Sample Finance Essay Paper on Islam Banking

Islam Banking

The financial crisis the plunged the financial markets over the past years have affected diverse conventional banks on a global platform. Conversely, Islamic banks were largely insulated from the crisis. According to El-Moussawi and Obeid, Islamic banks were relatively from such negative effects as the Shariah principles under which they operate prohibited them from investing in most of the instruments which were adversely affected by the financial recession. Conventional banks had therefore accumulated types of instruments that were adversely affected greatly during the recession. Ultimately, these Islamic banks operate in significantly different macroeconomic environments compared to conventional banks (El-Moussawi & Obeid 2011, p. 181). For example, Islamic and conventional banks differ in their performances which in the microeconomic context refer to technical efficiency. This is because Islamic banks, under the Shariah principles, operate under significantly lower technical efficiency compared to traditional banks for different reasons. Foremost, Islamic banks apply strict Shariah rules. This translates to the fact that, several of Islamic banking products are not standardized. This increases operational costs. Consequently, Islamic banks are regarded as typically small in comparison to conventional banks.

According to Hasan and Dridi (2010, p. 181), technical effectiveness increases with magnitude in the banking industry. According to Jill, Marwan, and Vasileios (2012, p. 3), most Islamic banks are owned by locals. They also hold that claims that banks owned by foreigners are theoretically more resourceful than their family-owned counterparts lack any substantial evidence. Consequently, Islamic banks are often under constant pressure to continue innovating. Western investors are increasingly more attracted to the traditional values associated with Islamic banking and financial principles leading to significant pressure on Islamic banks.  These Western investors are often disheartened with the banking performances of traditional banks. Such disillusionment was further enhanced by the recent financial crisis that gripped the global economies (Hassan, Mohamad & Bader 2009, p. 57). Consequently, the appetite for Islamic investment products has been growing stronger as. This according to Cihak and Hesse is because, Islamic banks not likely to fail into fail category as the conventional banks. As a result, Islamic banks are no longer regarded as only features of traditional Muslim regions bearing in mind there are more than three hundred financial institutions spread across seventy countries (Čihák & Hesse 2010, p. 107).

 Currently, there are at least five Islamic banks in the United Kingdom which is acknowledged as the only country in European Union to have Islamic banks. There are also nineteen Islamic financial institutions in United States. Therefore, based on critical and in-depth analysis of both banking systems, it is evident that the two banking systems have widespread interest. Differentiating the two banking industries however requires a focus on countries with at least a sixty percent Muslim population. This percentage will provide more accurate results in comparing Islam and conventional banks as there is sufficient data to refer to for the evaluation to be effective and reliable (Mona 2013, p. 8). By comparing the populations, Ariss states there is strong competition between Islamic and conventional banks. Ariss also asserts that, it is also likely that the degree of competition between Islamic and conventional banks will continue to grow (Ariss 2010, p. 96). This is because Islamic banking products are increasingly appealing to consumers from other religious groups other than Islam. For example, Alexakis and Tsikouras asserts that there are large ratings by agencies like Moody’s as they have commenced to acknowledge Islamic finance is equally important and influential like conventional banking (Alexakis & Tsikouras 2009, p. 97).

Several researchers including have been seeking to distinguish gross and net efficiency between Islamic and conventional banks. Gross efficiency refers to both managerial and efficiency managerial competiveness arising from modus operandi. Conversely, net efficiency refers to the ability of managers to offer manage the banks efficiently. Abdul-Majid, Saal and Battisti (2010, p. 32), conducted a study in banks located in Malaysia to determine gross efficiency. The scores were based on the banks’ SFA. They also applied cost function to determine gross efficiency among conventional banks while making no allowance for various characteristics of each bank. The researchers also sought to differentiate net efficiency scores between Islamic and conventional banks. The process involved determining estimated scores of net efficiency. This was achieved by including banks’ operating characteristics to the SFA cost function (Koutsomanoli-Filippaki, Margaritis & Staikouras 2009, p. 561).

 The research study reveals that traditional banks had significantly higher gross efficiency compared to Islamic banks (Abdul-Majid, Saal & Battisti 2011b, p. 2387). The significance of the Islamic dummy costs included ing environmental variables were applied by the researcher to suggest that, the differences are significant in proving Islamic and conventional banks is different. Thus, traditional banking systems are more efficient compared to Islamic banking systems in regard to gross and net efficiencies. The researchers have asserted that, the traditional banking systems’ mode of operation is more efficient compared to Islamic banking system due to the following reasons (Abdul-Majid, Saal & Battisti 2011a, p. 2123).

