Benefit of islamic banking

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Chapter 2: literature review

2.1 introductions

2.2 Performance

K.H.Azam Ahamed (2008), explored about the benefit of Islamic banking in his country, which is Sri Lanka. The author found that even the population of Muslim in Sri Lanka being just 8% of the population, a considerable growth is reported in the past few years. This is because of some benefit provided by Islamic banking industry encourages people to step into Islamic Banking. One of the reasons is profit sharing of a financed project. The financier and the beneficiary share the actual or net profit/loss rather than throwing the risk burden only to the entrepreneur. Besides, Islamic financing is not centered only on credit worthiness and ability to repay the loans and interest. The most important thing that Islamic banking system considered is the worthiness and profitability of a project, while the ability to repay the loan is sub-segmented under the profitability. Beside consider the credit worthiness and interest rate, Islamic banks also apply Islamic moral/ethical criteria in their provision of financing. Another important characteristic which forms the basis for the development of Islamic banks is the relationship with depositors. They deal with their customers on investment grounds rather than a pre-determined fixed interest rate. Furthermore Islamic banks eliminate the barrier between those who save and those who invest, and bring them closer to the real market. The limitation of this study is the author did not much discuss about the challenge and problem faced by the Islamic banks in Sri Lanka.

Hamim S. Ahmad Mokhtar, Naziruddin Abdullah and Syed M. Al-Habshi (2003), investigated the efficiency of the full-fledged Islamic banks, Islamic windows and conventional banks in Malaysia. The author use the Stochastic Frontier Approach to measure the efficiency of Islamic window performs in Malaysia. By using economic and linear programming techniques, the author had the advantage of following noise in the measurement of inefficiency. This approach needs to specify the functional form for production, cost or profit. The author used two concepts for the study, which are technical efficiency (TE), and cost efficiency (CE). The output-oriented measure of TE is a bank's ability to achieve maximum output by given sets of inputs, while the input-oriented TE reflects the degree to which a bank could minimize its input used in the production of given outputs. Cost efficiency (CE) is a measurement of a bank's cost from the best practice bank's cost if both were to produce the same output bundle under the same market conditions (Berger & Mester, 1997; Vander Vennet, 2002). By using the Stochastic Frontier Approach, the author found that the average TE and CE of conventional banks are higher than the Islamic banking system. This is because Islamic banking is still considered at an early development stage. The limitation of this journal is Anjum Siddiqui (2004), studied the widely used Islamic banking contracts, risks of the contract, and then performance of Islamic banking. In this paper the author stated that the saving and investment contracts offered by Islamic banking have a different risk profile than conventional bank due the Islamic prohibited of interest. This cause the number of regulatory issues pertaining to capital adequacy and requirements rose. The author used Pakistan as his case studied to study Islamic banking in that country. He found that various performance indicators show that there is evidence that Islamic banks in Pakistan tend to engage in little long-term project financing. With the better risk management and maintained adequate liquidity, the banks able to perform well with respect to the returns on their assets and equity. The limitation of this study is the author does not have enough information and relative performance of Islamic versus conventional banks before he make the substantive conclusion as this kind of research need to examine large scale of banks across various countries.

M. Mansoor Khan and M. Ishaq Bhatti (2007), discussed about paradigm of Islamic banking industry and special features, facts and figures over the recent development of Islamic banking globally. Thin this paper the author explored and found that Islamic banking and finance industry has been improve tremendously and become the alternative choice to conventional banking system across the globe, especially in the Middle East, South East and South East Asia. There are some reasons about the recent success of Islamic banking and finance, such as worldwide spiraled oil prices, prolonged boom in the Middle Eastern economies, product innovation and sophistication and improve of technology advancement. The success of Islamic banking and finance has been attracted 24 percent of world's Muslim population (over 1.3 billion), and other ethical groups across the globe. The limitation of this study is, the author does not use statistical testing and analysis to figure out the main factors and their actual contributions in making Islamic banking and finance emerge as the fastest growing industry of the global finance. The author just uses the on-going developments in Islamic banking and finance industry as consideration.

M. Raquibuz Zaman and Hormoz Movassaghi (2000), examined the major products and services offered by various Islamic banking institutions (IB) as well as analyzing such institutions' financial performance. The author compares the Islamic banking form the aspect of financial position, products and services of Islamic banking to find out how well the Islamic banking industry performed. The author also found that a true IBI could not offer long-term CDs on fixed rates, nor could it provide fixed-rate mortgages or installment loans. The ideal rates will vary with the changing business and economic conditions so that neither the depositors nor the borrowers and investors face undue economic hardships from financial transactions. The limitation of this journal is the author using the 1996's information and data to analysis the Islamic banking industry, thus this outdated information may not represented the current position of Islamic banking industry.

