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Effect of the Financial Crash on Islamic Banks in the UK

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Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Published: Thu, 01 Mar 2018

Chapter 1: Introduction

Introduction to the Subject

Background of the Subject

General Objective

The purpose of this study is to examine how the internal factors of the Islamic Banking affected their performance before, during and after the financial crisis in the GCC in comparison to the conventional banking in the same area.

Research Questions

This study aims to answer the following questions:

– How did the financial crisis affect the profitability of Islamic Banks in comparison to Conventional Banks?

– What are the internal factors (bank specific characteristics) that influence the profitability of Islamic banking for every year from 2006 – 2009?

– Did these factors have the same impact on the profitability of Islamic Banking before, during and after the financial crisis?

– Did these internal factors influence the profitability of Islamic Banking in the same manner as of the Conventional Banking?

Need for the Study

Significance of the Study

Assumptions of the Study

Limitations of the Study

Although we cannot neglect the importance of the external factors on the profitability of Islamic Banking, they were not included in this study. To understand the reason behind this decision, we need to go through the different types of external factors and how they are classified:

– Macroeconomic Factors

– Country Regulation Rules

– Bank Regulation Rules

These factors were not included for the following reasons:

– Since we are examining the performance of 92 banks (27 Islamic Banks and 65 Conventional Banks) in 6 countries, the number of countries used in the study is not significant enough to study the impact of GDP and inflation accurately on Bank profitability especially when examining each year separately

– Country Regulation Rules as per the IMF Database, although it differs slightly for the selected countries, did not change over the period from 2006 to 2009. This means that for each bank, these factors remained constant.

– Data about Bank Regulation Rules could not be obtained for GCC banks

Delimitation of the Study

This study was delaminated to the Islamic and Conventional Banks in the GCC whose data could be obtained in the Bankscope database.

Chapter 2: Literature Review

Overview of Islamic Banking

Islamic Baking has established as an alternative to conventional interest-based banking. The first stirring of the Islamic Banking movement began in 1963 by Dr. Ahmed Alnajar in a small town in Egypt, called Mit Ghamar. Dr. Alnajar completed his education in Germany and found that it had many saving banks operating on interest. He took the idea from a savings bank in Germany and created his own small Islamic bank that was interest free.

After Dr. Alnajar’s small bank proved successful, the establishment of other Islamic banks followed. In 1971, the Nasser Social Bank was founded in Egypt with the objective of lending out money as a charity on the basis of a profit and loss sharing system and helping people in need. And in 1975, the idea of Islamic banking spread to other Islamic regions such Dubai Islamic bank in United Arab Emirates and The Islamic Development (IDB) Bank in Jeddah, Saudi Arabia (Wilson, 1990).

Even though Islamic Banking has only been around for thirty years and is still in an evolving stage, Islamic Banking is the fastest growing segment of the credit markets in the Muslim countries. In 2009, Assets held by Islamic Banking banks rose by 28.6 percent to $822bn from $639bn in 2008, according to The Banker’s “Top 500 Islamic Financial Institutions” survey while conventional banks posted annual asset growth of just 6.8 percent.

Furthermore, GCC states accounted for $353.2bn or 42.9 percent of the global aggregate, while Iran remained the largest single market for Shariah-compliant assets, accounting for 35.6 percent of the total.

Finally, Islamic banking operations are not limited to Islamic countries but are spreading throughout the world. One reason is the “growing trend toward transcending national boundaries, and unifying Muslims into a political and economic entity that could have a significant impact on the pattern of world trade” (Abdel-Magid, 1981).

Islamic Banking Rules and Principles

Islamic banking rules are according to the Islamic Shariah derived from the Quran and prophet Mohamed’s sayings. The three main practices that are clearly prohibited in the Quran and the prophet’s sayings are, Riba (Interest), Gharar (Uncertainty), and Maysir (Betting).

