking is a mechanism that is suppose to work within the principals of Shariah considering the ethical and moral values while conducting the financial dealings.

Islamic banking is the new emerging banking system but its origin goes back to the times of Prophet Muhammad (P.B.U.H) who acted as an agent for Hazrat Khatja (Prophet’s Wife) and looked after the business operations.

Islamic banking is growly vastly in the global financial market. The reasons that are enhancing its growth are that:

There is an increasing demand for Shariah products in the Islamic countries.

Investors due to the crisis like the financial crisis 2008-09 want to reduce their risk therefore need for diversification is inevitably rising.

(Hassan et al. 2010)

The first Islamic bank was established in Egypt more than 30 years ago. Today, the Shariah compliance asset have reached market share of $4 trillion according to Standards and Poor’s. The largest Islamic banks are situated in Malaysia, Saudi Arabia and Iran.

Islamic banks design and development into new islamically products are attracting new customers along with they are progressing continuously into innovation in order to be compatible in the financial markets. This is because these newly emerging banking system needs to generate a feasible and satisfactory rate of return to its investors. (Bashir et al. 2003).

In 2004, the market share of Islamic banks in countries of GULF COOPERATIVE COUNCIL (GCC) was reported to be between 5%-24%.In 2008, it was surprised to notice that it increased to 35% in GCC. (Hassan et al. 2010).

Islamic banks are not just operating in the Muslim countries but also emerging in the Non-Muslim countries. For example in America “Lariba-American Finance House? is providing services in areas of leasing to purchase, construction finance, small businesses and trading finance.

In the U.K, Islamic bank of Britain was established in 2004 with the permission from Financial Services Authority (FSA).

Due to such an impact of Islamic banks in the world, many countries like Pakistan and Iran have attempted to introduce Islamic banking System. Therefore there has been no previous attempt to evaluate the progress of Islamic banks in Pakistan. Islamic research also lacks empirical studies in this regard which is one of the motives of this study to be able to evaluate and assess the performance of First Islamic bank (Meezan Bank) in Pakistan and arrive at the truth whether this new system of banking has a bright future or is just a phenomenon in journals!!!

Literature Review

Definition of Islamic Banking

Islamic banks are managed according to the Shariah which prohibit the transactions based on interest as directed by Holy Quran. The distinctive feature of Islamic banking is the existence of the Shariah board that is comprised of Islamic scholars who are charged with the responsibility that the operations of the bank are in the light of the Holy Quran. (Christofi 2007).

The term Islamic finance is applied to the provision of goods and services on deferred payments. Therefore we can say that Islamic banking provides services, machinery, and equipment to consumers at convenience of payment. It allows both parties to share profit and keep risk at one side. (Kahf et al. 1998).

Islamic banking basic purpose is to promote the practise of the Islamic law, tradition in order that the financial dealings in the business environment are practised accordingly. (Association of Islamic banking institute Malaysia 2011).From this implementation of behaviour, it will help to protect the Muslim communities in the world from the forbidden tasks in Islam.

Islamic banks are financial institutions that operate the activities of the bank in the guidance of Shariah and the basic model followed in Islamic banks is the profit and loss sharing. According to Al Isma’il (2010) these banks do not get engaged in the dealings of usury. According to author in the article “Concept of Islamic Banking “concludes:

Islamic banks collect and invest money in accordance to the Shariah principals.

The amount invested can either generate a profit or a loss.

These transactions are free from the element of riba (interest).

Similarly, some researchers believe that Islamic banks are financial institutions that collect money (deposit) and utilize it in a way that serves both the society and individual needs according to the shariah principals.

Evolution of Islamic Banking

Islamic banking is not a new concept; it was present at times of the Holy Prophet (P.B.U.H) via the system of Bait al-Mal, which basic motive at that time was to distribute booty of war, zakat and jazyah.The revenues gathered from this mal were distributed among the needy of the society and the mahajirs.Hazarat Umer the second caliph of Islam, established system of pension. A dewan was appointed to register the individuals for the scheme of pension.Hazarat Umer is the first registered individual in the history of Islam for taking care and feeding of needy in Islamic region. (Imam-ud-din 2005).

