Islamic Banking Versus Commercial Banking: Prospects & Opportunities

ISLAMIC BANKING VERSUS
COMMERCIAL BANKING:
PROSPECTS & OPPORTUNITIES
OUTLINE
Principals and development of Islamic nance

Theory and prac<ce of Islamic nancial intermedia<on

Theore<cal & prac<cal dierences between Islamic & conven<onal banking

Comparison of nancial ra<os of Islamic and conven<onal banks

Future challenges

Areas for improvement and steps forward
ISLAMIC BANKING VERSES COMMERCIAL BANKING

I. Principals of Islamic nancial system
1) Prohibi)on of Interest (RIBA)
An excess Any unjus<able increase of capital whether are

loans or sales in the central tenant of the system.
Islamic regula<ons encourage the earning of prot but forbid
the charging of interest.

2) Money as a poten)al capital
It joins hands with other resources to undertake a produc<ve

ac<vity.

3) Risk sharing
When interest is prohibited, suppliers of fund become investors instead

of creditors.
Investors & nancial intermediary rela<onship is based on prot & loss
sharing principals.
4) Prohibi)on of specula)ve behavior
Discouraging hoarding & prohibits transac<ng featuring extreme

uncertain<es.
5) Sanc)ty of contracts
Upholding contractual obliga<ons & the disclosure as a sacred duty to

reduce the risk of asymmetric informa<on & moral hazard.

6) Sharing-approved ac)vi)es
Only ac<vi<es that dont violate the rules of shariah qualify for
investment.
Any business Dealing with alcohol, gambling or casinos is
prohibited.
7) Social jus)ce
In Principle , any transac<on leads to injus<ce & exploita<on is

prohibited.

II. Development & growth of Islamic nance
1) Development of Islamic nance
A rapidly growth part of the nancial sector in the world ( >15% annual
growth rate).
Not only Islamic countries, more than 300 nancial ins<tu<ons in over 50
countries prac<ce some form of Islamic nance.
The market current turnover is es<mated to be $350 Billion compared
with $5 Million in 1985.
Islamic nance industry has reached $1.4 Trillion by the end of 2011,
expected to be $4 Trillion over medium term.
Global conven<onal banks (HSBC, Ci<banketc.) have setups separate
windows to oer Islamic banking services.

2) Emergence & evolu)on of Islamic ins)tu)ons in recent history
In Muslim countries:
o 1963, local saving banks was established in Egypt to prac<ce their work on a none-
interest bases to enhance the banking habit.
o Aher 1974, many Islamic banks were established in dierent Muslim countries due to
the sharp increase of the oil prices.
o Sudan, Iran, Pakistan started the Islamiza<on of banking system during 1980s.
In the western world:
o In 1983 Islamic nance house started in Luxemburg.

o recently, besides establishing Islamic banks, Islamic windows in leading banks
pursuing this market very aggressively.
Theory & prac<ce of Islamic nancial intermedia<on

I. Basic contracts & instruments
1) Financing instruments
Used to nance obliga<ons arising from the trade and sale of

commodi<es or property and collateralized by the product being
nanced, such as:
a)Murabahah
A bank purchases a product for a customer who doesnt have a capital. Both
agree on a prot margin added to the cost, the customer should pay the bank
later the whole amount.
b)Bay Al-Muajjil
A sale transac<on with deferred payment allows the sale of a product on the
bases of deferred payment.

c) Bay Al-Salam
The buyers pays the seller the full price of a product which the seller promises to
deliver at a specic future date.
d) Ijarah
A medium term nancial instrument gives something in return for rent,

resembles the leasing contract.
e) Is<snah
To facilitate the manufacture of an asset at the request of the buyer. Once the
manufacturer undertakes to manufacture the asset for the buyer, the
transac<on of Is<snah comes into existence.

2) Inves)ng instruments
Vehicles for capital instrument in the form of a partnership.

a)Mudarabah
A fund management instrument , could be short, medium or long term,

whereby an investor entrust capital to an agent to undertake a project.
b)Musharakah
An equity partnership instrument which could be either medium or long

term partnership, where two or more persons combine either their
capital or their labor to share the prot & losses.
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II. Structure & components of nancial

statements for Islamic banks
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Theore)cal Balance Sheet of an Islamic bank based on maturity prole
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Theore)cal Balance Sheet of an Islamic bank based on func)onality
13

Composi)on of an Islamic bank Balance Sheet
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ISLAMIC BANKING DEPOSIT PRODUCTS

