A comparative analysis of Islamic and Conventional Banking, Summaries of Economics

Download A comparative analysis of Islamic and Conventional Banking and more Summaries Economics in PDF only on Docsity! 1 A Comparative Analysis of Islamic and Conventional Banks: How Capital Structure Affects Performance Author Institutional Affiliation Course Instructor Due Date 2 A Comparative Analysis of Islamic and Conventional Banks Introduction This literature review aims to compare the profitability and efficiency of Islamic and conventional banking, two different types of banking. Islam forbids interest; hence the Islamic banking system consists of goods compliant with Shari’ah principles and does not include riba (interest), hence the name interest-free banking (Abdul-Majid et al., 2010). The system evolves as time passes, and there is a rising desire for interest-free products. Financial operations that follow Shariah, or Islamic law, are known as Islamic banking, Islamic finance, or Shariah-compliant finance (Abdul-Majid et al., 2010). Two key tenets of Islamic banking are sharing profits and losses and forbidding lenders and investors from collecting and paying interest (Toumi, 2021). A growing number of clients want to conduct their banking in an Islamic manner, and many commercial banks are launching Islamic banking products in addition to traditional ones. Numerous non-Muslims also patronize Islamic banks. Some non-Muslim nations also place a high value on Islamic banking. More than 250 Islamic financial institutions are functioning in close to 80 countries, according to National Bank for Development of Egypt data (“The rise in Islamic banking”, 2015). Each social system has a unique economic structure. Islam has a matching economic system since it is a comprehensive and unique social structure. Islamic economics is quickly evolving into a unique and diverse economic framework. As a result, several Islamic financial institutions have mushroomed in Muslim and non-Muslim nations, including Africa (Thomi, 2014).). The current literature review concludes that Islamic banking institutions are more profitable, efficient, and creditworthy than other banking forms owing to the distinctive consideration of assets and liability. 5 Ijarah This product is typically used to buy cars, delivery vans, and other types of vehicles. The client pays monthly rentals to the bank, which buys the client’s car (Ahmad & Saif, 2010). Ownership of the vehicle is given to the client upon payment of the purchase price plus the profit. Musharakah Musharakah is a partnership agreement wherein the bank and the client commit a certain amount of funds to a project. They divide the gain or loss in such a way that the gain is divided in a predetermined proportion with mutual consent, and the loss is divided between the partners in the proportion they invested their money (Ahmad & Saif, 2010). This product is typically utilized in mortgage loans for homes, for instance, in new construction and remodeling. Financial Performance Financial performance is considered in diverse ways. Measuring financial performance entails different items, for instance, total interest expense, total interest income, deposits, loans, and advances. Operational performance is a vital issue in IB. Efficiency and profitability are relevant parameters for IBs (Abdul-Majid et al., 2010). Evaluating the performance of banks involves diverse criteria, including profitability, quality of products, innovation, liquidity, management performance, and productivity. Islamic Banking Products and Associated Financial Performance Islamic finance and the linked products form the foundation of Islamic banking, which counts among the most rapidly growing finance industry sectors in over 300 institutions within 75 countries (Thomi, 2014). IBs financial performance is improved its 6 aspect of leverage savings, creditworthiness, and ROA. The IBs capital structure plays a significant role in protecting the institutions against adverse profit events. IBs products are deemed superior relative to CBs. As a result of stability, formidable capitalization, and profitability. Comparison of Islamic and Conventional Banking Model Assets In its distinctive profit-loss sharing agreements, Islamic banks play the role of partners or financiers for their clients. When functioning as partners, an Islamic bank and a customer commit money to a project. Subsequently, earnings are then shared according to the pre-set terms. Losses are also divided according to each partner’s capital contribution. On the other hand, when acting as a financier, an Islamic bank enters into a contract with a capable entrepreneur and gives the entrepreneur money (Toumi, 2021). While the enterprise’s profits are split according to the contract terms, losses are often fully assumed by the fund provider. According to some scholars, the distinction between IBs and CBs is due to the restrictions imposed by Shariah laws. For instance, interest-based transactions (riba) are not permitted, and Islamic banks are only permitted to engage in operations supported by actual transactions. Due to the nature of profit-sharing and loss-bearing agreements, IBs have greater portfolio asset losses than CBs. Profit-loss-sharing transactions carry greater risk than non-PLS transactions, which require collateral operations because they do not include collateral and resemble equity financing. The two models are identical, even if their modes may differ (Ika & Abdullah, 2011). Islamic banks continue to prioritize interest-based funding, highlighting the discrepancy between Islamic banking doctrine and actual business practice. 