Foundation of Islamic Banking

The Islamic banking institutions in the world follow the shariah ruling which is derived from the Holy Quran, the Sunnah (Hadis of Prophet), and Fiqah (the legal advice of Muslim scholars).According to the Shariah board, all the Islamic banks in the world have to abide by the consent that there should be:

Avoidance of riba (interest).

Goods and services that are haram in Islam cannot be produced and cannot be consumed.

Gharar which is the element of uncertainty cannot be undertaken.

Zakat must be paid.

According to Ahmad (1984) in order for the Islamic banks to exist there should be absence of interest.Riba is the Arabic name for interest and according to the Islamic definition it is the profit that comes from any effort made.

In Islam riba is strictly prohibited but trade is allowed due to this unclear concept has raised many conflicts between different schools of thoughts. Hazrat Shah Wali Ullah Dehlvia, a scholar highlighted? Riba? as loan that comes with a condition. The return on this loan needs to be more than the amount borrowed. In the pre historic days of Islam interest was an evil that surrounded the society. Due to existence of interest, individuals were able to create monopolies and this could be obvious from the notion that rich clever individuals who lend money to needy had a share in the property and if they were unable to pay back the loan, they could lose what they once possessed.(Uloom 2001).

Gharar is an Arabic word which is referred to as uncertainty. Thus gharar can be defined as the sale of goods or items whose time period or certainty is not known due to the risky nature just like gambling. (Academy for international modern studies).

According to the Hanafi school of thought in Islam, Gharar is referred to as the sale whose outcomes are hidden and not known. (Islamic Banker 2009).

Haram activities are not allowed in Islam especially in terms of investment. According to Samad et al (1998) Muslims are not allowed to invest in activities that are related to production or consumption of, pornography, pork, alcohol, tobacco, gambling and harmful drugs. Therefore it becomes very limited for the Islamic banks to invest according to the Quran guidance.

Zakat is an Arabic word that refers to “Growth? and “Purification.Zakat is the process of redistribution of wealth in islam.It is the Islamic tax (Zakat) that is an important tool in redistribution of wealth in the society. Therefore every Islamic bank is compiled to establish a zakat fund in order to help the poor of the society. (Suleiman 2009).

Previous Research:

Iqbal (2001) attempts to evaluate the performance of Islamic Banks and Conventional banks using Ratio analysis for the period covering 1990-98.For this study, the author evaluates 12 Islamic and Conventional banks from Saudi Arabia, Kuwait, Bahrain, Egypt, UAE, Jordan,Bangladesh,Malaysia and Turkey.

From the research, Iqbal concludes that in terms of profitability ratios, ROA and ROE for Islamic banks tend to be greater than Conventional banks. Islamic banks have 2.3% and 22.6% of ROA and ROE respectively while Conventional banks have 1.35% and 15% respectively.

In terms of Cost effectiveness, Islamic banks are identified with 52.4% of cost to income ratio while Conventional banks have 60.3%.

With Liquidity ratio, Iqbal makes an astonishing discovery. He identifies that Islamic banks suffer from liquidity problem. The liquidity ratio for Islamic banks compared to conventional banks 31.9% was found to be 18.5%.

The conclusion drawn from the study by Iqbal is that Islamic banks made a better use of resources and for the period of 1990-98, Islamic banks have higher growth rate compared to the traditional banks.

Abdel and Bashir (2003) undertake a comparative study to evaluate the financial conditions that affect the performance of Islamic banks. For this research, the author utilized the data from1993-98 from eight Middle East countries namely Bahrain, Egypt Jordan, Kuwait, Qatar, Sudan, Turkey and UAE.

In order to identify the characteristics that affect the banks performance, a model is established that uses internal and external indicators. The internal indicators are evaluated by looking at the banks financial ratios while the external are measured by considering banks market share, regulatory compliance and public confidence.

Regression is used as a method for the study, for which the author uses Capital ratio, leverage ratio, loan, liquidity and foreign ownership.