CONTRACT OF WADIAH
Wadiah is a contract ( akad )between the owner of goods and

custodian of the goods.
To protect the goods from being stolen, destroyed etc.
To ensure the safe custody of the goods
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CONTRACT OF WADIAH
17

CONTRACT OF WADIAH
Operates under the contract of Wadiah Yad Dhamanah

(guaranteed custody).
The bank accepts deposits from its customers looking
for safe custody and
convenience.
The bank requests permission to make use of the
customers funds for investment purposes.
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CONTRACT OF WADIAH
The customers may withdraw their balances at any

time.
Profit generated from the use of the customers
funds belongs to the bank.
However, the bank may at its absolute discretion
rewards the customers by declaring profits to them.
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CONTRACT OF WADIAH
DISCRETIONARY REWARD
Under the contract of Wadiah, the custodian i.e. the Bank is not
allowed to mention or to promise any reward on the deposit
received.
The owner/depositors too cannot demand any rewards or
return from their Bank on their savings.
Wadiah is purely a contract on safe custody of goods without
any promise on rewards or returns.
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CONTRACTOF QARDH
Qardh literally means a debt or loan without interest

.
There should be no promise of return or reward either by the borrower
or the lender.
The Bank may use an appropriate portion of its fund to provide
benevolent loans to certain selected customers.
This is an act of social responsibility to help a person who is in need.
The borrower is obliged to pay only the principal amount of the loan.
The Bank cannot demand the borrower to pay anythingabove the
principal loan amount.
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CONTRACT OF MUDHARABAH
The depositor, who is the owner of the capital places a

specified sum of money with the Bank, (who acts as the
entrepreneur) for the purpose of participating in the profits
made from the utilisation of the fund.
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Operates under the contract of Mudharabah (Trustee Profit Sharing).
The Bank accepts deposits from its customers looking for investments
opportunities.
The customer is the Capital Provider, while the Bank acts as the
entrepreneur.
Both parties agree with the profit distribution / sharing ratio.
The customer does not participate in the management of the funds.
In the event of a loss, the customer bears all the losses.
Profits generated from the use of the customers funds will be distributed
according to the predetermined ratio.
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ISLAMIC BANKING FINANCING PRODUCTS
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III. Islamic nancial ins<tu<ons in prac<ce
Early forms of Islamic nancial ins<tu<ons were concentrated in commercial

banking ac<vi<es, todays Islamic nancial ins<tu<ons can be divided into
the following broad categories
1) Islamic banks
Could be public or private sector.

A hybrid of conven<onal commercial banks & investment banks, it
resembles universal banks.
2) Islamic windows
A setup in a conven<onal bank that oer Shariah-compliant product.
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3) Islamic investment banks & funds
Aiming to capitalize on large investment syndica<ons, market-making

and under wri<ng opportuni<es.
Succeeded in developing innova<ve large-scale transac<ons in
infrastructure nance.
4) Islamic mortgage companies
Targeted at the housing market for Muslim communi<es in western

countries.
Four models:
1.
2.
3.
4.
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Ijarah.
Equity partnership (diminishing Musharaka).
Murabahah. (sales transac<on).
Along the lines of corpora<ve socie<es.

5) Islamic insurance companies (Takaful)
Takaful means mutual or joint guarantee. The par<cipants agree to share

their losses by contribu<ng periodic premiums in the form of investment.
They have to redeem the residual value of prots aher fullling the claims
and premiums, which is a cri<cal dierence between contemporary
insurance and Takaful. Takaful is a given solidarity.
6) Mudaraba companies
Similar to that of closed-end fund managed by specialized professional

management companies. Unlike the Islamic bank, they are not allowed to
accept deposits. Funded by equity capital.
Two types; Mul<purpose (more than one investment purpose) and
Specic purpose.
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Theore<cal & prac<cal dierences between Islamic &

conven<onal banking
I. Dierent concepts of borrowing, nancing & investment
1) Dierent modes of borrowing
According to the state banks of Pakistan 2008, conven<onal banks

average for deposits ranged from 2.09% - 2.30% per annum while
borrowing rate average ranged from 11.20% - 11.56%. The dierence is
7.82%. Islamic banks average rate on PLS deposits ranged from 3.5% to
3.79%. Prot & loss sharing deposits earn more than 1% higher.
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conven<onal banking
2) Dierent modes of nancing
Conven<onal banks high rates of interest on all types of loans. Which may
be the cause of the business failure & the default of the loan. Islamic bank
provides loans on prot & loss (PLS) bases, and only for produc<on
purposes.
3) Dierent modes of investment
Conven<onal banks; 50% in government treasury bills, bonds, term