Prohibition of Riba or any predetermined or fixed rate in financial institutions is the most important factor in the Islamic principles pertaining to banking. As stated in the Quran “Allah forbids riba”. Riba means an increase and under Shariah the term refers to the premium that must be paid by the borrower to the lender along with the principle amount as a condition for the loan (Omar and Abdel, 1996).

Gharar occurs when the purchaser does not know what has been bought and the seller does not know what has been sold. In other words, trading should be clear by stating in a contract the existing actual object(s) to be sold, with a price and time to eliminate confusion and uncertainty between the buyers and the sellers.

Maisir is considered in Islam as one form of injustice in the appropriation of others’ wealth. The act of gambling, sometimes referred to betting on the occurrence of a future event, is prohibited and no reward accrues for the employment of spending of wealth that an individual may gain through means of gambling. Under this prohibition, any contract entered into, should be free from uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions.

Therefore, and according to Ahmed and Hassan (2007), the principles of Islamic banking and finance enshrined from al-Qur’an and Prophet Mohamed‘s Sayings can be summed up as follows:

– Any predetermined payment over and above the actual amount of principal is prohibited.

– The lender must share in the profits or losses arising out of the enterprise for which the money was lent.

– Making money from money is not acceptable in Islam.

– Gharar (deception) and Maisir (gambling) are also prohibited.

– Investments should only support practices or products that are not forbidden or even discouraged by Islam.

Islamic Banking Products

Islamic Banking products have to be done according to Islamic rules and principles, based on profit and loss sharing as well as avoiding interest. According to BNM statistics 2007, Al Bai Bithaman Ajil financing is the most common in Islamic Banking. There are a lot of Islamic Banking products; however there are some famous Islamic products that will be discussed in this section.

1. Al Bai Bithaman Ajil /BBA

This involves the credit sale of goods on a deferred payment basis. In BAA, the Islamic bank will purchase certain assets on a deferred payment basis and then sell the goods back to the customer at an agreed price including some margin or profit. The customer will make payment by installments over an agreed period. A fixed rate BBA is a powerful hedging tool against interest rates (Rosly, 1999).

2. Murabahah

Murabahah is a contract of sale. The Islamic Bank acts as a middle man and purchases the goods requested by the customer. The bank will later sell the goods to the customer in a sale and purchase agreement, whereby the lender re-sales to the borrower at a higher price agreed on by both parties. These are more for short term financing

3. Mudharabah

According to Kettel (2006), Mudharabah is a basic principle of profit and loss, where instead of lending money at a fixed rate return, the banker forms a partnership with the borrower, thereby sharing in a venture’s profit and loss. Mudharabah is an agreement between the lender and entrepreneur, whereby the lender agrees to finance the project on a profit sharing basis according to a predetermined ratio agreed by both parties concerned. If there are any losses the lender will bear all the losses.

4. Musharakah

Musharakah means partnership whereby the Islamic institution provides the capital needed by the customer with the understanding that they both share the profit and loss according to a formula agreed before the business transaction is transacted. In Musharakah all partners are entitled to participate in the management of the investment but it is not compulsory. Musharakah can help in providing financing for large investments in modern economic activities

5. Al Ijarah

Ijarah means meaning to give something on a rental basis. In Ijarah, the bank acquires ownership based on the promise and leases back to the client for a given period. The customer pays the rental but the ownership still remains with the bank or lender. As the ownership remains with the lessor (bank), it continues to give the service for which it was rented. Under this contract, the lessor has the right to re-negotiate the quantum of the lease payment at every agreed interval to ensure rental remains in line with the market rates (Hume, 2004).

6. Wadiah

Wadiah is a trust contract and the bank provides gift (hibah) and various types of benefits to the customer. This is exactly like a normal conventional savings account.

7. Istisna

Istisna allows one party buys the goods and the other party undertakes to manufacture them according to agreed specifications. Normally, Istisna is used to finance construction and manufacturing projects.

8. Salam

Salam is defined as the forward purchase of specified goods with full forward payment. This contract is normally used for financing agricultural production. According to Hassan (2004), Salam based future contracts for agricultural commodities, supported by Islamic Banks, can help to overcome the agricultural financial problems

Table 2.1 lists the products of conventional banking and their correspondent products in Islamic Banking.