These are used as an alternative to the internal indicators conversely for the external indicators microeconomic, taxation and financial structuring of the country.

From the study, the conclusion drawn is that the ratio and loan portfolio play a significant role in analysing the performance of Islamic banks. The profitability of Islamic banks can be well explained by foreign capital and therefore Islamic banks established in low income countries are motivated by the foreign capital. Due to the reserve requirement for the banks, Islamic banks face a challenge as their investments gets limited. Factors such as GDP and increase inflation have a consequence on the performance of the banks.

Hassan and Dridi (2010) conduct a comparative study. They examine the performance of Islamic banks and Conventional banks during the financial crisis by analysing the effects on profitability, credit and asset growth. The authors selected banks from Saudi Arabia, Bahrain, Kuwait, UAE, Qatar, Jordan, Turkey and Malaysia.

Conclusion of Hassan and Dridi (2010) suggest that Islamic banks faced weaknesses in risk management that affected the profitability of the banks compared to the Conventional banks in 2009.Weaker performance of the Islamic banks in few countries could have been due to the insufficient regulatory framework of the countries.

During the crisis, the credit and asset growth of Islamic banks were better compared to Conventional banks.

Islamic banks profitability before the Global crisis broke was on average same as conventional banks. This paper suggests that better regulations and innovations in products are needed to encourage the growth of Islamic banks.

Research Objectives

To examine the features of Meezan bank in Pakistan.

To examine the Islamic banking model used by Meezan bank in terms of (Mudaraba/Musharika).

To evaluate the performance of Meezan bank with Conventional banks in terms of :

Profitability

Efficiency

Liquidity

To draw conclusions about the prospects of Meezan bank in Pakistan.

Data and Methodology

Islamic banking is a new growing financial institution across the globe but unfortunately it lacks empirical studies. Therefore the aim of this research is to fill the gap by evaluating the prospect of Meezan bank in Pakistan.

Theoretical studies on Islamic banking has been undertaken by many researchers not just in Muslim countries but also in non-Muslim regions but due to the reason that Islamic banking is not as old as Traditional banking system, its lacks availability of data. Therefore establishing empirical research in this area has become a major challenge to the new researchers.

For this research, a case study is selected. There are ten Islamic banks operating in Pakistan which include a full fledge Islamic banks and Islamic windows opened by Conventional banks. The reason to select Meezan bank for the case study is that the data covering 2005-09 was available. Secondly, it holds the prestigious honour to be the first Islamic bank in Pakistan which quickly established braches all over the country since its existence in 2003.In 2007, Meezan bank opened its 100th branch and in 2009 the bank was reported to have 42% share of Islamic banking branch network.Currently, Meezan bank is having 40% of market share in Islamic banking in Pakistan. This pioneer Islamic bank is awarded as the “Best Islamic Bank in Pakistan? by Red money Group, Malaysia in 2010.

For the data on the Conventional Banks in Pakistan five banks are selected for the study which includes Alfalah bank limited, Faisal bank limited, Habib bank limited , United bank limited and Askari Bank Limited. The research covers the period of 2005-09.Data for Islamic banks and Conventional banks will be taken from the financial statements of the banks and from Bank scope database.

Ratio analysis is one of the profound techniques that aid to assess the performance of banks. Therefore the method to compare the two different banking systems will depend on:

Profitability Measures: the main objective of any firm is to maximize share holders wealth by utilizing the resources efficiently and effectively. Therefore for this research banks profitability will be evaluated by :

Return on asset: It refers to the way in which the management of the bank utilizes the resources and assets in order to generate profits. (Alexandru et al. 2006).

Return on equity: It measures what actually the shareholders get out of the investment they make. It is therefore regarded as the true measure of return for investment. (Ross et al. 2010).

Profit margin: It tells that for every pound invested by the bank, how much they are getting in return. (Ross et al. 2010). Example if bank X has invested £ 1 and it has a profit margin of 15.5% it indicates that for every £, its generating more than 15.5cents.The aim of every bank is to have a higher profit margin.

Liquidity Measures: It is the ability with which the bank is able to pay off its short term debt obligations. (Investopedia 2010).

