ISLAMIC AND CONVENTIONAL

BANKING COMPARATIVE ANALYSIS

PAKISTAN’S PERSPECTIVE

SAID ALI
L3F09PMBA0114

MASTER IN BUSINESS ADMINISTRATION

FACULTY OF COMMERCE
UNIVERSITY OF CENTRAL PUNJAB
LAHORE, PAKISTAN
ACKNOWLEDGEMENT
First of all I would like to thank my Allah Almighty, Who gave me the courage, health, and
energy to accomplish my thesis in due time and without Whose help this study which
required untiring efforts would have not been possible to complete within the time limits.

Special thanks go to my friend Nawel Mekkawi who helped me with compiling data from the
various banks‘ financial statements.

I appreciate the many helpful review comments from my thesis Supervisor Mr. Bilal Sarwar
in improving my dissertation.

Last but not least, I extend my thanks to my entire family for moral support and prayers for
my health and encouragement during my work on this dissertation.
TABLE OF CONTENTS
Sr. No. Description Page No.
List of illustrations and tables 1
Preface 2
Executive Summary 3
Chapter 1 Introduction and overview 4

1.1 Definition of banking; conventional & Islamic 4

1.2 Brief history of banking (conventional and Islamic) 6
1.3 Types of banks 9
1.4 Instruments of conventional banking 10
1.5 Instruments or modes of Islamic finance 13
1.6 Islamic banking in Pakistan 15
1.7 Conventional vs. Islamic banks – theoretical perspective 16
1.8 Structure of financial sector of Pakistan 19
1.9 Financial Statements of a Conventional & Islamic 23
Banks – A Dissection
Chapter 2 Literature review 27

Chapter 3 Research and methodology 34

3.1 Analysis techniques 34

3.2 Financial ratio analysis 35
3.2.1 Liquidity ratios 35
3.2.2 Profitability ratios 37
3.2.3 Risk and solvency ratios 38
3.2.4 Efficiency ratios 42
3.3 Underlying assumptions of the comparative analysis 45
3.4 Limitation of financial analysis 46
3.5 Empirical results 47
3.5.1 Liquidity ratios analysis 47
3.5.2 Profitability ratios analysis 50
3.5.3 Risk and solvency ratios analysis 54
3.5.4 Efficiency ratios analysis 59
Chapter 4 Concluding Remarks 63

4.1 Summary of Findings 63

4.2 Conclusion 65
4.3 Recommendations 66
Bibliography 67
Appendices 72
Appendix A Tables of ratio analysis 72
Appendix B Comparative analysis of Islamic financing products 80
Appendix C Glossary of terms 82
Websites 87
 LIST OF THE ILLUSTRATIONS AND TABLES

Table 1.1 Structure of the financial system of Pakistan – 2008……………………..….20

Figure 1.1 A pictorial depiction of the financial system of Pakistan – 2008………….....22
Table 1.2 Balance sheet of a conventional bank – based on functionality……………...23
Table 1.3 Balance sheet of an Islamic bank – based on functionality…….………….…24
Figure 3.1 Loan to Deposit Ratio (LDR)………………………………….………….….47
Table 3.1 Loan to Deposit Ratio (LDR)………………………………….……………..47
Figure 3.2 Cash & Portfolio Investment to Deposit Ratio (CPIDR)…………………….48
Table 3.2 Cash & Portfolio Investment to Deposit Ratio (CPIDR)…………………….48
Figure 3.3 Loan to Asset Ratio…………………………………………………………..49
Table 3.3 Loan to Asset Ratio…………………………………………………………..49
Figure 3.4 Return on Assets Ratio……………………………………………………….50
Table 3.4 Return on Assets Ratio……………………………………………………….50
Figure 3.5 Return on Equity Ratio……………………………………………………….51
Table 3.5 Return on Equity Ratio……………………………………………………….51
Figure 3.6 Earning per share Ratio………………………………………………………52
Table 3.6 Earning per share Ratio………………………………………………………52
Figure 3.7 Profit to Expense Ratio…………………………………………………….…53
Table 3.7 Profit to Expense Ratio…………………………………………………….…53
Figure 3.8 Debt to Equity Ratio……………………………………………………….…54
Table 3.8 Debt to Equity Ratio……………………………………………………….…55
Figure 3.9 Debt to Total Assets Ratio……………………………………………………55
Table 3.9 Debt to Total Assets Ratio……………………………………………………56
Figure 3.10 Equity Multiplier Ratio………………………………………………………56
Table 3.10 Equity Multiplier Ratio……………………………....………………………56
Figure 3.11 Capital Adequacy Ratio………………………………………………………57
Table 3.11 Capital Adequacy Ratio………………………………………………………57
Figure 3.12 Non Performing Loans to Net Loans Ratio…………………………………..58
Table 3.12 Non Performing Loans to Net Loans Ratio…………………………………..58
Figure 3.13 Asset Utilization Ratio………………………………….…………..………..59
Table 3.13 Asset Utilization Ratio……………………………………..…….…………..59
Figure 3.14 Income to Expense Ratio……………………………………………………..60
Table 3.14 Income to Expense Ratio……………………………………………………..60
Figure 3.15 Operating efficiency Ratio…………………………………………………...61
Table 3.15 Operating efficiency Ratio…………………………………………………...61
Table 3.16 Comparison of Islamic Banks' and Conventional Banks' Financial Ratios...62

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PREFACE
Islamic banks have managed to position themselves as an additional and alternate financial
institution which offers banking facilities similar to conventional banks in almost most of the
countries of the world, though started few decades ago.
In Pakistan, Islamic banking and finance started in eighties with the elimination of interest in
compliance with the Principles of Islamic Shari‘ah. But the initiative to introduce Islamic
Banking was launched back in 2001 after the Supreme Court verdict on elimination of
interest from the financial system of the country, the government decided to promote Islamic
banking in a gradual manner and as a parallel and compatible system that is in line with best
international practices.
The performance evaluation of Islamic Banks is especially important because of globalization
effect, as globalization has put Islamic Banks in tough competition with conventional banks
in almost all markets of the world. Some countries of the world have allowed Islamic banking
industry as parallel financial system while some have just started with experimental models,
while some are still studying it as a viable financial system. The existing research in Islamic
Banking and finance has focused primarily on the conceptual issues underlying interest free
banking.

This paper is organized in four chapters; chapter 1, Introduction and overview describe the
theoretical framework of banking, Islamic banking, various modes of finance in conventional
and Islamic Banking, financial structure of Pakistan and a dissection of the financial
statements of both types of banks. Chapter 2 describes the literature review on Islamic
banking performance vis-à-vis conventional banking in various countries of the world.
Chapter 3, gives the research methodology and various financial ratio analysis used for the
performance review of both types of banking systems on sample basis over the period of 5
years 2004-2008 and also the empirical findings. While Chapter 4, consists of Concluding
remarks, which summarizes the findings, conclusion on the performance review of both types
of banks in Pakistan and gives few recommendations.

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EXECUTIVE SUMMARY
This dissertation analyses the performance of Islamic vis-a-vis conventional banks in
Pakistan over the period of 2004-2008. Pakistan has been chosen as a focal point for the
study since both types of banks are performing in the market and there has been no such
study previously in the country. The study investigates whether Islamic banks are performing
well in Pakistan compared to the conventional banks. Financial ratio analysis for liquidity,
profitability, risk, solvency and efficiency analysis of the sample of banks from both
categories was performed to test the overall performance. The results indicate that Islamic
banks in Pakistan have better asset quality, more liquid, profitable compared to their
counterpart Conventional Banks. Finally, total expenses in conventional banking are high
which affects profitability and significant amount of non performing loans affect their
solvency and increases credit risk.

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CHAPTER 1 INTRODUCTION & OVERVIEW OF THE TOPIC

1.1 BANKING – DEFINED

From the Italian banca meaning 'bench', the table at which a dealer in money worked. A bank
is now a financial institution which offers savings and cheque accounts, grant loans and
provides other financial services, making profits mainly from the difference between interest
paid on deposits and charged for loans, plus fees for accepting bills and other services
(Carew, 1996).

