Literature Review On The Principles Of Islamic Finance
As we discussed in the previous chapter about the history of the Islamic and commercial banks, Islamic banking system provides to their customers the same products and services as the conventional banks with small differentiation between the two systems due to the principles of the Islamic finance. Therefore, there are many studies have examined the financial transactions of the two systems and evaluated their financial performance and stability.
However, during the last three decades many financial crises have been occurred and affected strongly on the two types of these banks, and many of the researchers have studded the financial performance and the stability of the commercial and Islamic banks, and there were different views about their financial performance and stability. Consequently, this chapter will illustrate the difference between the two systems and will illustrate how Islamic bank avoiding the interest in their financial transactions with their customers. Moreover, we will discuss some studies have evaluated the financial performance and stability of the two systems in different regions and different periods with an explanation the effect of the recent financial crisis on commercial and Islamic banks.
The principles of the Islamic banking system
Islamic banking system operates according to Islamic laws and Islamic shariha. Consequently, Islamic financial system derives their rules and principles from the holly Quran and the prophet Mohammad saying. Hence, Islamic laws prohibited Riba (interest), Gharar (risk) and Maysir (gambling) due to the negative effect of these three issues on the investor.
According to Iqbal (2001) and Siddiqi (2004) who defined Riba (interest) as large or small increasing on the value of the initial loan on the investor who took the loan from the bank and the investor must pay this money to the lender. Therefore, Islamic finance prohibited any excess or fee on the value of the initial loan due to the negative effect of this increasing on the investor. Furthermore, Ghara (Risk) is selling items or products whose features are uncertain, which will may cause risk to the investor and make the trading of the investor as gambling. Finally, Maysir (betting or gamblling) is forbidden in Islamic finance due to the ambiguity in this type of trading, which will not guarantee the returns. Therefore, Riba (interest), Ghara (Risk) and Mayser (Gambling) considered as the main three issues are forbidden in Islamic finance and if these three principles are prevented in the bank then will be proper Islamic banking system.
However, the Islamic banking system applying many types of financial methods that comply with Islamic laws in order to avoid the interest between the investor and the bank, such as Mudarabah, Musharkah, Murabaha, Bai Muajjall (Postponed sale), Bai Salam (Peac Sale), Istisna-or Industrialization contracts, Ijarah and Qard Hasson.
Mudaraba (Speculation) or (capital trusts):
Mudaraba is a contract between the investor and the bank in order to introduce the fund and the resources to the investor, and also the profits and losses will be shared between the two parties according to a specific percentage that they agreed upon from the beginning of the process. Whereby, the investor will be responsible for all the financial losses and another party will be responsible for all the operating losses.
Musharaka (Full partnership):
Musharaka can be defined as a full partnership between the bank and the investor in the profit and loss depend on the percentage that they agreed upon it. In general, it is seen as cooperation or a joint process between the Islamic bank and the client or the business company for conducting certain transactions. It is possible that the Islamic bank can perform as the money provider to finance different kinds of industries.
Murabaha (Growth on Sales):
Murabaha is a contract between the bank and the investor in order to provide the investor with the initial fund to buy the goods for the products or for the services. Also, the investor will pay the costs of the products and the profit margin ratio to the bank by agreed upon payment or lump sum with no increase in the profit margin ratio.
Istisna (Manufacturing contracts):
Istisna is one of the Islamic financial transactions, and in this type of contracts the helps the investor to buy the industrial material to start the business with advance cash payments or by deferred payments and date of delivery.
Ijara (Leasing operations):
Ijara is a pre-payment for a rent contract between the two involved parties, where the owner of the building or the offices leases the assets to the lessee, who uses the location. (Lewis & Alguad, 2001).
Quard Hassan (Good Loan):
Quard Hassan is a type of lending; in this type of lending the bank introduces the money to those who need the money to decrease their hard working situation. Also, the bank can lend the money on the basis of zero-interest to any one of the societies for different aims, including money for expenditures in relation with education or marriage. Lewis & Algaud, (2001), Metwally (2006)
Islamic Banking Transactions:
The financial transactions of Islamic banks have developed since the first Islamic bank has been opened in order to introduce the best services to their customer according to Islamic laws. Therefore, Islamic banking system depends on their investments on the money of the shareholders and the depositors. Consequently, several studies have discussed the sources of Islamic bank and the usages of this money such as Abdul-Gafoor (2003), Alam (2000) and Haron (1995). (revise it again).