Deposit Services

Current Deposit

Wadiah Wad Dhamana / Qard Hasan

Savings Deposit

Wadiah Wad Dhamana / Mudaraba

General Investment deposit

Mudaraba

Special Investment deposit

Mudaraba

Retail / Consumer Banking

Housing & Property Finance

BBA / Ijara wa Iktina /Diminishing Musharaka

Hire Purchase

Ijara Thumma Al-Bai

Share Financing

BBA / Mudaraba / Musharaka

Working Capital Financing

Murabahah/ Bai Al-Einah/ Tawarruq

Credit Card

Bai Al-Einah/ Tawarruq

Charge Card

Qard Hasan

Corporate Banking/ Trade Finance

Project Financing

Mudaraba / Musharaka / BBA / Istisna / Ijara

Letter of Credit

Musharaka/ Wakala/ Murabaha

Venture Capital

Diminishing Mudaraba/ Musharaka

Financing Syndication

Musharaka + Murabaha/ Istisna / Ijara

Revolving Financing

Bai Al-Einah

Short-term Cash Advance

Bai Al-Einah/ Tawarruq

Working Capital Finance

Murabaha/ Salam/ Istijrar

Letter of Credit

Murabaha

Letter of Guarantee

Kafala + Ujr

Leasing

Ijara

Export/ Import Finance

Musharaka/ Salam/ Murabaha

Work-in-Progress, Construction Finance

Istisna

Bill Discounting

Bai al-Dayn

Underwriting, Advisory Services

Ujr

Treasury / Money Market Investment Products

Sell & buy-back agreements

Bai al-Einah

Islamic Bonds

Mudaraba / Mushraka + BBA / Istisna / Ijara

Government Investment Issues

Qard Hasan/ Salam/ Mudaraba

Other Products & Services

Stock-Broking Services

Murabaha/ Wakala/ Joala

Funds Transfer (Domestic & Foreign)

Wakala/ Joala

Safe-Keeping & Collection (Negotiable Instruments)

Wakala/ Joala

Factoring

Wakala/ Joala/ Bai al-Dayn

Administration of Property, Estates and Wills

Wakala

Hiring of Strong Boxes

Amana/ Wakala

Demand Draft, Traveller’s Cheques

Ujr/ Joala

ATM Service, Standing Instruction, Telebanking

Ujr

Source: Obaidullah, 2005

Financial Crisis and the Islamic Banking

To be able to compete with conventional banks, Islamic banks have to offer financial products that are comparable to the ones offered by the conventional banks. This exposes the Islamic banks to similar credit, liquidity and risks driven by market instability. Despite that, Islamic banks managed to remain stable at the early phases of the crisis. That was driven by three main Factors. First, Islamic bank’s financing activities are strongly tied to the real economic activities than their conventional counterpart.

Even though Musharakah and Mudharabah both provide better risk sharing while keeping strong link to the real sector, they are used minimally for different reasons. Most financing activities are done through Murabah and Ijarah followed by Istinsa. In the GCC and during 2007, Murabaha comprised of 65.4%, Ijarah 12.78% and Istinsa 2.83%. Both Murabaha and Ijrah transactions require the Islamic bank to know the client’s purspose and use of finance as well the ownership of the asset by the bank. This help in ensuring that the funds are used for their stated purposes. On the other hand, conventional banks do not require disclosing the use of funds as long as the client is believed to creditworthy or can post suitable collateral.

Second, Islamic banks avoid direct exposure to exotic and toxic financial derivative products. Since

Shariah prohibits riba and gharar, the asset portfolio of Islamic banks did not include any CDOs, CMBSs, and CDSs which turned out to be highly toxic for conventional banks and amplifying factor for the crisis. These derivative products, initially used for hedging purposes, became device for highly speculative investments among conventional financial institutions. Unavailability of hedging instruments for Islamic financial institutions, which was perceived as weakness before the crisis, became a strengthening factor for them. However, exposure to other investment risks driven from equity markets, sukuk, real-estate and ownership stakes in other businesses remain a source of concern when overdone or undertaken purely for speculative gains.