M. Suyanto (2005), evaluated the performance of bank Muamalat Indonesia during year 2000-2004. The author conducts the research by using statistical technique and made inter-bank comparisons with conventional banks in Indonesia. The financial ratio that the author calculates does not show any different in performance. However, the Non-Net Interest Margin appears to be higher than conventional banks. Besides, the author also founf that the Indonesian experience in Islamic Banking is very difference to those found in Bangladesh. The data on Islamic Bank Bangladesh Limited (IBBL) shows that majority of financing has hovered around in the vicinity of 2% during the bank's 16 years existence. Financing to the agriculture has been minimal. (Hassan, 1999). The limitation of the study Abdus Samad & Hassan (1999), examined the profitability performance of Islamic bank in Malaysia (BIMB) and compared 8 conventional banks by using the financial ratios. The study found that the average profit of BIMB is significantly lower than the conventional banks. The authors argued that this is to be expected since the investment opportunity set for BIMB in stocks and securities is smaller due to religious constraint.

Hassan (1999) examines the Islamic baking principles in theory and its application with case study of Bangladesh. The abundance of short-term funds compared to long -term funds available for lending is a rational response on behalf of banks to solve information a asymmetries prevalent in credit market. In traditional finance literature, it is shown that debt contract (murabaha) is superior to equity contract. However, equity contract can be superior to debt contract in an economy where informational asymmetries resulting from adverse selection and moral hazard are trust given to banking firm,It is naturally expected that as a custodian of trust for the depositos' deposits, Islamic bank is likely to be more liquid and become more solvent compared to its counterpart conventional banks,Islamic bank management, according to Islamic ethics, is accountable to the depositors in this world and the world hereafter for their failure to keep the trust entrusted upon them. It is, therefore, expected thet the liquidity and solvency ratio of the Islamic bank will be higher than conventional banks.

Mariani Abdul Majid, Nor Ghani Md Nor and Fathin Faizah Said (2001), analyzed the productive efficiency of Malaysian commercial (Islamic and conventional) banks over the 1993 to 2000 time period by using the stochastic cost frontier approach. The authors stated that Malaysian Islamic banks have to operate in an increasingly competitive environment due to the response to the ASEAN Free Trade Agreement (AFTA), and response to the general globalization of markets. Despite its growth, the share market of the Islamic banking system in Malaysia is relatively small compared to the size of the overall banking system. This study finds that there is no statistically significant difference in the level of efficiency between Islamic and conventional banks operating in Malaysia based on data from 1993 to 2000. There is also no evidence to suggest that bank efficiency is a function of ownership status (public/private or foreign/local). The limitation of the study

Kwan and Eisenbeis (1996) used semi-annual data for a sample of 254 bank holding companies from 1986 to 1991 in order to find the relationship between scale and efficiency. The banks were grouped into size-based quartile to allow for different production technologies for each size class. Separate cost functions was estimated for each size quartile using the method of maximum likelihood. After controlling for other factors, smaller banking firms on average were found to be less efficient than larger banking firms. Smaller banking firms tended to exhibit larger variations in inefficiencies than larger firms do. These findings suggest that on average, large banking firm operates closer to its respective efficient frontier than the small banking firms. Average inefficiency appears to decline over the period 1986 to mid 1990, apparently responding to the increased competition in banking wrought by market and regulatory changes. Persistence of inefficiency rankings suggests that relatively efficient (inefficient) banking firms tend to stay relatively efficient (inefficient) over a fairly long period.

Metwally (1997) compared the performance of 15 conventional banks and 15 "riba" free or interest-free banks from all over the world. The study tested for structural difference between the two groups of banks in terms of liquidity, leverage, credit risk, profit and efficiency. The study found that "riba" free banks face more difficulties in attracting deposits compared to the conventional banks. Secondly, " riba" free banks tend to be more conservative in utilizing funds for lending and are disadvantaged in terms of investment opportunities. As a result, this bank has higher cash to deposits ratio compared to conventional banks. However, statistical results suggest that profitability and efficiency differences are not statistically significant between the two types of banks.

2.3 Problem

Abdelkader Chachi (2005), analyzed some of the theoretical and empirical issues that need further research and discussion, in order to provide continued support to the practice of Islamic banking. The first issue is about the problem of asymmetric information and the cost involved in reducing it. Next is the problem of moral hazard in Islamic banking. The author also took consideration about adverse selection problem of verifying ex-ante and intention that frequently involve in transaction. The last problem that the author analyzed is the agency costs and the need for monitoring the counterparties' behavior.