7 Asset growth is a crucial determinant of capital structure change. Conventional banks (CBs) alter their leverage strongly in reaction to the total assets relative to Islamic Banks. This attribute is due to conventional banks’ upper-hand capacity in sourcing funds externally. Consequently, conventional banks tend to attain leverage alterations faster and inexpensively. Conversely, Islamic banks (IBs) possess more regulatory capital; however, the ability to respond to risks is lower. According to the research results by Hoque & Liu (2022), Islamic banks have a lower capacity to respond to risks; hence they are in a disadvantaged position relative to the CBs regarding capital structure management. As such, IBs have the onus to expand their financing tools as well as the funding sources for the reduction of adjustment and enhance their capacity to deal with risk. Liability Islamic banks must gather deposits and outside funds like conventional banks provide funding for the growth of the actual economy in society. IBs must then use these resources to finance readily available assets, for instance, mortgages and commercial loans. Profit-sharing investment accounts, demand deposits and savings deposits comprise an Islamic bank’s liabilities. In principle, IBs should have a different capital structure than CBs because Islamic banks obtain funding from profit-sharing investment account (Toumi, 2021). Investment account holders (IAHs) do not have any influence over or governance powers over Islamic banks, even though profit-loss sharing (PLS) investment accounts adhere to Shariah principles and can be utilized in place of conventional interest-bearing deposits. IBs typically do not opt to transfer the loss to IAHs even if the investments earn a negative return while still offering competitive returns. IAHs may deposit money into different financial institutions if the return accrued is no longer competitive. The shifted commercial risk is, therefore, probable to materialize. It illustrates how IBs could risk equity 10 discovered that conventional banks make more money than conventional ones, with a Return on Asset ratio nearly three times as high. However, the comparison between the chosen bank’s profitability throughout 2000–2007 showed significant growth, indicating a promising future for Islamic banks (Ahmad & Saif, 2010). The authors propose that to increase public acceptance of the Islamic financial system, Islamic banks should create new markets and accounting procedures (Hanif, 2014). The researcher asserts that a bank’s primary source of funding is the deposits made by its clients. Ahmad & Saif (2010) made another attempt to compare the profitability of Islamic and conventional banks and finance companies in Malaysia using empirical methods. In order to investigate the gap, the author produces six profitability ratios, including return on assets and return on deposits ratios. They discovered that compared to traditional interest-based banks, the ratio outcomes for Islamic banks are much greater. However, the author argues that this is since Islamic banks’ overhead costs are discounted, which lowers their operating costs, and that Riba still needs to be eliminated from the Islamic banking system (Abdul-Majid et al., 2010). To fully create the system per the criteria of religion, they should improve risk sharing in their roles. Additionally, this improvement will guarantee business success. The author goes on to say that by utilizing the ideas of economies of scale and economies of scope, Islamic banks can increase their profitability. By focusing on moral concerns, this objective can be accomplished. Given that the Islamic banking system is still in its infancy, the abovementioned higher results for Islamic banks in Pakistan could be explained by the empirical findings of two authors Ahmad & Saif (2010), who investigated how underdeveloped financial systems exhibit higher profitability but lower levels of efficiency. These results were obtained by choosing banks from both industrialized and developing nations as samples. The authors calculated various profitability and efficiency ratios for the purposes mentioned earlier. The 11 regression results demonstrated that higher bank development lowers bank profits while increasing bank efficiency as bank rivalry increases. Similar results were found in a study undertaken by Faizulayev (2011), which sought to understand how Islamic banks control their profitability. Their conclusions were based on comparing the ROE and ROA ratios analysis. The findings imply that Islamic banks are more profitable than traditional banks. Additionally, it has been discovered that Islamic banks are more creditworthy and less susceptible to the Return on Assets’ cyclical character. Conclusion The Islamic economic system, based on justice and morality, includes Islamic banking and finance and has the favor of modern financial revolution due to capacity to foster economic equality and sustain profitability Because it is interest-free, Islamic banking differs from regular banking. Islamic banking has distinct risk profiles and operates according to distinct principles. The government and central bank, which also regulate conventional banks, are the first regulation that applies to Islamic banks. The second type of regulation is provided by the Shariah Supervisory Board, which also approves the output of Islamic banks and monitors compliance with the board’s rules. The central bank sets down some regulations unique to Islamic banking. For instance, establishing an Islamic bank requires greater minimum capital than opening a conventional bank. Because Islamic banking is asset-based and requires the bank to own the products it later sells, which ultimately are paid for by the client, it raises the cost. As a result, Islamic banks must pay higher taxes and registration fees. Even though it is a relatively new idea in modern times, international finance is one of its fastest-growing sectors. By offering a variety of credit contracts, it helps its clients raise their economic standards. Importantly, Islamic banks do not provide any interest-bearing goods or services, and they have a Shari’ah board overseeing their organizational structure and 12 corporate governance to guarantee that their business activities comply with Islamic law and do not mistreat less advantaged customers.