nance cer<cates for security, they suer badly in case of stock market
crash.
Islamic banks; can not invest in government bonds. Nevertheless, the
Sukuk issued by Islamic government would act as a prac<cal solu<on for
(IB) liquidity.
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conven<onal banking
II. Dierent visualiza<on of the role of money
1) Conven)onal banks
Uses interest to make money out of money. They use money as a

commodity which is bought & sold.
2) Islamic banks
Use money as a medium of exchange to facilitate trade transac<ons. They

supply money to traders to purchase real assets or industrialists to
produce value-added products. If nance takers generate prot they will
share it with the Islamic bank. If they suer losses the bank will share the
loss.
30

conven<onal banking
III. Dierent altude of risk sharing & income distribu<on
1) Dierent concepts of risk sharing
Conven<onal banks; being interest rates based, their depositors do not

share the risk with the bank in case of economic shock. Also banks
receive xed rates from borrowers regardless their losses in case of
business failure.
Islamic banks; their deposits and investors are ready to share risk with
the bank in case of nancial shocks. The bank as well, is responsible to
take risk in case of business failure.
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conven<onal banking
2) Dierent approaches of income distribu)ons
The interest-based nancial system is pro-rich and an< poor, unlike

Islamic nancial system which play a vital role in eradica<on of poverty
through Zakat and prot & loss sharing principle.
3) Having dierent objec)ves and goals
Islamic bank works for all benet of the overall society and for equitable
alloca<on of resources through credit distribu<on. While the
conven<onal bank works for a specic class that is rich.
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Comparison of nancial ra<os of Islamic and

conven<onal banks
Based on the ndings of a recent research in Pakistan on two similar groups of
conven)onal & Islamic banks (Average of 6 banks each group).
1) Earning ra)os
Islamic Banks
Conventional
Banks
(ROA) Return on Assets
0.079
-0.75
(ROD) Return on Deposits
0.07
-0.93
(ROE) Return on Equity
1.297
-2.27
(EPS) Earning per Share
0.38
-0.34
Ratios
33

conven<onal banks
3) Debt management ra)os
Islamic Banks
Conventional
Banks
Debt / equity
2.3
8.0
Deposit times capital
3.78
5.71
Debt / assets
0.78
0.85
Equity / equity + debt
31.3
17.17
Ratios
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conven<onal banks
2) Asset quality management
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Ratios
Islamic Banks
Conventional
Banks
NPLs / advances
Non-performing loans / advances
1.06
5.88
Provisions / NPLs
Provision / non-performing loans
47.09
40.89
NPL / deposits
Non-performing loans / deposits
1.22
6.24

conven<onal banks
4) Liquidity ra)os
Islamic Banks
Conventional
Banks
Earning assets / total assets
95%
93%
Advances / deposits
83%
70%
Yield on earning assets
2.7%
1.83%
Ratios
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conven<onal banks
5) Solvency ra)os
Islamic Banks
Conventional
Banks
Equity / total assets

Capital adequacy ratio (CAR)
21.78%
14.59%
Equity / deposits
36.2%
20.09%
The earning assets / deposits
143.79
115.98
Ratios
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6) Cash to deposit ra)o

Ratios
Islamic Banks
Conventional
Banks
Cash & balance / total deposits
11.55%
12.55%
Islamic Banks
Conventional
Banks
Investments / deposits
15.39%
23.85%
Investments / total assets
4.37%
9.25%
Islamic Banks
Conventional
Banks
Borrowing / total assets
4.37%
4.25%
Borrowing / total deposits
5.86%
11.92%
Borrowing / total advances
12.93%
16.05%
7) Investment to deposit ra)os