A bank is defined by Merriam-Webster‘s online dictionary (Merriam Webster Dictionary) as

‗‗an establishment for the custody, loan, exchange, or issue of money, for the extension of
credit, and for facilitating the transmission of funds.‘‘

According to Oxford English Dictionary (Oxford English Dictionary), Bank is an

organization offering financial services, especially the safekeeping of customers‘ money until
required and making loans at interest. 2 (the bank) the store of money or tokens held by the
banker in some gambling or board games.

According to Banking Companies Ordinance (1962), ―banking means the accepting, for the
purpose of lending or investment, of deposits of money from the public, repayable on demand
or otherwise, and withdrawal by cheque, draft, order or otherwise.‖

Islamic banking has been defined as banking in consonance with the ethos and value system
of Islam and governed, in addition to the conventional good governance and risk management
rules, by the principles laid down by Islamic Shari‘ah. Interest free banking is a narrow
concept denoting a number of banking instruments or operations, which avoid interest.
Islamic banking, the more general term is expected not only to avoid interest-based
transactions, prohibited in the Islamic Shari‘ah, but also to avoid unethical practices and
participate actively in achieving the goals and objectives of an Islamic economy (Islamic
Banking Department, 2008) .

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Banking activities conducted in accordance with the Islamic Shari‘ah principle is said to be
Islamic banking. The main sources of Shari‘ah are Quran and Hadeeth which has specifically
forbidden usury (interest in the modern form) from all transactions, as enjoined in the
following verses from the Holy Quran.

1. First Revelation (Surah al-Rum, verse 39)

"That which you give as interest to increase the peoples' wealth increases not with God; but
that which you give in charity, seeking the goodwill of God, multiplies manifold." (30: 39)

2. Second Revelation (Surah al-Nisa', verse 161)

"And for their taking interest even though it was forbidden for them, and their wrongful
appropriation of other peoples' property. We have prepared for those among them who reject
faith a grievous punishment (4: 161)"

3. Third Revelation (Surah Al 'Imran, verses 130-2)

"O believers, take not doubled and redoubled interest, and fear God so that you may prosper.
Fear the fire which has been prepared for those who reject faith, and obey God and the
Prophet so that you may receive mercy."

4. Fourth Revelation (Surah al-Baqarah, verses 275-81)

"Those who benefit from interest shall be raised like those who have been driven to madness
by the touch of the Devil; this is because they say: "Trade is like interest" while God has
permitted trade and forbidden interest. Hence those who have received the admonition from
their Lord and desist may keep their previous gains, their case being entrusted to God; but
those who revert shall be the inhabitants of the fire and abide therein forever." (275)

"God deprives interest of all blessing but blesses charity; He loves not the ungrateful sinner."
(276)

"Those who believe, perform good deeds, establish prayer and pay the zakat, their reward is
with their Lord; neither should they have any fear, nor shall they grieve." (277)

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"0, believers, fear Allah, and give up what is still due to you from the interest (usury), if you
are true believers." (278)

"If you do not do so, then take notice of war from Allah and His Messenger. But, if you
repent, you can have your principal. Neither should you commit injustice nor should you be
subjected to it." (279)

"If the debtor is in difficulty, let him have respite until it is easier, but if you forego out of
charity, it is better for you if you realize." (280)

"And fear the Day when you shall be returned to the Lord and every soul shall be paid in full
what it has earned and no one shall be wronged. ― (281)

1.2 BRIEF HISTORY OF BANKING (CONVENTIONAL & ISLAMIC)

Emergence of conventional banking

Banking has been in existence in one form or other form throughout history of mankind from
prehistoric times to the modern times with more sophistication.

Major events in banking history;

- Florentine Banking - The Medicis and Pittis among others

- Knights Templar- earliest Euro wide /Mideast banking
- 1100-1300.Banknotes - Introduction of paper money
- 1602 - First joint-stock company, the Dutch East India Company founded
- 1720 - The South Sea Bubble and John Law's Mississippi Scheme, which caused a
European financial crisis and forced many bankers out of business
- 1781 - The Bank of North America was found by the Continental Congress
- 1800 - Rothschild family founds Euro wide banking.
- 1803 - The Louisiana Purchase was the largest land deal in history
- 1929 - Stock market crash
- 1989 - junk bond scandal and charges against Michael Milken resulted in new legislation
for investment banks
- 2001 - Enron bankruptcy, causing new legislation for annual reporting.

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Oldest Private Banks
- Barclays which was founded by John Freame and Thomas Gould in 1690. The bank was
renamed to Barclays by Freame's son-in-law, James Barclay, in 1736.
- Hope & Co., founded in 1762.
- Barings Bank founded in 1806.
- Rothschild family 1700 - present.
Oldest national banks
- Bank of Sweden - The rise of the national banks
- Bank of England - The evolution of modern central banking policies
- Bank of America - The invention of centralized check and payment processing technology
- Swiss banking
- United States Banking
- The Pennsylvania Land Bank, founded in 1723 and receiving the support of Benjamin
Franklin who wrote "Modest Enquiry into the Nature and Necessity of a Paper Currency" in
1729 Imperial Bank of Persia (Iran) (Lonymics, 2009).

From Barter to Payment Systems

Money is the basis of banking. And the basis of money is the need for a substitute for directly
bartering for everything we need. ‗‗Barter‘‘ is defined as trading without the use of money—
and it can be traced back to the very origin of civilization. Can you imagine how our
economy would operate if we didn‘t use money? You would either have to be completely
self-sufficient or have to produce a good or service that you could trade for whatever you
could not produce yourself. Most of us would spend our time making almost everything we
needed (including growing food, building shelter, and making clothes) or working at a
specialty that others needed so we could trade for many of the necessities of life. The
specialties would be few. Our technological advances would be restricted by an incredibly
inefficient system of exchanging goods and services.

The development of money was a significant advance over barter as a payment system. But
today we have extended the concept of payment systems way beyond the original concept of
money. One of the first steps into more sophisticated payment systems was the development
of checks and checking accounts and more recently the development of plastic money.

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Banking also fulfills a valuable role in society by:

+ Playing a key role in financial intermediation,

+ Creating financial products and services that benefit businesses and consumers,

+ Driving a thriving financial system regulated by state and federal governments,

+ Facilitating the creation of money,

+ Being involved in the transfer of funds,

+ Reinventing the financial future - the future of banking (Dilley, 2008).

Brief history of Islamic banking

Islamic banking is new only with respect to the emergence of Western- style banking
institutions claiming to adhere to Islamic rules on the prohibition of interest. There have, of
course, always been various Islamic trusts and mutual societies concerned with helping
people through cash flow problems or with financing larger projects. The first modern
experiment with Islamic banking was undertaken in Egypt under cover without projecting an
Islamic image—for fear of being seen as a manifestation of Islamic fundamentalism that was
anathema to the political regime. The pioneering effort, led by Ahmad El Najjar, took the
form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963.
This experiment lasted until 1967, by which time there were nine such banks in the country,
and over the next three decades a diverse number of Islamic Banks, Islamic Investment
Banks, and Islamic Development Banks emerged, and eventually received government
backing in some Muslim countries, e.g. Pakistan, Malaysia, the Gulf States and across the
world. They have largely focused on trying to become major players in international banking
and developing instruments akin to those used by other banks whilst finding technical legal
explanations to accommodate those developments with the stipulations of Islamic Law. Thus
they can often be seen as an attempt to make banking practices more acceptable to Muslims
and to provide competition for non-Muslim banks (Islamic Party of Britain, 2003).

1.3 TYPES OF BANKS

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Banks come with a variety of names, and one bank can function as several different types of
banks. Following are the most common types of banks:

a. Retail banks

A retail bank is a bank that works with consumers, known as 'retail customers'
providing the most common banking services like checking and saving accounts,
customer deposits, auto or mortgage loans and running or short term finances.

b. Commercial banks

A commercial bank is a bank that works with businesses and individuals handling the
banking needs of large and small businesses in addition to the above mentioned retail
banking activities funded and unfunded facilities, both short and long term, locker
services, remittances, dealing in forex and so on.

c. Investment banks

Investment banks help companies use investment markets i.e. equity and debt markets
by helping issuing stocks or bonds, consultations on mergers and acquisitions, among
other things.

Some large investment banks also serve as commercial banks or retail banks.

d. Central banks

A central bank is an organization responsible for managing and supervising banking

activity in a country. In Pakistan, central bank is the State Bank of Pakistan. The
central bank has three primary goals:

 Conduct monetary policy

 Supervise and regulate financial firms

 Provide financial services including interbank clearance,

Most consumers do not interact with the central bank. Instead, large financial
institutions generally work with the central bank in the background. The central bank

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 is also expected to protect the economy from suffering the effects of any financial
crisis.