Current ratio: It measures the short-term liabilities of the bank (Ross et al. 2010).

Loan to asset ratio: It measures the total percentage of asset invested in loans of a bank.

Efficiency: Banks prefer to have a lower efficiency ratio as it is the percentage of expense to the revenue. (Wikipedia 2010).

Asset utilization: It serves as a bench mark for the bank as it guides how effective is the management of the bank utilizing the bank’s assets ,inventory and account receivable on day to day basis.( Reference for business 2007).

Cost to income ratio: This efficiency ratio tells us how costs are changing with changing income and banks prefer to have this ratio to be lower in percentage. (Money terms 2011).

Table 1: Return on Asset for conventional banks of Pakistan

(In percentage for 2005-09)

Years

Habib bank

Alfalah Bank

Unite Bank

Faysal

Bank

Askari Bank

Average

ROA

ROA

ROA

ROA

ROA

ROA

2005

1.82

0.51

1.72

2.87

1.38

1.66

2006

2.1

0.48

2.21

2.48

1.34

1.72

2007

1.45

1.06

1.68

1.57

1.49

1.45

2008

1.44

0.79

1.36

0.81

0.20

0.92

2009

1.55

-0.68

1.48

0.67

0.42

0.68

(Source: Derived)

Table 2: Return on Asset for Meezan bank in Pakistan

(In percentage for 2005-09)

Year

ROA

2005

1.36

2006

1.30

2007

1.43

2008

0.72

2009

0.82

(Source: Derived)

FIGURE 3

Figure 3 depicts the position of both the banks during 2005-09.What we actually observe is that Meezan bank have witnessed a growth from 1.36% in 2005 to1.43% in 2007 which is similar to the traditional banks ROA.Similarly, Conventional banks from 2006 to 2007 show a decline in ROA from 1.72% to 1.45% but it is that fact that ROA on conventional banks is greater than Islamic banks. During 2007-08 Meezan face a drop in their ROA, which means there can be impact of the financial crisis while Conventional bank ROA does not show any progress during 2008-09 and declines further. But from the graph it is obvious that despite Conventional bank operating in the country for many decades, Meezan bank after crisis increased ROA from 0.72% in 2008 to 0.82% in 2009.

Descriptive statistic for Conventional and Meezan Bank.

Type of Banks

Mean

Standard deviation

Conventional

1.28

0.46

Meezan

1.12

0.33

From the descriptive statistic we can say that the average mean of conventional banks tend to be greater than Islamic that is 1.28 and 1.12 respectively while the standard deviation tends to be more in conventional that is 0.46 compared to Meezan bank.

To test the significance of mean at 95% level of significance

H0: No difference between the mean of both banks.

H1: There is difference between both the banks mean.

T-statistic 0.62945312

T-critical 1.894578604

At 95% level of significance we find that there is no difference between the mean of both the banks as t -statistic is less then t- critical therefore we accept ho.

Time Scale

The time scale for this comparative study is three months starting from 1 June 2011 to 30 August 2011.Key Dates for this study is divided into:

March – May 2011 - Review of Literature.

1st June to 10th June - Literature Review will be drafted.

11th June to 15th June –Finalizing the Literature with Supervisor.

16th June to 26th June- Research strategy is developed in consultation.

27th June to 30th June – Finalizing of the research strategy with Supervisor.

1st July to 10th July- Compiling data for the case study.

11th July to 21st July- Data analysis will take place.

22nd July to 30th July- Changes to data analysis if needed.

1st August-10th August-Conclusion drawn with the supervisor.

11th August to 15th August –Reviewing the research done so far.

16th August-30th August –Writing and compiling the research.

1st September- Final submission.

Resources

In order for this study to take place, the following resources have been used to the best effort.

Financial statesman of Conventional Banks of Pakistan and for Meezan bank annual reports are referred from 2005-09.

For additional information regarding the Islamic banks and Islamic financial institutions, IBIS portal is used.

Bank scope database

Internet especially for accessing to the websites of banks used in this research.

Journals

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