The three basic methods of Islamic deposit accounts are the following:
Islamic current account considered as a service provided to depositors for the banks transfers transactions and for the pay cheques through transfer systems.
These accounts could be paid on demand without any interest paid to the depositors, and it is also possible to keep these accounts in the form of foreign currency in order to make it easier to conduct international trade.
Islamic saving account is the same as the commercial saving account. Whereby, Islamic saving account introduces to the customer benefits and services instead of interest due to the prohibited of interest.
Islamic investment deposit account is an especial account for the customers who want to make an investment by using their money according to the concept of profit and loss sharing. Therefore, Islamic investment account divided to tow types as follows:
Specified investment accounts:
In this type of accounts the bank will be responsible to invest the money of the customers in specific investment, or in conditional investment, in specific projects or specific sectors.
Unspecified investment accounts.
This account introduces to the customer the opportunity to grants the bank the full authority for the investment, with regard to the banks’ ability and wishes to invest in any relevant transaction.
Islamic banking system provides many services to their customers the same as commercial banks such as letters of guarantee, travellers cheque letters of credit, money transfer, performance bonds and foreign exchange transactions. Moreover, Islamic banks are able to collect some kinds of fees, such as administrative or service fees, according to the expenditures generated on the service and provided in correspondence with the Islamic sharia.
Also, the Islamic banks are in the position to change a commission ratio when the financial transactions are for the purpose of selling and buying metals such as the gold on behalf of the client due to the bank's responsibility is to act as an agent.
The financial performance and stability of Islamic and conventional banks
In this part we will discuss some studies have evaluated the financial performance, efficiency, stability and the financial risk of the two types of banks, in different regions, periods and different samples as follow.
(Ali, 2010) evaluated the financial performance of the top 10 conventional and the top 10 Islamic banks during the recent global financial crisis during the period (2006-2009). Ali, (2010) made a comparison between the two types of banks in the total assets, total equity, net profit, market capitalization and the financial indicators. The overall results show that the total equity of conventional banks increased by 24%. On the other hand, the total equity of commercial banks risen by 36%. Furthermore, the net profit of commercial banks decreased from 116 billion to 42 billion. In contrast, the net profit of commercial banks increased by 9%. Moreover, Islamic banks encountered a decline by 8.5% while the commercial banks went through losses by 42.8% in the market capitalization.
As a result of the strong impact of the global financing crisis on the conventional banks, five of the largest 10 commercial banks in the world received assistance from the governments, ($163 billion.), at the same period, one Islamic bank demanded assistance from the government to restructure its position and its shares in the market.
The total return of Islamic down Jones declined during the years from (2007 to 2008) by 24.7%.While the total return of MSCI world index declined by 34.7%.
According to (Safiullah, 2010) who evaluated the financial performance of Islamic and conventional banks in Bangladesh by examining the interest free in Islamic banks and the interest based in commercial banks through using the Statistical Package for Social Science (SPSS) and financial ratio analysis on four commercial banks and four Islamic banks.
The results show that the financial performance of Islamic banks under the concept of interest free seems to be better than commercial banks in liquidity, business development and profitability. Secondly, the financial performance of commercial banks under the concept of interest is more efficient than Islamic banks in the commitment to community and economy. Finally, the overall result of the performance of the two types of banks in Bangladesh showed that the financial performance of the Islamic banking system in Bangladesh is more efficient than commercial banks.
In contrast, there are some studies have evaluated the financial performance for the two types of the banks in different regions and different period, and they got different results than Ali and Safiullah.
Erusan (2008) applied SPSS analysis and ANOVA analysis on 12600 observations from the foreign banks, local banks and the finance companies and classify these observations into one, three, sex, nine, twelve, and fifteen months of rates, in order to examine the performance of the return on the deposits in the two types of banks by T-testing the observations.
The overall results indicate to that the returns on the deposits in foreign banks; commercial banks and finance companies are higher than Islamic banks. On the other hand, the result of ANOVA show that Islamic bank achieved the smallest means performance in June compared with commercial banks. Furthermore, the finance companies achieved the highest rate of mean performance in January compared with the other.