Third, Islamic banks in general have a larger proportion of their assets in liquid form than their conventional counterparts. This is driven by two main reasons: (1) there is no lender of last resort (LOLR) facility available to Islamic banks, and they do not have access to market liquidity in the form of the interbank market, high liquidity was maintained for risk management purpose. (2) Excess liquidity is required due to lack of interest-free short-term investment opportunities as real economic investments require some development period.

As the global financial crisis became a global economic crisis, it started to affect Islamic banks in an indirect manner. The financial crisis has triggered a chain reaction whereby the slowdown in the real economies of the developed countries has started to affect economic growth and investment activities in export driven economies of the developing countries through lower trade in goods and services as well as through the declining commodity prices including that of oil. The economic downturn is not only affecting the investment and financing activities of financial institutions including those of Islamic banks, it is also reducing the funding of these banks through lower personal savings and declining corporate profits. It should be noted that most of the Islamic banking industry comprises of commercial banks whose major funding source are retail deposits, investment banking constitutes only a small portion of the industry. Islamic banks in some regions may face risk on their financing and investment side of the balance sheet due to the crisis induced volatility of equity markets where these banks have large positions. Downturn in the real estate markets where these banks have large direct and indirect exposures is also another source of risk. Similarly, the changing wealth position of their high-net-worth (HNW) clients who also hold financial exposure in the hard-hit conventional financial sector of the West and therefore are now postponing any investment plans is also a factor. The relative importance of each of these factors varies by the region. For example, the banks in the GCC and particularly in the UAE are more exposed to real estate market risk, followed by risk of international equity markets. For the banks in Asia, their investments in domestic and international equity markets are a source of concern as equity markets are showing higher volatility. In some of the countries, the existing fiscal imbalance which has widened after the crisis is also a factor in the increased volatility of the markets

Previous Literature

The study of bank profitability is an important tool to evaluate bank operation by examining the different factors affecting bank profitability and using these factors for management planning and strategic analysis. In the last four decades, many studies have been conducted to study both bank profitability and the determinants of bank profitability either for particular country or for a panel of countries. These studies normally divide these factors into internal factors and external factors. Internal factors represent the bank-specific characteristics such as bank size, liquidity structure; liabilities…etc while external factors can be macroeconomic factors such as inflation and GDP growth or Country-specific regulations rules and practices.

In the area of banking profitability, many studies have been conducted to investigate the profitability of conventional banks while only few were conducted in the field of Islamic banking. In this chapter, we will review these studies for conventional banking first and then will focus on studies in the Islamic banking field. Then we will cover the conceptual framework of this research.

Conventional Banking

Different studies have been conducted in the field of conventional banking profitability. Short (1979), Bourke (1989), Molyneux and Thornton (1992), Goddard, Molyneux, and Wilson (2004), Peters et al. (2004) are some of the researchers in the field.

Short (1979) is one of the early scholars who studied the relationship between banking profit rates and concentration for sixty banks in Canada, Western Europe and Japan during the 1970’s and he included independent variables including government ownership and concentration by using H index to quantify concentration. Results showed that the government ownership impact on profitability varied throughout the countries studied but expressed an overall negative relationship. He also found evidence that indicated higher concentration rates lead to higher profit rates (Short, 1979).

Bourke (1989) also compared concentration to bank profitability but included other determinants. Bourke (1989) covered ninety banks in Australia, Europe, and North America between 1972 and 198 and examined different internal and external factors: internal factors such as staff expenses, capital ratio, liquidity ratio, and loans to deposit ratio; external factors such as regulation, size of economies of scale, competition, concentration, growth in market, interest rate, government ownership, and market power. His results show that increase in government ownership leads to lower profitability in banking. He also found that concentration, interest rates, and money supply are positively related to profitability along with capital and reserves of total assets as well as cash and bank deposits of total assets. Bourke adds that well capitalized banks enjoy cheaper access to sources of funds as they are less risky than less capitalized banks (Bourke, 1989).