1.4 INSTRUMENTS OF CONVENTIONAL BANKING

Conventional banking and some concepts

Conventional banks are based on the capitalistic model of economics charging interest for the
man made factor of production i.e. capital, through dealing in money (taking deposits and
granting loans) during its normal operating activities.

Interest - defined

The standard dictionary definition for interest is as follows:

‗A charge made for a loan or credit facility‘. (Ismail, 2009)

According to Wikipedia encyclopedia

Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed
money, or, money earned by deposited funds. Assets that are sometimes lent with interest
include money, shares, consumer goods through hire purchase, major assets such as
aircraft, and even entire factories in finance lease arrangements. The interest is calculated
upon the value of the assets in the same manner as upon money. Interest can be thought of
as "rent of money" (Wikipedia).

Banks usually employ various products or instruments in order to perform its basic
banking function or the modern expanded activities.

Traditional banking operating activities are;

Exchange of currency,

Commercial notes and loans,

Offering saving deposits,

Safekeeping of valuables,

Supporting government activities with credit,

Fund transfer services,

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 Trust services.

Modern banks activities;

Consumer Loans,

Financial advices,

Cash management,

Equipment leasing,

Venture capital loans,

Selling insurance products, (bancassurance),

Securities underwriting and brokerage services,

Merchant bank services. (Dilley, 2008)

Some basic and widely used banking products and services are explained below:

Deposits

Traditional banking deposit products can be divided into four categories:

1. Transaction (current) accounts

2. Savings accounts

3. Fixed deposit accounts

4. Other

The features of these accounts vary considerably depending on the type of account, its
restrictions, and the specific policies of the bank where they are offered.

Loans and Other Credit Services

Loans and other credit services are an important and significant source of income for banks
and loans extended by banks mostly are secured. A secured loan is one in which an asset,
such as inventory or property or cash, is pledged against repayment of the loan. There are two
major categories of credit facilities: fund based loan facilities and non-funded facilities.

FUNDED CREDITS NON-FUNDED CREDITS

a) Current or running finance a) Letters of Credit

b) Term Finance b) Guarantees
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c) Syndication / Consortium Financing
d) Negotiations of Export bills under L/C - Shipping Guarantees
e) Preshipment Finance (Packing Credit) - Bid Bonds
f) Import Financing - Advance Payment Guarantees
- Performance Bonds

1) Finance against Trust Receipt (FTR) - Others

2) Finance against Imported Merchandise (FIM)
g) Contract Financing

Some of the modern expanded banking products are explained below;

Banking also includes a great variety of additional products and services that meet customers‘
financial needs. A few of these products and services are cash management and safe deposit
boxes.

Cash Management

Banking includes many services provided primarily to businesses under the umbrella term of
cash management. Cash management is a package of banking services that help keep funds
working, speed up the payment receipt process, and improve profitability.

A company can use cash management services in these ways as well as others:

- Balances in transaction accounts are kept low and other idle funds are maintained in
interest-earning accounts.

- Interest-earning funds are transferred into transaction accounts only when needed to
meet checks presented for payment.

- Lockbox services are used so that payments from customers are deposited more
quickly to the business‘s deposit accounts.

A lockbox is a collection system where customers—usually of a business—send payments to

a central location for the facilitation of rapid collection.

Typically a bank provides the service on behalf of its customers.

The bank commonly receives payment and facilitates speedy deposit into the customer‘s
deposit accounts.

Safe Deposit Boxes (Lockers)

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Another banking service that may be available to customers is a safe deposit box. Customers
rent metal boxes (various sizes are available) that are stored in a vault in the bank. In these
boxes, customers typically store valuable papers and small objects, such as family heirlooms.
The boxes have two locks so that unauthorized access is prevented; the customer has one key
and the bank has the other (Dilley, 2008).

1.5 INSTRUMENTS OR MODES OF ISLAMIC FINANCE

Principles of Islamic banking

Following are the six basic principles which are taken into consideration while executing any
Islamic banking transaction. These principles differentiate a financial transaction from a
Riba/interest based transaction to an Islamic banking transaction.

1. Sanctity of contract: Before executing any Islamic banking transaction, the counter parties
have to satisfy whether the transaction is halal (valid) in the eyes of Islamic Shari‘ah. This
means that Islamic bank‘s transaction must not be invalid or voidable. An invalid contract is a
contract, which by virtue of its nature is invalid according to Shari‘ah rulings. Whereas a
voidable contract is a contract, which by nature is valid, but some invalid components are
inserted in the valid contract. Unless these invalid components are eliminated from the valid
contract, the contract will remain voidable.

2. Risk sharing: Islamic jurists have drawn two principles from the saying of prophet
Muhammad (SAW). These are ―Alkhiraj Biddamaan‖ and ―Alghunum Bilghurum‖.

Both the principles have similar meanings that no profit can be earned from an asset or a
capital unless ownership risks have been taken by the earner of that profit. Thus in every
Islamic banking transaction, the Islamic financial institution and/or its deposit holder take(s)
the risk of ownership of the tangible asset, real services or capital before earning any profit
there from.

3. No Riba/interest: Islamic banks cannot involve in Riba/ interest related transactions. They
cannot lend money to earn additional amount on it. However as stated in point No. 2 above, it
earns profit by taking risk of tangible assets, real services or capital and passes on this
profit/loss to its deposit holders who also take the risk of their capital.

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4. Economic purpose/activity: Every Islamic banking transaction has certain economic
purpose/activity. Further, Islamic banking transactions are backed by tangible asset or real
service.

5. Fairness: Islamic banking inculcates fairness through its operations. Transactions based on
dubious terms and conditions cannot become part of Islamic banking. All the terms and
conditions embedded in the transactions are properly disclosed in the contract/agreement.

6. No invalid subject matter: While executing an Islamic banking transaction, it is ensured

that no invalid subject matter or activity is financed by the Islamic financial transaction.
Some subject matter or activities may be allowed by the law of the land but if the same are
not allowed by Shari‘ah, these cannot be financed by an Islamic bank.

Following are the modes of finance which are of three categories:

1) Participatory modes of Finance

a) Mudaraba

b) Musharaka

2) Non Participatory modes of Finance

a) Murabaha

b) Musawamah

c) Salam

d) Istisna

e) Ijarah

f) Ijarah wa Iqtina (Ijarah Muntahiyyah Bittamleek)

3) Sub contracts

a) Wakalah

b) Kafalah

c) Rahn

1.6 ISLAMIC BANKING IN PAKISTAN

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1980
Council of Islamic Ideology presents report on the elimination of Interest genuinely
considered to be the first major comprehensive work in the world undertaken on Islamic
banking and finance.

1985
Commercial banks transformed their nomenclature stating all Rupee Saving Accounts as
interest-free. However, foreign currency deposits in Pakistan and foreign loans continued as
before.

1991
Procedure adopted by banks in 1985 was declared un-Islamic by the Federal Shari at Court
(FSC). The Government and some banks/DFIs made appeals to the Shari at Appellate Bench
(SAB) of the Supreme Court of Pakistan.

1997
Al-Meezan Investment Bank is established with a mandate to pursue Islamic Banking.

1999
The Shari at Appellate Bench of the Supreme Court of Pakistan rejects the appeals and
directs all laws on interest banking to cease. The government sets up a high level
commission, task forces and committees to institute and promote Islamic banking on parallel
basis with conventional system.

2001
State Bank of Pakistan sets criteria for establishment of Islamic commercial banks in private
sector and subsidiaries and stand-alone branches by existing commercial banks to conduct
Islamic banking in the country.

2002
Meezan Bank acquires the Pakistan operations of Societe Generale and concurrently Al
Meezan Investment Bank converts itself into a full fledged Islamic commercial bank. The
first Islamic banking license is issued to the Bank and it is renamed Meezan Bank.

2004
The State Bank establishes a dedicated Islamic Banking Department (IBD) by merging the

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Islamic Economics Division of the Research Department with the Islamic Banking Division
of the Banking Policy Department. A Shari‘ah Board has been appointed to regulate and
approve guidelines for the emerging Islamic Banking industry. The Government of Pakistan
awards the mandate for debut of international Sukuk (Bond) offering for USD 500 million.
The offering is a success and establishes a benchmark for Pakistan.