Munawar Iqbal, Ausaf Ahmad and Tariqullah Khan (1998), identified the challenges facing Islamic banking to remain viable, to meet the growing competition and to develop and prosper. The author focused the study on the problems and challenges facing Islamic banking in a mixed environment's private corporate sector. They found that Islamic banking is suffered from the lack of institutional support specifically geared to their needs. Besides, the appropriate legal framework and supportive policies needed to allow financial institution to operate according to Islamic rules and give room in financial markets for Islamic transactions. The lack of effective supervisory framework is also one the weakness of prevailing system and deserves serious attention. Islamic banking do not deal with interest bearing bonds, therefore their need for equity is higher. Lastly, Islamic bank also lack of short term instruments in which they can profitably invest for short periods. The limitation of the study is the author use email to send the questionnaire to the respondents, and only 60% of respondents reply. Besides, the results of the questionnaire have not been fully analyzed.

Mamun Rashid, M. Kabir Hassan and Abu Umar Faruq Ahmad (2008), examined the quality perception of the customers towards domestic Islamic banks in Bangladesh. In this report the authors found that alongside religion being the rigorous factor for choosing Islamic banking, there are other factors which are significant to the customers when selecting a service provider. The study revealed alongside religion, factors like depositors' desire to achieve highest return, convenient financial transactions system, consistency in service with uniformity, and higher cost-benefit implications were substantial to clients for choosing their intended services.the author recommended that interalia, for strict compliance with Islamic Shari`ah with emphasis on technological development, forming Centralised Shari`ah council and integrated social development rather than private status building. Otherwise it would be a matter of concern for banks to amplify their customer's satisfaction.

Hassan, M. K., & Ahmed, M. (2001), studied on Customers' perception and found that it has become an enduring research agenda in banking. Due to higher demand, specialist research should be done to check updates of satisfaction. Previous studies conducted in this area were mainly centered to service quality, customer satisfaction with Islamic financial services, behavior of customers and their perception regarding existing services and policies of Islamic banks, knowledge of Islamic banking in Pakistan, Malaysia, Kuwait, Iran, and Indonesia etc. Among others, Islamic legal and supervisory frameworks, knowledge of Islamic economics were found to be imperative in advancement of Islamic financial system and customer satisfaction in this industry. Additionally, these studies suggested global uniform legal set-up with respect to Islamic Shari`ah to supervise Islamic banks. As Prophet Muhammad pbuh) said that Muslims must accomplish anything in the most scientific and artistic way (Owen and Othman, 2001), it is vital to consider quality aspects to enhance customer management in Islamic banking.

Owen, L. and Othman, A. Q. (2001), conducted a study regarding the development of service quality and perception of the customers towards Islamic banking. They surveyed the customers of KuwaitFinance House (KFH) and tested famous service quality model, 'CARTER.' Cartermodel has six quality and perception dimensions, explicitly, 'C' for Compliance, 'A' for Assurance, 'R' for Reliability, 'T' for Tangibles, 'E' for Empathy and 'R' for Responsiveness. Compliance had five variables and the outcome is to check the ability to fulfill Islamic Law and to operate under the principles of Islamic banking and economy. Assurance had five variables regarding knowledge and ability of the employees in satisfying the customer demand. Reliability included four variables to ensure the dependability on bank and accuracy of its services. Tangibles had five variables which explained the physical facilities and presentation of services. Empathy, which included nine variables, inspects attention of the personnel towards customer satisfaction and lastly, Responsiveness which had another five variablesused to identify the willingness of the bankers/banks to provide prompt services and help customers. The survey was administered among 22 operating branches of KFH using five-poring Likert scale. Factor analysis was done to show the loading/ weights of individual variables within the factors. The analysis did not show any regression results. The recommendations outlined the importance of knowledge building program on customers, training for employees in both generic and specialised format, communicating the customers regarding new service offerings, cost-benefit aspect of services purchased by the customers, positive word of mouth etc. They also argued that to be successful in Islamic banking, it is not only important to be externally (externally refers to tangible benefits of banking services) unsullied rather it is persistent being acquiescent internally (internally means compliance to Shari`ah and avoiding riba). The authors highlighted the importance of SERVQUAL, SERVPERF models.

Keuhn, K. and Bley, J. (2004), studied the perception and knowledge among students. They tested hypotheses on lack of basic Islamic product knowledge, aspect of religion, cultural differences etc. and found interesting results. Due to language barriers it prohibits students to learn Islamic financial system. Nevertheless, the study was mainly concentrated towards having an adequate marketing and education policy on Islamic banking and economics.