Later, Molyneux and Thornton (1992) studied the determinants of European banks profitability. The paper examined eighteen counties in Europe between 1986 and 1989. This paper replicated Bourke’s (1989) work by using internal and external determinants of bank profitability. However, Molyneux and Thornton (1992) results showed that government ownership expresses a positive coefficient with return on capital (profitability) which contradicts with Bourke’s findings. Other results were similar to Bourke’s, showing that concentration, interest rate, and money supply were positively related to bank profitability (Molyneux and Thornton, 1992).

In one of the recent papers on bank profitability on European banks, Goddard, Molyneux, and Wilson (2004) shows similar findings to the paper by Molyneux and Thornton (1992). It investigates the determinants of profitability in six European countries and it covered 665 banks between 1992 and 1998. The study used cross-sectional and dynamic panel models. The variables used in the regression analysis were ROE, the logarithmic of total assets, Off Balance Sheet (OBS) dividends, Capital to Asset Ratio (CAR). The results from both models were similar: evidence reveals that there is a positive relationship between size (total assets) and profitability. Meanwhile, OBS appears to have a positive relationship with profitability for UK but neutral or negative for other European countries. Moreover, results also state that CAR has a positive relationship with profitability. Furthermore, the paper touched on ownership type by indicating that there is high competition in banking due to the fact that there is foreign bank involvement in domestic banks, and that profitability is not linked to ownership (Goddard, Molyneux, and Wilson, 2004).

Peters et al. (2004) studied the characteristics of banks in post-war Lebanon for the years 1993 to 2000 and compared the results to a group of banks from five other countries in the Middle East including UAE, KSA, Kuwait, Bahrain and Oman for the years 1995 through 1999. They used Return on Equity (ROE) measure profitability and leverage and they employed regression models that relate bank profitability ratios to various explanatory variables. This study tests the relationships between bank profitability and size, asset portfolio composition, off-balance sheet items, ownership by a foreign bank, and the ratio of employment to assets. The results show a strong association between economic growth and bank profitability, whether measured by ROE or ROA. They found that Lebanese banks are profitable, but not as profitable as a control group of banks from five other countries located in the Middle East.

Islamic Banking

In the area of Islamic Banking, Bashir (2000) assessed the performance of Islamic banks in eight Middle Eastern countries. He analyzed important bank characteristics that affect the performance of Islamic banks by controlling economic and financial structure measures. The paper studied fourteen Islamic banks from Bahrain, Egypt, Jordan, Kuwait, Qatar, Sudan, Turkey, and United Arab Emirates between 1993 and 1998. To examining profitability, the paper used Non Interest Margin (NIM), Before Tax Profit (BTP), Return on Assets (ROA), and Return on Equity (ROE) as performance indicators. There were also internal and external variables: internal variables were bank size, leverage, loans, short-term funding, overhead, and ownership; external variables included macroeconomic environment, regulation, and financial market. In general, results from the study confirm previous findings and show that Islamic banks profitability is positively related to equity and loans. Consequently, if loans and equity are high, Islamic banks should be more profitable. If leverage is high and loan to assets is also large, Islamic banks will be more profitable. The results also indicate that favorable macro-economic conditions help profitability (Bashir, 2000).

Hassoune (2002) examined Islamic bank profitability in an interest rate cycle. In his paper, compared ROE and ROA Volatility for both Islamic and conventional banks in three GCC region, Kuwait, Saudi Arabia, and Qatar. He states that since Islamic banking is based on profit and loss sharing, managements have to generate sufficient returns for investors given that they are not willing accept no returns (Hassoune, 2002).