2006
A numbers of new dedicated Islamic Banks, namely Bank Islami and Dubai Islamic Bank,
commence operations in Pakistan.

2007
Two new dedicated Islamic Banks start operations in Pakistan, namely Emirates Global
Islamic Bank and Dawood Islamic Bank. (Meezan Bank Website, 2009)

1.7 CONVENTIONAL VS. ISLAMIC BANKS – THEORETICAL PERSPECTIVE

There is always an underlying theoretical framework on the base of which the foundation of a
financial system is built. Both conventional and Islamic banking has its own. Islamic banking
is based on the principles of the normative scientific theory of economics while modern
banks are based on the principles of the positive theory of economics.

Like conventional bank, Islamic bank is an intermediary and trustee of money of other people
but the difference is that it shares profit and loss with its depositors. This difference that
introduces the element of mutuality in Islamic banking makes its depositors as customers
with some ownership of right in it (Presley & Dar, 2000/2001).

Islamic banking and conventional banking differs in that while the conventional banking
follows conventional interest-based principle, the Islamic banking is based on interest-free
principle and principle of Profit-and-Loss (PLS) sharing in performing their businesses as
intermediaries (Mohamed Ariff, 1988).

While Islamic banks perform mostly the same functions as conventional banks, they do this
in distinctly different ways. Some of the distinguishing features of Islamic banking are given
below.

Risk-sharing

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The most important feature of Islamic banking is that it promotes risk sharing between the
provider of funds (investor) and the user of funds (entrepreneur). By contrast, under
conventional banking, the investor is assured of a predetermined rate of interest. Since the
nature of this world is uncertain, the results of any project are not known with certainty ex
ante, and so there is always some risk involved. In conventional banking, all this risk is borne
by the entrepreneur. Whether the project succeeds and produces a profit or fails and produces
a loss, the owner of capital gets away with a predetermined return. In Islam, this kind of
unjust distribution is not allowed.

In Islamic banking both the investor and the entrepreneur share the results of the project in an
equitable way. In the case of profit, both share this in pre-agreed proportions. In the case of
loss, all financial loss is borne by the capitalist and the entrepreneur loses his labour.

Emphasis on productivity as compared to credit-worthiness

Under conventional banking, almost all that matters to a bank is that its loan and the interest
thereon are paid on time. Therefore, in granting loans, the dominant consideration is the
credit-worthiness of the borrower.

Under profit-and-loss sharing (PLS) banking, the bank will receive a return only if the project
succeeds and produces a profit. Therefore, an Islamic bank will be more concerned with the
soundness of the project and the business acumen and managerial competence of the
entrepreneur. This feature has important implications for the distribution of credit as well as
the stability of the system.

Moral dimension

Conventional banking is secular in its orientation. In contrast, in the Islamic system all
economic agents have to work within the moral value system of Islam. Islamic banks are no
exception. As such, they cannot finance any project which conflicts with the moral value
system of Islam. For example, they will not finance a wine factory, a casino, a night club or
any other activity which is prohibited by Islam or is known to be harmful to society. In this

17
respect Islamic banks are somewhat similar to the ‗ethical funds‘ now becoming popular in
the Western world.

Wider set of products

An important point to be noted in the way Islamic banking works is that it offers a wider
choice of products. In addition to some fixed-return modes that can serve necessarily the
same functions that interest serves in conventional banking, Islamic banks can use a variety
of innovative profit-sharing financing techniques.

Closer links between the monetary and real sectors

Another important feature of Islamic banking is that even in the case of fixed return modes
that create debt, such as interest-based financing, there is a crucial difference. Debt creation
in Islamic finance is generally not possible without the backing of goods and services, and the
resultant debt instruments are not tradable except against goods and services. Monetary flows
through Islamic financial modes are tied directly to the flow of goods and services, so there is
little room for a sudden and mass movement of such funds as compared to the flow of
interest-based short-term funds. Hence destabilizing speculation is expected to be
significantly curtailed. (Molyneux, 2005)

Review & Audit

Islamic Bank is required to be viewed by Shari‘ah audit in addition to the normal audit, while
the conventional bank is satisfied with statutory audit only. It is important to mention that the
Shari‘ah does not prohibit all gains on capital. It is only the increase stipulated or sought over
the principal of a loan or debt that is prohibited.

18
1.8 STRUCTURE OF FINANCIAL SECTOR OF PAKISTAN

Pakistan has a well-developed banking system, which consists of a wide variety of

institutions ranging from a central bank to commercial banks and to specialized agencies to
cater for special requirements of specific sectors. The country started without any worthwhile
banking network in 1947 but witnessed phenomenal growth in the first two decades. By
1970, it had acquired a flourishing banking sector with nationalization and privatization of
the banking sector going on simultaneously in the following decades (Khan, 2004).

19
Table 1.1 Structure of the financial system of Pakistan – 2008
---- in million Rupees ----

No of Number of Total Assets Total Financial

institutions branches Assets

State Bank of Pakistan - banking assets 1 16 1,135,820 1,111,342

Other financial institutions

Public sector commercial banks 4 1,064,038 998,314

Local private banks 20 7,760 4,229,249 3,954,821

Foreign Banks 6 68 231,730 219,501

Specialized banks* 4 388 127,640 119,020

Islamic Banks 6 514 276,000 259,418

Sub -Total 40 8,730 5,928,657 5,551,074

Developing financial institutions 7 96,450 91,428

Microfinance banks 7 15,006 14,339

Non banking financial companies** ***

20
 Investment banks 12 58,017 56,030

leasing companies 16 65,920 63,524

Housing finance services 5 149 144

Modarabas 27 29,703 29,703

Mutual funds 109 339,718 339,718

Venture capital funds 4 3,760 3,623

Sub -Total 173 - 497,267 492,742

Insurance Companies
Private

Life & non - insurance companies 31 336 91,873 90,654

Public

Life insurance companies 1 461 193,118 190,557

Non - life insurance companies 1

Sub -Total 33 797 284,990 281,211

Grand Total 261 9,543 7,958,191 7,542,136

21
* Specialized banks include Zarai Tarqiati bank, Industrial Development Bank, Punjab

Provincial Cooperative bank & SME Bank.

** Data is based on their annual financial statements as of June 30, 2008

*** Estimated data in this column.

Source of data:

(State Bank of Pakistan, 2009)

(Insurance Association of Pakistan, 2009)

(Securities & Exchange Commission of Pakistan, 2009)

A pictorial depiction of the financial system of Pakistan - 2008

Figure -1.1

22
1.9 FINANCIAL STATEMENTS OF A CONVENTIONAL & ISLAMIC BANKS – A
DISSECTION
A typical balance sheet structure of the two types of banks is as follows;

The following table shows stylized balance sheet of a conventional commercial bank. On the
liability side, it accepts demand and saving deposits, issues term certificates such as
certificate of deposits and has capital.

Table 1.2 Balance sheet of a conventional bank – based on functionality

Assets Liabilities

Cash and cash balances with other banks Customers‘ deposits

Cash and cash balances with the central bank Due to banks and other financial institutions

Loans and advances to customers Other liabilities

Financial assets held for trading Sundry creditors

Investments in associates, subsidiaries and

Equity and reserves
joint ventures

On the asset side, there is much more diversity and options in the form of marketable
securities, trading accounts, lending to corporations and to consumers.

From the risk point of view, two observations can be made. First, the deposits create
instantaneous pre-determined liabilities irrespective of the outcome of the usage of the funds
on the asset side, thus creating an asset-liability mismatch. Second, medium- to long-term
assets are financed by the stream of short-term liabilities, exposing the bank to a maturity
mismatch risk and discouraging the bank from investing in long-term non-liquid projects. An
increase in the level of non-retail deposits or funding could expose a conventional bank to
greater volatility in satisfying its funding requirements, requiring increasingly sophisticated
liquidity risk management. Certain funding instruments also expose a bank to market risk.