2.4 Prospect

James S (2008), examined the prospect of Islamic banking in Malaysia. The local Islamic banking and Takaful industry has made steady progress since the establishment of the first Islamic bank in 1983 and the formation of the first Islamic insurance company or takaful in 1984.the author stated that at the end of 2000, the share of Islamic banking, deposit and financing are rising. The delivery channels have also improved significantly as there are now more than 2,200 branches of Islamic banks and IBS banks offering Islamic banking products and services. In addition, the capital market has seen the rapid growth of Islamic debt and equity markets. Apart from its growing share, the prospects of Islamic banking are also bright with the flush of petroleum money. The limitation of this study is the author is using his own opinion and do not made a big scale of data collection from public to support his opinion.

2.5 Public Acceptance and Factors of Selection

Ahasanul Haque, Jamil Osman and Ahmad Zaki Hj Ismail (200x), analyzed the factor influence selection of Islamic banking in Malaysia. The author determined the customer satisfaction as the heart of the research. The key concepts and elements of satisfaction provide a template by which information can be gathered about what does and what does not work. Customer satisfaction often depends on the quality of product or service offering. In the context of services, some describe customer satisfaction as an antecedent of service quality (Bitner, M.J., 1990). This study tries to identify the consumer perception about the Islamic banking and the relationship among the affective factors. Quality of services, confidence in bank, social and religious perspective and availability of services are the main factors affecting the customer satisfaction. At the end of the research, the author found that Customer perception and satisfaction can be considered as the key contrast to bank for overall performance. The limitation of this study is the author use the convenient sampling method to collect the data and questionnaire, thus it cannot be able to gather a comprehensive sample of population. Besides, this study also not mentions relationship between the customers' perception and some other very important factors.

Haron, S., Ahmad, N., and Planisek, S. (1994), studied on the selection criteria used by Muslim customers in Malaysia when selecting their banks. The author found that the most important factors that Muslim in Malaysia to select the sevices of Islamic bank are fast and efficient service, the speed of transaction, and friendly bank personnel. In this study, the author also found was the potentiality of individual customers in patronizing an Islamic bank when they had knowledge of this new system. 80 per cent of Muslim and 53 percent of non-Muslim respondents indicated that they would consider establishing a relationship with an Islamic bank if they had substantial understanding of its operations.

Metawa and Almossawi (1998), examined about the factors of selection on Islamic bank in Bahrain the most important reason to choose Islamic banking is the perceivable of Islamic principles. The next reason is reward extended by the banks, followed by influence of family and friends, and convenient location. On the other hand, the author also found that socio-demographic factors such as age, income and education were important criteria in bank selection. The limitation of this study is the author only select two Islamic banks' customer in Bahrain, which is Bahrain Islamic Bank and Faisal Islamic Bank of Bahrain to do the research. Thus the outcome that the author gets may not sufficient.

Norafifah Ahmad & Sudin Haron (2001), studied about the perceptions of IMalaysian corporate customers towards Islamic banking products and services. The authors do a research among the persons responsible for the financial affairs of the companies listed in the Kuala Lumpur Stock Exchange. In the research, the author found that Islamic banking products were not popular among Malaysian corporate customers. Besides, the lack of knowledge about Islamic banking also one of the reason people not to patronize Islamic banking. The most important factors to choose Islamic banking among the respondents is the cost and benefits that can get from Islamic banking to the company. The limitation of the study is the authors only choose the respondents among the persons responsible for the financial affairs of the companies.

Rosenblatt, J., Laroche, M., Hochstein, A., Mctavish, R., and Sheahan, M. (1988), sampled 423 Canadian corporate treasury personnel in their study to determine the responsible person in selecting bank for their organization, factors attributed to the selection of the bank, and perceptions of these personnel on the bank's service quality. They found that almost half of these corporate treasurers were solely responsible in the selection of the bank. The two factors that influenced their decision-making were banks with better branching networks and which offer quality services. Half of the respondents in this survey also preferred the bank to assign special officer who had the most knowledge about the customers' business operations. The corporate treasurers were also more concerned about quality products and services than innovative products. They also were not keen on the concept of "one-stop banking center".

Dusuki and Abdullah (2007) discovered that competence and courtesy of employees and their ability to convey trust and confidence onto their customers (e.g. friendliness of staff, efficiency and effectiveness in handling transactions; knowledge and experience of the bank personnel) are intrinsic to choosing a bank. Moreover, giving special attention to customers' demand (Erol et al, 1990; Shook and Hassan, 1988), availability of financial advice at free of cost (Iqbal and Mirakhor, 1987), availability of credit and other services on flexible terms (Homound, 1985 and Shirazi, 1990) were branded as essential features.