Bashir and Hassan (2004) studied the determinants of Islamic banking profitability covers 43 Islamic Banks between 1994 and 2001 in 21 countries. Their figures show Islamic banks to have a better capital asset ratio compared to commercial banks which means that Islamic banks are well capitalized. Also, their paper used internal and external banks characteristics to determine profitability as well as economic measures, financial structure variables, and country variables. They used, Net-non Interest Margin (NIM), which is non interest income to the bank such as, bank fees, service charges and foreign exchange to identify profitability. Other profitability indicators adopted were Before Tax Profit divided by total assets (BTP/TA), Return on Assets (ROA), and Return on Equity (ROE).

Results obtained by Bashir and Hassan (2004), were similar to the Bashir (2000) results, which found a positive relationship between capital and profitability but a negative relationship between loans and profitability. Bashir and Hassan also found total assets to have a negative relationship with profitability which amazingly means that smaller banks are more profitable. In addition, during an economic boom, banks profitability seems to improve because there are fewer nonperforming loans. Inflation, on the other hand, does not have any effect on Islamic bank profitability. Finally, results also indicate that overhead expenses for Islamic banks have a positive relation with profitability which means if expenses increase, profitability also increases (Bashir and Hassan, 2004).

Alkassim (2005) examined the determinants of profitability in the banking sector of the GCC countries and found that asset have a negative impact on profitability of conventional banks but have a positive impact on profitability of Islamic banks. They also observed that positive impact on profitability for conventional but have a negative impact for Islamic banking. Liu and Hung (2006) examined the relationship between service quality and long-term profitability of Taiwan’s banks and found a positive link between branch number and long-term profitability and also proved that average salaries are detrimental to banks’ profit.

Masood, Aktan and Chaudhary (2009) studied the co-integration and causal relationship between Return on Equity and Return on Assets for 12 banks in KSA for the period between 1999- 2007. For their research, the used time series model of ADF unit-root test, Johansen co-integration test, Granger causality test and graphical comparison model. They found that there are stable long run relationships between the two variables and that it is only a one-direction cause-effect relationship between ROE and ROA. The results show that ROE is a granger cause to ROA but ROA is not a granger cause to ROE that is ROE can affect ROA input but ROA does not affect the ROE in the Saudi Arabian Banking sector.

Conceptual Framework

Theoretical framework is a basic conceptual structure organized around a theory. It defines the kinds of variables that are going to be used in the analysis. In this research, the theoretical framework consists of seven independent variables that represent four aspects of the Bank Characteristics. Theses aspects are the Bank Size (Total Assets), Capital Structure (Equity and Tangible Equity), Liquidity (Loans and Liquid Assets) and Liabilities (Deposits and Overheads). Bank profitability is the dependent variable and two measures of bank profitability are used in this study, namely return on average equity (ROAE) and return on average assets (ROAA).

In this section we develop the hypothesis to be examined in this research paper.

Development of Hypotheses

This paper attempts to test seven hypotheses. A hypothesis is a claim or assumption about the value of a population parameter. It consists either of a suggested explanation for a phenomenon or of a reasoned proposal suggesting a possible correlation between multiple phenomena. According to Becker (1995), hypothesis testing is the process of judging which of two contradictory statements is correct.

Hypothesis 1: Profitability has a positive and significant relationship with the total assets (ASSETS).

Total Assets of a company represents its valuables including both tangible assets such as equipments and properties along with its intangible assets such as goodwill and patent. For banks, total assets include loans which are the basis for bank operations either through interest or interest-free practices. Total assets is used as a tool to measure the bank size; banks with higher total assets indicate bigger banks. Molyneux and el (2004) included total assets in their study and found a positive significant relationship between total assets and profitability. Therefore, total assets are expected to have positive relation with profitability which means that bigger banks are expected to be more profitable. Total assets are converted logarithmic to be more consistent with the other ratios

Hypothesis 2: Profitability has a positive and significant relationship with equity to asset ratio (EQUITY).

Total equity over total assets measures bank’s capital structure and adequate. It indicated bank ability to withstand losses and handle risk exposure with shareholders. Hassan and Bashir (2004) examined the relationship between EQUITY and bank profitability and found positive relationship. Therefore, EQUITY is included in this stud


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