23
For Islamic financial institutions, the nature of financial intermediation, including the
function of banking, is different from that of conventional financial institutions. This is the
key to understanding the difference in the nature of risks in conventional and Islamic
banking. For Islamic banks, the Mudaraba contract is the cornerstone of financial
intermediation and thus of banking. The basic concept is that both the mobilization and (in
theory) the use of funds are based on some form of profit sharing among the depositors, the
bank, and the entrepreneurs (users of funds). The financial intermediation is merely a ‗pass-
through‘ arrangement similar to funds management, with the difference that there are
multiple portfolios on the asset side.

Following table presents a stylized balance sheet of an Islamic bank, displaying different
activities and financial instruments. This balance sheet classifies the functionality and
purpose of different instruments – a common practice among Islamic banks.

Table 1.3 Balance sheet of an Islamic bank – based on functionality

Application of funding Sources of funding

Cash balances Demand deposits (amanah)

Financing assets (Murabaha, salam, Ijara,

Investment accounts (Mudaraba)
Istisna)

Special investment accounts (Mudaraba,

Investment assets (Mudaraba, Musharaka)
Musharaka)

Fee-based services (ju‘ala, kafala, and so forth) Reserves

Non-banking assets (property) Equity capital

The structure of a typical balance sheet has demand deposits and investment accounts from
customers on the liability side and Islamic financing and investing accounts (the equivalent of
conventional banks‘ loans to customers) on the asset side. This pattern reflects the nature of
banks as intermediaries, with ratios of capital to liabilities at such a low level that their
leverage would be unacceptable to any business outside the financial services industry. The

24
analyst should be able to assess the risk profile of the bank simply by analyzing the relative
share of various asset items and changes in their proportionate share over time.

While the types of liabilities present in an Islamic bank‘s balance sheet are nearly universal,
their exact composition varies greatly depending on a particular bank‘s business and market
orientation, as well as the prices and supply characteristics of different types of liabilities at
any given point in time. The funding structure of a bank directly affects its cost of operation
and therefore determines a bank‘s potential profit and level of risk. The structure of a bank‘s
liabilities also reflects its specific asset-liability and risk management policies.

When compared with conventional banks, balance sheet risk profile of Islamic banks is
different. First, the foremost feature of an Islamic bank is the ‗pass-through‘ nature of the
balance sheet. This feature removes the typical asset-liability mismatch exposure of a
conventional bank, as the Islamic bank‘s depositors‘ return is linked to the return on the
assets of the bank. However, this feature also introduces some operational issues, such as
estimation and accrual of ex-post returns and the treatment of intra-period withdrawal of
deposits.
Second, the nature of assets of two institutions is different. Whereas a conventional bank
tends to stay with fixed income very low credit risk debt securities, an Islamic bank‘s assets
are concentrated on the asset-based investments which has credit risk but are also backed by a
real asset. As a result, the lending capacity of the Islamic banking sector (at least for
commercial banks) is bound by the availability of real assets in the economy. Thus, there is
no leveraged credit creation.

Third, the assets of Islamic banks contain financing assets where tangible goods and
commodities are purchased and sold to the customers. This practice creates distinct
exposures. For example, in case of conventional banking, the asset is financed by a loan from
the bank to the customer whereas in case of an Islamic bank, the asset and the financing are
coupled together. The bank is not limited to the exposure as a financier but can develop
additional exposures resulting from dealing with physical assets. Another feature which
distinguishes the risks of an Islamic bank from a conventional bank is the general lack of
liquid securities on the asset side. This feature is not a design issue but is a temporal
phenomenon until a well-functioning securities market for Shari‘ah-compliant instruments is

25
developed.

Finally, due to prohibition of interest, Islamic banks cannot issue debt to finance the assets
which consequently discourages creation of leverage. Due to the lack of leverage, Islamic
banks can be considered less risky during a time of financial crisis. For Islamic banks, the
financial intermediary is closely associated with the asset and is able to perform better
monitoring of the asset as well as the obligor. These features can enhance the stability of the
banking system. (Iqbal & Greuning, 2009)

26
CHAPTER 2 LITERATURE REVIEW

While there has been extensive literature examining the efficiency features of the U.S. and
European banking markets over recent years, the work on Islamic banking is still in its
infancy. Typically, studies on Islamic banks‘ efficiency have focused on theoretical issues
and the empirical works have mainly relied on the analysis of descriptive statistics rather than
rigorous statistical estimation (El-Gamal, 2005).
(Metwally, 1997) tested the primary differences among the financial characteristics of Islamic
and Conventional banks in terms of liquidity, leverage, credit risk, profitability and efficiency
using statistical techniques for 30 banks over the period 1992-1994. He found that there are
no major differences amongst profitability and efficiency between the banks.
(Samad, 2004) examined the comparative performance of Bahrain‘s interest-free Islamic
banks and the interest-based conventional commercial banks during the post Gulf War period
with respect to (a) profitability, (b) liquidity risk, and (c) credit risk. Nine financial ratios are
used in measuring these performances. The financial ratios for Islamic and conventional
commercial banks in Bahrain for the period 1991-2001, the paper concluded that there is no
major difference in the performance between Islamic and conventional banks with respect to
profitability and liquidity. However, the study finds that there exists a significant difference
in credit performance.
(Rosley & Abu Bakr, 2003) evaluated the relative performance of the Islamic Banking
Scheme (mainstream banks offering Islamic services) to mainstream banks (conventional) in
Malaysia for the period 1996-1999. The study found that Islamic Banking Scheme (IBS)
banks have recorded higher return on assets (ROA) as they are able to utilize existing
overheads carried by mainstream banks. As this lowers their overhead expenses, it is found
that the higher ROA ratio for IBS banks does not imply efficiency. It is also inconsistent with
their relatively low asset utilization and investment margin ratios.

(Samad & Hassan, 1999) evaluated inter-temporal and interbank performance of Islamic bank
(Bank Islam Malaysia Berhad (BIMB) in profitability, liquidity, risk and solvency; and
community involvement for the period 1984-1997. Financial ratios are applied in measuring
these performances. The study found that BIMB is relatively more liquid and less risky

27
compared to a group of 8 conventional banks. The analysis of the primary data identified
reasons why the supply of loans under profit sharing and joint venture profit sharing is not
popular in Malaysia. 40% to 70% bankers surveyed indicated that lack of knowledgeable
bankers in selecting, evaluating and managing profitable project is a significant cause.
To measure efficiency of Islamic banks in Bangladesh, (Sarker, 1999) utilizes Banking
efficiency model and claims that Islamic banks can stay alive even within a traditional
banking architecture in which Profit-and-Loss Sharing (PLS) modes of financing are less
dominated. Sarkar (1999) further claims that Islamic financial products have different risk
characteristics and consequently different prudential regulations should be in place.

(Ahmad & Hassan, 2007) explained the main operational differences between Islamic and
Conventional Banks in Bangladesh applying financial ratio measures for the period 1994-
2001. They found that in order to establish a fair comparison between Islamic and
Conventional banks, Islamic Banks should have their own inter-bank money market plus a
developed secondary financial market. Since Islamic Banks operate within the traditional
banking law, the findings also suggested that Islamic Banks should have an independent
authority for regulatory purposes besides the Islamic law.
(Nishat, 2009) in their study of the Islamic banks in Bangladesh considered 12 important
financial ratios and common size income statement and balance sheet information of Islamic
banks for 2001 to 2006. The ratios were compared with simple industry average and other
banks after distributing these into three generations, namely; generation one, two and three.
Results showed poor performance of Islamic banking sector in almost every aspect,
especially in the areas of profit maximization, investor management and operating
inefficiency. The report identified unique banking system, lack of efficient human resources,
lack of marketing and awareness creating activities, absence of Islamic capital and inter-bank
markets and lack of direct government control as precedent problems. The study reported to
bring about immediate change in HR management and policy, changes in operating policy,
increase in marketing and awareness creating activity, guidelines and supervision of the
government through direct Islamic Banking Law.

(Kader & Asarpota, 2007) utilize bank level data to evaluate the performance of the UAE
Islamic banks. Balance sheets and income statements of 3 Islamic banks and 5 conventional
banks in the time period 2000 to 2004 are used to compile data for the study. Financial ratios

28
are applied to examine the performance of the Islamic banks in profitability, liquidity, risk
and solvency, and efficiency. The results of the study show that in comparison with UAE
conventional banks, Islamic banks of UAE are relatively more profitable, less liquid, less
risky, and more efficient. They conclude that there are two important implications associated
with this finding: First, attributes of the Islamic profit-and-loss sharing banking paradigm are
likely to be associated as a key reason for the rapid growth in Islamic banking in UAE.
Second, UAE Islamic banks should be regulated and supervised in a different way as the
UAE Islamic banks in practice are different from UAE conventional banks.