Ratios
8) Borrowing ra)os
Ratios
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Future Challenges
1) Liquidity
Liquidity- enhancing nancial instruments & the development of capital

market.
2) Limited scope
Can benet from economies of scale &enhancement of scope. Both

approaches oer diversica<on benets.
3) Concentrated banking
Diversifying their base of depositors, reduce their exposure, introduc<on

of Internet banking, geographical diversity on the liabili<es side.
4) Concentrated banking
Risk management framework can be enhanced by improving the

transparency in current nancial disclosure.
Measurement & management of risk need to be supplemented with
analy<cal method.
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Areas of improvement & steps forward
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To enhance Financial Engineering that includes the design, development &

implementa<on of innova<ve nancial instruments, new securi<es or new
process of crea<ve solu<on to corporate nance problems, provided to be
Shariah complaint.
There is need to establish suppor<ng ins<tu<ons to act as a Lender of Last
Resort .
There is need to achieve Uniformity in, & Harmoniza)on of, Shariah Standards
across markets & borders.
To develop Fee -Based Services like, Joalah, Wakalah & Kifalah to exploit the
full capabili<es of Islamic banks by diversifying the scope of non bank nancial
services.
Developing benchmarks based on the rate of return reec<ng Islamic modes
of nancing instead of using interest base benchmarks such as the London
interbank oered rate (LIBOR) which has been accepted on an adhoc based.
Crea)ng a secondary market to enhance the liquidity, & standardizing
contracts, to reduce the risk of asset backed securi<es.
Areas of improvement & steps forward

Standardizing the opera)ons & instruments will pave the way for pooling
assets, much needed for enhancing liquidity in the market.
By expanding the scope of services, Islamic bank could spread the xed
costs since they are similar to universal banking in a form of hybrid between
commercial & investment banking.
Having a Shariah board for every ins<tu<on is not ecient. A Shariah board
for the system as a whole is needed to ensure that rules are dened &
enforced in compliance with the contractual obliga<ons to all stockholders.
Well developed Islamic capital market will benet borrowers, ins<tu<onal
investors, together with enhancing the stability of Islamic banks.
A well developed Islamic micronance industry will promote economic
development in underdeveloped Islamic countries, also it will economically
empowered the poor segments of society since they will be able to move
from being non-bankable to bankable, this will expand the base of the
depositors & investors.
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Questions?
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ISLAMIC BANKING VERSUS

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Principals and development of Islamic nance

An excess Any unjus<able increase of capital whether are

2) Money as a poten)al capital

It joins hands with other resources to undertake a produc<ve

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Principals and development of Islamic nance

When interest is prohibited, suppliers of fund become investors instead

4) Prohibi)on of specula)ve behavior

Discouraging hoarding & prohibits transac<ng featuring extreme

Upholding contractual obliga<ons & the disclosure as a sacred duty to

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Principals and development of Islamic nance

In Principle , any transac<on leads to injus<ce & exploita<on is

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Principals and development of Islamic nance

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Principals and development of Islamic nance

In the western world:

o In 1983 Islamic nance house started in Luxemburg.

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Theory & prac<ce of Islamic nancial intermedia<on

Used to nance obliga<ons arising from the trade and sale of

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Theory & prac<ce of Islamic nancial intermedia<on

A medium term nancial instrument gives something in return for rent,

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Theory & prac<ce of Islamic nancial intermedia<on

Vehicles for capital instrument in the form of a partnership.

A fund management instrument , could be short, medium or long term,

An equity partnership instrument which could be either medium or long

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Theory & prac<ce of Islamic nancial intermedia<on

II. Structure & components of nancial

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Theory & prac<ce of Islamic nancial intermedia<on

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Theory & prac<ce of Islamic nancial intermedia<on

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Theory & prac<ce of Islamic nancial intermedia<on

ISLAMIC BANKING VERSES COMMERCIAL BANKING

Theory & prac<ce of Islamic nancial intermedia<on

ISLAMIC BANKING VERSES COMMERCIAL BANKING

ISLAMIC BANKING DEPOSIT PRODUCTS

Wadiah is a contract ( akad )between the owner of goods and

ISLAMIC BANKING VERSES COMMERCIAL BANKING

ISLAMIC BANKING DEPOSIT PRODUCTS

ISLAMIC BANKING VERSES COMMERCIAL BANKING

ISLAMIC BANKING DEPOSIT PRODUCTS

Operates under the contract of Wadiah Yad Dhamanah

ISLAMIC BANKING VERSES COMMERCIAL BANKING

ISLAMIC BANKING DEPOSIT PRODUCTS

The customers may withdraw their balances at any

ISLAMIC BANKING VERSES COMMERCIAL BANKING

ISLAMIC BANKING DEPOSIT PRODUCTS

ISLAMIC BANKING VERSES COMMERCIAL BANKING

ISLAMIC BANKING DEPOSIT PRODUCTS

Qardh literally means a debt or loan without interest

ISLAMIC BANKING VERSES COMMERCIAL BANKING

ISLAMIC BANKING DEPOSIT PRODUCTS

The depositor, who is the owner of the capital places a