First, Islamic banks operate mainly with customized contracts. The contracts can either be equity-type or service-type. Equity-type contracts refer to an equal profit and loss sharing system while services-type contracts refer to where leasing agreements and mark-up pricing sales determine the sharing ratios. Islamic banks therefore operate as guided by contracts which are developed as diverse relevant parameters including collateral and repayments. Islamic banks acting as the financer therefore requires that feasibility studies are conducted. They also analyze profitability of all equity-related contracts. To conduct this analysis, the process is costly and time-consuming and Islamic banks have to incur the costs associated (Shahid, Rehman, Niazi & Raoof 2010, p. 37). Consequently, Islamic banks are required to gain approval for their financial products. The approvals are acquired from the Shariah board of the bank. The approvals are done for every Islamic bond issue which is known as sukuk as well as for every majority of equity-based contracts. The fee-based contracts are however more standardized hence, rarely requiring approval from the Shariah board. This however does not hinder all Islamic banks from sustaining more administration overheads and operational risks compared to costs and risks involved in running conventional banks (Srairi 2010, p. 51). Additionally, Islamic bank managers are required to make-up for the disadvantages associated with the Islamic banking system. As a result, they are required to be more efficient than the managers found in conventional banking systems. This investigation of Islamic and conventional banks therefore reveals inter-bank variations in regard to efficiency. This is because both Islamic and conventional banking systems consider various operational characteristics including the operation environment. This is because they influence both gross and net operational efficiency (Awdeh & El-Moussawi 2009, 17).

According to Said, another difference between Islamic and conventional banks can be identified by taking into account of key variables including their macroeconomic environment and bank-specific characteristics of two banking systems differing in their gross operational efficiency. Islamic banks, in particular, had significantly higher net operational efficiency compared to traditional banks (Said 2012, p. 159). Consequently, the type efficiency for Islamic banks is lower than conventional banks. The authors therefore assert that, the Islamic method of banking record lower efficiency than conventional banking systems. This discovery is in line with the fact that, Islamic banks comply with Shariah law. More so, efforts undertaken by managers within Islamic banks in order to recoup competence gone astray due to modus operandi affirms conventional banks employ managers who have received more intense training (Sufian 2009, P. 127). 

Thus, the expanding demand levels for Islamic financial products should be used as a coincidence to affirm that Islamic bank managers ought to improve managerial efficiency. This is because Islamic and conventional bank managers differ basically in regard to how they undertake bank operations. According to Turk-Ariss (2010b, p. 782), the conventional bank intermediation is generally based on debt. More so, conventional banks allow transfer of risks. Conversely, Islamic banks are more asset-based. More so, they are mainly focused on risk sharing which is also widely known as the profit and loss sharing principle. Consequently, the Islamic law prohibits Islamic banks from practicing transactions that are speculative without a clear underlying principle. This explains why the financial crisis that was widespread across many global economies did not adversely affect Islamic banks. This is because they do not operate using the instruments that triggered the recent global financial crisis (Lozano-Vivas & Pasiouras 2010, p. 1441).

According to Ching and Liu, the principle of sharing profits and losses in the literature of Islamic law and economics is regarded as the most ideal base from the entire financial transaction. The same principle however in practice, based on the evidence acquired indicates that most financing transactions offered by Islamic banks are not in the form of profit and loss sharing principles (Chong & Liu, 2009, p. 132). Beck, Demirgüç-Kunt and Merrouche conducted an empirical study in 2010. The findings were applied in concluding that Islamic and conventional banking systems had relatively insignificant differences as actually assumed. More so, there are certain regulatory and supervisory challenges for countries facing the increasing entry of Islamic banks. Thus, the process of comprehending the Islamic banking based on the perspective of financial stability is critical for the following reasons. Foremost, it should be acknowledged that Islamic banks are likely to become systemically relevant as they continue to grow and increasingly interact with conventional banks that have proven to be systemically important. The second reason is based on the fact that, there is a lack of Islamic instruments for hedging results in the concentration risks in a small number of institutions. This reason has prompted financial researchers and experts to argue that, Islamic banks have special characteristics. These characteristics ought to be recognized and disclosed for the implementation of effective banking supervision. More so, the characteristics are also critical in the development of an optimal operation of Islamic banking in accordance with Sharia law (Beck, Demirgüç-Kunt & Merrouche 2010, p. 52).

According to Boumediene and Caby, small Islamic banks tend to be more stable than small conventional banks. Conversely, large conventional banks tend to be more stable than large Islamic banks. The authors have however found that, the increasing market share of Islamic banks does not have a significant influence on the stability of other banks. For example, the authors conducted a study to determine the stock return of Islamic banks and the conventional ones during the subprime crisis in 2007. The results indicated that, during that the crisis return volatility of Islamic banks was relatively lower than that of the conventional banks (Lewis 2010, p. 83). This indicates that, Islamic banks are more resistant than conventional banks. This however should not be applied as prove that Islamic banks are protected from various risks. Instead, it should be prove affirming conventional and Islamic banks have different risk characteristics necessitating a better understanding and more precise risk management (El-Moussawi & Obeid 2010, p. 183).

According to Turk-Ariss (2010a, p. 105), Islamic banks are less competitive than their conventional bank counterparts. More so, the bank profitability among Islamic banks increases significantly in the presence of market power. The author however asserts that, the presence of market power in regard to Islamic banks does not guarantee a higher level of profitability. This is because Islamic banks allocate a larger share of their assets to financing and capital ratios in comparison to conventional banks. It is therefore clear that, conventional banks operate in countries with a higher market share of Islamic banks as this enables them to be more cost-effective though less stable. As a result, higher capitalization and liquidity reserves among Islamic banks should be applied in explaining why Islamic banks performed relatively better than conventional banks during the recent crisis (Imam & Kpodar 2010, p. 35).


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