(Alkassim, 2005) in his dissertation analyzed the profitability of Islamic and conventional
banking in the Gulf Cooperation Council over the period 1997-2004. The study investigated
whether internal bank characteristics may explain the difference in profitability between the
two types of banking. In addition, a regression analysis is applied on a sample of banks to test
the influence of these variables on bank performance. Furthermore, results indicated that
conventional banks in the GCC have better asset quality compared to Islamic banks.
However, Islamic banks are better capitalized. Empirical results also suggest that interest-free
lending in Islamic banking advocate profitability.
(Saleh and Rami, 2006) examined and analyzed the Jordanian experience with Islamic
banking and in particular the experience for the first and second Islamic bank in the country,
Jordan Islamic Bank for Finance and Investment (JIBFI), and Islamic International Arab
Bank (IIAB) in order to evaluate the Islamic banks‘ performance in the county. They used the
performance evaluation methodology by conducting the profit maximization, capital
structure, and liquidity tests and found that the efficiency and ability of both banks has
increased and both have expanded their investment and activities and had played an
important role in financing projects in Jordan. Another interesting finding of the paper that
these banks have focused on the short-term investment, perhaps this seems to be the case in
most Islamic banking practices. Another finding is that the Bank for Finance and Investment
(JIBFI) has a high profitability that encourages other banks to practice the Islamic financial
system. The paper also found that Islamic banks have a high growth in the credit facilities
and in profitability.
(Badreldin A. M., 2009) evaluated lack of performance measures for Islamic Banks. It then
adapted a currently applied ROE Analysis Tool used in conventional banks, to the currently
established model of Islamic Banks and tests its applicability and evaluates its usefulness.

29
The findings suggest that such an adapted model would be quite successful for use in Islamic
banks and would offer much better analysis and basis of comparison within the Islamic
financial system. It also suggests that much of the previously measured performance of
Islamic Banks is unsound and should be revised for accuracy and reliability because of the
flawed methods used for measurement in the first place.
(Danesh, 2007) employed the non-parametric DEA approach while investigating the relative
efficiency of Islamic Banks to their Conventional counterparts in the Gulf Cooperation
Council (GCC), over the period 2000-2006 And also examined the determinants of Islamic
Banking efficiency using a second-step regression model approach. In general, the DEA
efficiency scores suggested that Islamic Commercial Banks ‗efficiency is indifferent to that
of Conventional Commercial Banks. In line with this finding, the regression analysis implies
that Islamic banking efficiency in the GCC markets is indifferent. However, Islamic Banks
were found to be relatively efficient in 2006. In addition, Wholesale banks, whether Islamic
or Conventional, are efficient. Finally, the model suggests that size and financial capital are
highly contributory to banking efficiency where the regional effect of Saudi Arabia is
negatively related to efficiency.
(M.Suyanto, 2009) in his study evaluated interbank performance of Bank Muamalat
Indonesia in profitability, liquidity, risk and solvency; and community involvement for the
period 2000 – 2004. Financial ratios are applied in measuring these performances. The study
found that BMI is relatively more profit and commitment to community development, but
less liquid compared to the conventional banks. BMI does not show (statistically) any
difference in risk performance with the conventional banks.

(Mohammad, Hassan, & Bader, 2007) in their paper measured and compared the cost and
profit efficiency of 80 banks in 21 of Organization of Islamic Conference (OIC) countries:
comprising of 37 conventional banks and 43 Islamic banks, using the Stochastic Frontier
Approach (SFA). In addition, it also assessed the efficiency of those banks based on their
size, age, and region. The findings suggested that there are no significant differences between
the overall efficiency results of conventional versus Islamic banks. However, there is
substantial room for improvement in cost minimization and profit maximization in both
banking systems. Furthermore, the findings show no significance difference in average
efficiency scores between big versus small and new versus old banks in both banking

30
streams. This implies that size and age did not affect the performance of banks in both
streams. Overall, the results are in favor of the more recent Islamic banking system.
(Moin, 2008) in his study examined and evaluated the performance of the first Islamic bank
in Pakistan, i.e. Meezan Bank Limited (MBL) in comparison with that of a group of 5
Pakistani conventional banks. The study evaluated performance of the Islamic bank (MBL) in
profitability, liquidity, risk, and efficiency for the period of 2003-2007. The study found that
MBL is less profitable, more solvent (less risky), and also less efficient comparing to the
average of the 5 conventional banks. However, there was no significant difference in liquidity
between the two sets of banks.
(Nasr & Shahid, 2007) in their paper proposed an alternative Banking procedure that can be
used to determine the Islamic and conventional deposit returns linkages. In this context, Data
of Term Deposits rates of returns from the largest Conventional Banks namely the Muslim
Commercial, Askari Commercial bank, Habib Bank Ltd and Islamic Banks, Al Faysal and
Al-Meezan Bank have been collected. The study also evaluated inter-bank performance of
Islamic Banks (Al-Faysal Bank and Meezan Bank) with the conventional Banks (Muslim
Commercial Bank, Askari commercial Bank, Habib Bank Limited).
The difference between performance of Islamic and conventional banks is estimated in term
of financial ratios and statistically verified by using an ARIMA statistical model. The main
purpose of the study is to determine the impact of fluctuations in one type of deposit returns
on other. This helps us to assess the role of Islamic banking in the overall Monetary
distribution channels and also determine direction of Monetary Policy in a country.
(Bashir, 2000) examines the determinants of Islamic banks ‗performance across eight Middle
Eastern countries between 1993 and 1998. Using cross-country bank-level data on income
statements and balance sheets of 14 Islamic banks in eight Middle Eastern countries for each
year in the 1993-1998, the study closely examines the relationships between profitability and
the banking characteristics. After controlling for economic and financial structure indicators
such as – macroeconomic environment, financial market structure, and taxation – the study
shows some very important and interesting results.
First, the profitability measures of the Islamic banks react positively to the increases in
capital and loan ratios, which is intuitive and consistent with previous studies. Second, the
study highlights the empirical role that adequate capital ratios and loan portfolios play in
explaining the performance of Islamic banks. Third, the results indicate that customer and

31
short-term funding, non-interest earning assets, and overhead are also important for
promoting banks‘ profits. Fourth, the results reveal that foreign-owned banks are more
profitable than their domestic counterparts. Fifth, keeping other things constant, there is
evidence that implicit and explicit taxes affect the bank performance measures negatively.
Sixth, favorable macroeconomic conditions have positive effect on performance measures of
the bank. Finally, the results of the study show that stock markets are complementary to bank
financing.

A similar study performed by (Hassan & Bashir, 2003) analyzes how the performance of the
Islamic banks is affected by bank characteristics and the overall financial environment. They
utilize cross-country bank level data on Islamic banks in 21 countries for each year in 1994-
2001 to closely examine the performance indicators of Islamic banks. In general, they find
their analysis of determinants of Islamic banks profitability consistent with previous findings.
The study indicate that controlling for macroeconomic environment, financial market
structure, and taxation, the high capital and loan-to-asset ratios lead to higher profitability.
Everything remaining equal, the regression result of the study reveals that there is negative
effect of implicit and explicit taxes on the bank performance measures, while there is positive
impact of favorable macroeconomic conditions on bank performance measures. That is,
favorable macroeconomic environment appears to kindle higher profit margins. Results also
show surprisingly a strong positive correlation between profitability and overhead. That is in
the Islamic banking market expense preference behavior appears to hold. They also find in
their study that size of the banking system has negative impact on the profitability except net
on interest margin.