Moreover, (Erusan, 2008) evaluated the fixed profit rate of commercial banks and the profit rate of Islamic banks in Malaysia over the period 2002 to 2006 by using one Islamic bank, 13 foreign conventional bank, 10 local commercial bank and 11 finance companies.
(Mahmud, 2009) examined the impact of the global financial crisis on the financial performance of 22 Islamic banks and 54 commercial banks in the gulf area during the period (2000-2008), through t-testing nine financial ratios in order to compare the following indexes (liquidity, profitability, credit risk, and efficiency of each system), Mahmoud (2009) reached the conclusion that during normal economic conditions, commercial banks are more profitable and efficient, higher liquidity risk comparing with the Islamic banks.
The global financial crisis decreased the variance in profitability and efficiency between the two systems as a result of the strong impact of credit pressure on the conventional banks and the good financial performance of the Islamic banks. Moreover, Islamic banks were less expose to credit risk in comparison with the conventional banks.
In addition, (Samad, 2004) examined the financial performance of the commercial banks and the Islamic banks during the period 1991-2001 by examining the Liquidity risk, credit risk and profitability ratio. Therefore, nine financial ratios and t-test have been used to examine those banks.
(Samad, 2004) found that of the analysis indicate to that there is no variation between the two types of banks in the performance of profitability and liquidity. Furthermore, commercial banking system is more exposure to credit risk than Islamic banks.
On the other hand, there are many of the researchers have examined the financial risk of the commercial and Islamic banks such as Ariss (2010) who evaluated the competitive situation of the Islamic and commercial banks over the period 2000-2006 by examining a sample of 58 Islamic and 192 commercial bank in 13 Asian and Middle East countries.
(Ariss, 2010) examined the sample of banks by using four financial ratios and H-statistics to evaluate and to compare the competitive situation in those banks. Therefore, the profitability results show that the Islamic banks allocate greater part of their assets to provide loans to finance their clients comparing with the commercial banks. Furthermore, the Islamic banks are less exposure to financial risks than the commercial banks, and the competitive situation of the commercial banks indicates to less concentration, and their competitive advantages are higher than Islamic banks.
Also, the world economic and financial survey (2009) indicated that the financial performance of the Islamic banks and the profitability slightly decreased in the Gulf cooperation council states, and he analyzed 50 conventional banks and 18 Islamic banks in the region during the financial crisis.
The survey's results revealed that commercial bank profitability fell greatly in 2008, and the Islamic banks were less prone to credit risk comparing with the commercial banks.
The purpose of (Cihak & Hesse, 2008) work was to test the financial stability of the conventional and Islamic banks in Asia and in the Middle East. Therefore, they used the Z score financial analysis tool which indicates to several structures of the financial ratio analysis, for instance, return on equity and return on assets, which is considering a useful instrument for measuring banks, solvency risk that operated out of capital and reserve.
They analyzed and observed 397 conventional banks and 77 Islamic banks, from south East Asia and the Middle East during the period 1993-2004 by comparing the Islamic and commercial banks which work in small and large capitals in order to analyze the financial stability of each system.
The result was that the financial situation of small Islamic banks was stronger and more stable compared with the small conventional banks and large Islamic banks. The reason was because of concentrating on investments with low risks. On the other hand, large conventional banks were stronger than the large Islamic banks, because of the difficulty to monitor the credits.
Also, there are some studies have evaluated the efficiency of the two system in order to determine the most efficient system such as Hamim & Mohktar (2006) who measured the efficiency of 20 commercial banks and 20 Islamic windows in Malaysia over the period 1997 to 2003, by using SFA approach. The overall results show that the total deposits of Islamic banks in Malaysia increased dramatically over the period of study. Furthermore, the results of evaluating the cost and technical efficiency of the two types of banks indicate to that the overall efficiency of commercial bank industry remained the same, and the Islamic banks increased has resin over the period of study. Moreover, the level of efficiency of the Islamic banking system is still lower than the commercial banking system in Malaysia. Finally, Islamic banking system in Malaysia seems to be more efficient than Islamic windows.