(Yudistira, 2004) in his study makes an empirical analysis on efficiency and provides new
evidences on the performance of 18 Islamic banks over the period 1997-2000. Panel data set
for this time period is extracted from non-consolidated balance sheets and income statements
of these Islamic banks with specific purpose of seeing the impact of recent financial crises on
efficiency of Islamic banks. This study is different from previous studies in that it utilizes
non-parametric approach, Data Envelopment Analysis (DAE) to analyze the technical
efficiency, pure technical efficiency, and scale efficiency of Islamic banks. Being in line with
the principle of Islamic financial system, the intermediation approach is used to specify input-
output variables of Islamic banks. The study finds several results. First, the overall efficiency

32
results indicate that there is a small (at just over 10%) inefficiency across 18 Islamic banks,
which is considerable as compared to many conventional counterparts. Similarly, global
crisis in 1998-1999 badly affected the performance of Islamic banks; however, they
performed better afterwards. Second, the results show that small and medium sized Islamic
banks faced diseconomies of scale which suggests that M&A should be encouraged.
Moreover, as compared to their non listed counterparts, publicly listed Islamic banks are
found to be less efficient. Lastly, Country specific factors mainly determined the efficiency
differences across sample data.

Furthermore, (Sufian, 2006) performs a similar study to provide new evidence on the relative
efficiency between the domestic and foreign banks Islamic banking operation in Malaysia
during the period of 2001-2004. Non-parametric Data Envelopment Analysis (DEA)
methodology has been utilized to distinguish between three different types of efficiency:
technical, pure technical and scale efficiencies.

33
CHAPTER 3 RESEARCH AND METHODOLOGY

This study is aimed at comparative analysis of Islamic banking vis-à-vis conventional

banking in Pakistan by taking samples of banks from both types of banks for the period of
five years from 2004-2008. Data for each year have been compiled from the financial
statements of the two sets of banks. Because there are so many tools for doing performance
assessment, we must remember that different techniques address measurement in very
specific and often narrowly defined ways. Yet normally, only a few selected relationships
will yield information the analyst really needs for useful insights and decision support. Any
particular ratio or measure is useful only in relation to the viewpoint taken and the specific
objectives of the analysis. When there is such a match, the measure can become a standard
for comparison. Moreover, ratios are not absolute criteria: They serve best when used in
selected combinations to point out changes in financial conditions or operating performance
over several periods and as compared to similar businesses. Ratios help illustrate the trends
and patterns of such changes, which, in turn, might indicate to the analyst the risks and
opportunities for the business under review. In today‘s competitive financial market, one can
better understand the performance of a bank by an analysis of inter-bank comparison. (Erich,
2001)

3.1 ANALYSIS TECHNIQUES

The financial analyst uses certain techniques to assess a company‘s financial and economic
condition.
 Vertical analysis — Converts financial statement amounts of a period into
percentages for comparison of one accounting period to another.
 Horizontal analysis — Tracks individual account growth rates from one period to
another, acting as an implicit indexation which is useful in countries with high
inflationary environments.
 Financial ratio analysis — Universally accepted techniques that focus on the
relationships between accounts in the financial statements; these techniques constitute
the basis for most financial analysis done by banks.

34
  Operating / non-operating funds generation analysis — Breaks down funds flows
from one period to another into operating and non-operating sources and uses of funds
to detect funds movements.

3.2 FINANCIAL RATIO ANALYSIS

In order to see how Islamic bank has performed in comparison with the conventional banks
over 5 years, the common technique of financial ratio analysis to assess the performance of
the two types of banks over the time horizon of 5 years. Financial measures expressed in
terms of various ratios have greater advantage than volume measures. The greatest advantage
is that ratio analysis compensates the disparities created by differences in bank size with
regards to assets, deposits and loans. These ratios are broadly categorized into four groups:

3.2.1 Liquidity ratios;

3.2.2 Profitability ratios;

3.2.3 Risk and solvency ratios; and

3.2.4 Efficiency ratios.

Since there are five conventional and Islamic banks in each group to compare with each
other, so we first calculated ratio of each bank in that group and then calculated average of
those five ratios to compare those average ratios with each other on yearly basis.

3.2.1 LIQUIDITY RATIOS

Liquidity is the life of a commercial bank. Liquidity means cash availability: how quickly a
bank can convert its assets into cash at face value to meet the cash demands of the depositors
and borrowers. The higher the amount of liquid asset for a bank, the greater is the liquidity of
the bank. (Samad, 2004) Liquidity is important for the firm to avoid defaulting on its
financial obligations and, thus, to avoid experiencing financial distress (Ross, Westerfield, &
Jordan, 2005). In general sense, the higher liquidity ratios mean bank has larger margin of
safety and ability to cover its short term obligations.
Because saving accounts and transaction deposits can be withdrawn at any time, there is high
liquidity risk for both the banks and other depository institutions. Banks can get into liquidity

35
problem especially when withdrawals exceed new deposit significantly over a short period of
time (Samad & Hassan, 1999). Among the various liquidity measures, this study uses the
following:
a. Loan to Deposit Ratio (LDR),
b. Cash & Portfolio Investment to Deposit Ratio (CPID), and
c. Loan to Asset Ratio (LAR).

a. Loan to Deposit Ratio (LDR)

Loan to deposit ratio measures the percentage of deposits used for advances by the bank. Loan to
deposit is the most important ratio to measure the liquidity condition of the bank. The higher
the ratio, the less liquid the bank will be. Here, loan means the advances for the conventional
banks and financings for the Islamic banks and are taken as net of provisions. Bank with Low
LDR is considered to have excessive liquidity, potentially lower profits, and hence less risk
as compared to the bank with high LDR. However, high LDR indicates that a bank has taken
more financial stress by making excessive loans and also shows risk that to meet depositors‘
claims bank may have to sell some loans at loss.
LDR is calculated as under:

Loans
Loan to Deposit Ratio =
Deposits

b. Cash & Portfolio Investment to Deposit Ratio (CPIDR)

It indicates the percentage of deposit and short term funds that are available to meet the
sudden withdrawals. The higher the ratio the better is the liquidity position of the bank,
therefore, the more is the confidence and trust of the depositors in the bank as compared to
the bank with lower CPIDR. This ratio boosts the trust and confidence of the depositors in the
bank as the depositors know that the bank has either enough cash or liquid investments which
is used for earnings as well as for liquidity.
CPIDR is calculated as under:

CPIDR = Cash & Portfolio Investments

36
 Deposits

c. Loan to Asset Ratio (LAR)

Loan to Asset ratio measures the percentage of assets that are tied up in loans. Loan to assets ratio
(LAR) is also another important ratio that measures the liquidity condition of the bank.
Whereas LDR is a ratio in which liquidity of the bank is measured in terms of its deposits,
LAR measures liquidity of the bank in terms of its total assets. That is, it gauges the
percentage of total assets the bank has invested in loans (or financings).

The higher is the ratio the less the liquidity is of the bank. Similar to LDR, the bank with low
LAR is also considered to be more liquid as compared to the bank with higher LAR.
However, high LAR is an indication of potentially higher profitability and hence more risk.

LAR is calculated as under:

Net Loans (Financing)

LAR =
Total Assets

3.2.2 PROFITABILITY RATIOS

The profitability ratio of the firm can be measured by calculating various profitability ratios.
General two groups of profitability ratios are calculated.
• Profitability in relation to revenues.
• Profitability in relation to investments.

These ratios are used to assess the ability of the business to generate earnings in comparison
with its all expenses and other relevant costs during a specific time period. Profitability ratios
are generally considered to be the basic bank financial ratio in order to evaluate how well
bank is performing in terms of profit. For the most part, if a profitability ratio is relatively
higher as compared to the competitor(s), industry averages, guidelines, or previous years‘
same ratios, then it is taken as indicator of better performance of the bank. Following four
profitability ratios are used to assess the performance of both samples of banks : a) Return on

37
assets (ROA) b) Return on Equity (ROE) c) Earnings per share (EPS) and d) Profit Expense
Ratio (PER).

a. Return on assets (ROA)

It is a common measure of managerial performance (Ross, Westerfield, & Jordan, 2005).