Also Yudistir (2004) measured the efficiency of 18 Islamic banks during the period (1997-2009), his measurement was founded on efficiency evaluation in which (DEA) was utilized to address the technical effectiveness of the Islamic banking industry, and the overall results show that the Islamic banks suffered from the financial crisis over the period 1998-1999, and they improved their financial performance after that period. Furthermore, there are diseconomies of scale for the medium and small banks.
(Johns & Pappas, 2009) assessed the efficiency of 19 Islamic banks and 50 conventional banks, during the period (2004-2009) by using data Envelopment Analysis (DEA) and six financial ratios in order to measure the technical efficiency.
This analysis showed that the Islamic banking system has higher return on investment compared with the commercial banking system. Furthermore, regardless of the fact that the Islamic banks total assets are less than the commercial banks total assets, still they are more effective in using and employing their resource to create revenues and profit.
(Shahid & Rehman, 2010) examined the efficiency of Islamic and commercial banks in Pakistan, they used a sample consisted of 5 conventional and 5 Islamic banks during the period (2005-2009).They applied the DEA model in order to measure the effectiveness of the two systems according to CRS & VRS approach.
Their findings showed that the TE of the conventional banks is better, but in CE and AE the two sectors revealed good competition. And the t-statistics shows the absence of notable difference in mean effectiveness scores between the two systems except in 2008.
(Mohammad, Hassan and Bader, 2007) have evaluated the profit and cost efficiency of Islamic and conventional banks in Middle East and North Asia, during the period 1990 to 2005, by applying stochastic frontier approach (SFA). On 37 conventional banks and 43 Islamic banks, and evaluation based on the region and size.
The results of the analysis showed that the cost efficiency of the Islamic banks was 31.8%, while this percentage for the conventional banks was 29.3%, profit efficiency for the commercial banks was 75.4%, and 75.1% for the Islamic banks. Furthermore, the findings show that the Islamic and the conventional banks are good in creating profit, and inefficient in controlling the costs.
In 2008, Majd tested the efficiency of 37 Islamic banks during the period (2001-2006) in 16 Asian and Middle East countries, the largest Islamic financial markets. Data Envelopment Analysis (DEA) has been used, and the results indicate to that their performance was good, but were inefficient in managing the usage of their resources, which might affect their financial performance in the following years.
The Islamic banks in Asia and Middle East achieved 66.7% in technical and pure technical efficiency, while this percentage for the Asian banks was 61.4%, which indicates that the Islamic banks in the Middle East were more efficient than the banks in Asia, and they perform better. Finally, the Islamic banks in Iran scored the highest percentage of efficiency (85.4%) among the Middle East and Asian countries.
The recent financial crisis:
The recent financial crisis or mortgage crisis that occurred in the United States of America during September 2007, effected strongly on many financial institutions and the economies of many countries in all over the world, due to the strong economic relationship between the international stock markets and the American stock market.
The recent financial crisis began when the banking sectors in the USA started to give financial facilities to the investors to take loans in order to buy property without any confirmation on the ability of the investor to pay the loan and the interest to the banks. Therefore, the demand on the real estate sector increased dramatically in USA, and the investors who were not able to pay their loans to the bank. The only solution for them was returning the house to bank. Consequently, the problem started to increase when the banks did not find buyers for these houses because of increasing the value of property, which led to decline the purchasing power of properties. Thus, the fixed assets of the banks increased dramatically with a shortfall in the cash which led to disability in covering the short and long term liabilities and led to collapse the banks in order to sell these assets and cover the liabilities. (Market crises, the financial system and the real economy: Analysis and implications for the global financial services industry 2010:213)
Consequently, there are many banks and financial institutions collapsed because of the financial crisis such as Lehman brothers banks that brought the huge negative impacts on the different sectors of the human life. Another example that clearly illustrates the great negative impact of the global financial crisis can be seen in the cases of the collapse of many auto firms in America and Europe, where many thousands of workers lost their jobs and their monthly payments, the only source to pay for their family expenses, for rent, food, education, and health care. Also, the effect of global financial crisis extended to too many sectors of human life such as, production process, increasing the unemployment and the governments become unable to achieve their plans and objectives, which led to difficulties to meet their financial duties and commitments.
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