ROA is a good indicator of a bank‘s financial performance and managerial efficiency. It
shows how competent the management is in allocating asset into net profit. The higher the
ROA, the higher is the financial performance or profitability of the banks (Samad, 2004).
ROA is calculated as under:

Net profit after tax

ROA =
Total Assets

b. Return on Equity (ROE)

The most common ratio used for measuring the return on the owners‘ investment is the
relationship of net profit to equity, or total shareholders‘ investment. In performing this
calculation, we don‘t have to make any adjustment for interest, because the net profit
available for shareholders already has been properly reduced by interest charges, if any, paid
to creditors and lenders. However, we do have to consider the impact of nonrecurring and
unusual events, such as restructuring and major accounting changes and adjustments (Erich,
2001). Shareholders‘ equity is composed of paid up share capital, share premium, any capital
or revenue reserves and retained profits. ROE is calculated as under:

Net profit after tax

ROE =
Shareholders‘ equity

c. Earnings Per Share (EPS)

It measures the profit available to the equity shareholders on a per share basis. It is computed
by dividing earnings available to the equity shareholders by the total number of equity share
38
outstanding. The analysis of earnings from the owners‘ point of view usually centers on
earnings per share in the case of a corporation.
Earnings per share is a measure to which both management and shareholders pay a great deal
of attention. It is widely used in the valuation of common stock, and often is the basis for
setting specific corporate objectives and goals as part of strategic planning. This ratio simply
involves dividing the net profit to common stock by the average number of shares of common
stock outstanding (Erich, 2001):

Net Profit available for common shares

EPS =
Average number of shares outstanding

d. Profit to Expenses Ratio (PER)

It measures the operating profitability of the bank with regards to its total operating expenses.
Operating profit is calculated as earnings before taxes and operating expenses means total
non-interest expenses. It is indeed considered to be one of the best indices for measuring
economic efficiency or profit performance.
The ratio measures the amount of operating profit earned for each dollar of operating
expense. The ratio indicates to what extent bank is efficient in controlling its operating
expenses. A higher PER means bank is cost efficient and is making higher profits (Samad &
Hassan, 1999).

PER is calculated as under:

Profit before tax

PER =
Operating expenses

39
3.2.3 RISK AND SOLVENCY RATIOS

These ratios are also referred to as gearing, debt or financial leverage ratios. The extent to
which a firm relies on debt financing rather equity is related with financial leverage. These
ratios determine the probability that the firm default on its debt contracts. The more the debt a
firm has the higher is the chance that firm will become unable to fulfill its contractual
obligations. In other words, higher levels of debt can lead to higher probability of bankruptcy
and financial distress. Although, debt is an important form of financing that provided
significant tax advantage, it may create conflict of interest between the creditors and the
shareholders (Ross, Westerfield, & Jordan, 2005). The greater the asset than all types of
liabilities, the more solvent the bank is. Customer deposits are a significant portion on the
liability side of the balance sheet of any type of bank whether Islamic or conventional.
Borrowed money in either form stands second among total liabilities for almost all banks
except all Islamic banks which are prohibited by Islamic Shari‘ah from taking or giving any
kind of interest-based debts. To assess risk and solvency of the bank, following measures are
usually used:

a. Debt to Equity Ratio (DER),

b. Debt to Total Assets Ratio (DTAR), and
c. Equity Multiplier (EM).
d. Capital Adequacy Ratio (CAR)
e. Non Performing Loans to Net Loans Ratio (NPL/NL)

a. Debt to Equity Ratio (DER)

It is one of the tools to measure the extent to which firm uses debt and measures the ability of
the firm‘s capital to absorb financial shocks. In case, debtors default in paying back their
loans (Qard-e-Hassan) or the asset values decrease bank capital provides shield against those
loan losses.

A lower debt to equity ratio of the bank is considered better as compared to the bank with
higher DER. DER is calculated as under:

40
 Total Debt
DER =
Shareholders‘ equity

b. Debt to Total Assets Ratio (DTAR)

It measures the amount of total debt firm used to finance its total assets and is an indicator of
financial strength of the bank. It provides information about the solvency and the ability of
the firm to obtain additional financing for potentially attractive investment opportunities.

Higher DTAR means bank has financed most of its assets through debt as compared to the
equity financing. Moreover, higher DTAR indicates that bank is involved in more risky
business. However, higher Credit to Total Asset ratio might increase the chances on being
looser, otherwise with effective governance and control. DTAR is calculated as under:

Total Debt
DTAR =
Total Assets

c. Equity Multiplier (EM)

How many times the total assets are of the shareholders‘ equity is measured by equity
multiplier. In other words, it indicates the amount of assets per dollar of shareholders‘ equity.
Higher value of EM means that bank has used more debt to convert into assets with share
capital. The higher is the EM the greater is the risk for a bank. EM is calculated as under:

Total Assets
EM =
Total Shareholders‘ equity

d. Capital Adequacy Ratio (CAR)

A bank must have sufficient capital to absorb risk of losses inherent in the assets of the
business so as to protect depositors and other creditors. Capital Adequacy Ratio (CAR)
measures the amount of capital reserve held for every unit of Risk-Weighted Asset (RWA).

41
Higher percentage of CAR would not directly reduce the credit risk but would help to survive
out of temporary credit disturbances since capital works as a cushion against risk. Capital
adequacy ratio is the ratio which determines the capacity of the bank in terms of meeting the
time liabilities and other risk such as credit risk, operational risk, etc. Different risk
weightage are given to different assets based on their risk profiles.

Regulatory Capital (Tier I and Tier II)

CAR =
Risk Weighted Assets (RWA)

e. Non Performing Loans to Net Loans Ratio (NPL/NL)

Non-Performing Loans (NPL) to Net Loans ratio indicates the level of direct credit risk and
the quality of loan portfolio. It shows the degree of loans infection after making adjustment
for the provision held. Non performing loans are loans and advances whose mark-up/interest
or principal is overdue by 90 days or more from the due date. Lower ratio indicates that the
management of the bank efficiently managing the credit portfolio of the bank. The higher
value of NPL/NL indicates greater risk for a bank.

Non performing Loans (Bad Loans)

NPL/NL =
Net Loans

3.2.4 EFFICIENCY RATIOS

Efficiency ratios measure how effectively and efficiently the firm is managing and
controlling its assets. These ratios indicate the overall effectiveness of the firm in utilizing its
assets to generate revenues, quality of assets and how successful the firm is in its liquidity,
the promptness of payment to suppliers of the firm, effectiveness of the inventory
management practices, and efficiency of firm in controlling its expenses. Higher value of
these ratios s taken as good indicator which means firm is doing well. Ratios used to measure
efficiency of the bank are: i) Asset Utilization (AU), ii) Income to Expense Ratio (IER), and
iii) Operating efficiency (OE).

42
 i. Asset Utilization (AU)

How effectively the bank is utilizing all of its assets is measured by assets utilization ratio
and shows productivity of assets. The bank is presumably said to using its assets effectively
in generating total revenues if the AU ratio is high. If the asset utilization ratio is low, the
bank is not using its assets to their capacity and should either increase total revenues or
dispose of some of the assets (Ross, Westerfield, & Jordan, 2005). Total revenue of the bank
in this study is defined as net spread before provision plus all other income. AU is calculated
as under:

Total Revenue
AU =
Total Assets

ii. Income to Expense Ratio (IER)

Income to expense is the ratio that measures amount of income earned per dollar of operating
expense. This is the most commonly and widely used ratio in the banking sector to assess the
managerial efficiency in generating total income vis-à-vis controlling its operating expenses.
High IER is preferred over lower one as this indicates the ability and efficiency of the bank in
generating more total income in comparison to its total operating expenses. Total income in
the study is defined as net spread earned before provisions plus all other income while the
Other Expenses in the income statement are treated as total operating expense for the study.
IER is calculated as under:

Total Income
IER =
Total Operating Expense

iii. Operating Efficiency (OE)

43
Unlike IER, which measures the amount of income earned per dollar of operating expense,
OE is the ratio that measures the amount of operating expense per dollar of operating
revenue. It measures managerial efficiency in generating operating revenues and controlling
its operating expenses. In other words, how efficient is the bank in its operations. Lower OE
is preferred over higher OE as lower OE indicates that operating expenses are lower than
operating revenues. Operating revenue in this study is defined as net spread earned before
provisions plus fee, brokerage, commission, and forex income. Other expenses is defined
same as we defined in the previous ratio. OE is calculated as under:

Total Operating Expenses

OE =
Total Operating Revenue

44
3.3 UNDERLYING ASSUMPTIONS OF THE COMPARATIVE ANALYSIS

Following are the underlying assumptions of this study;

a. Since all banks in Pakistan (whether Islamic or conventional banks) follow State Bank
of Pakistan‘s instructions, so it is assumed that the financial statements of the sample
of both types of banks are prepared under the same accounting framework.
b. Both Islamic banks and conventional banks are placed on equal footing under ratio
measures irrespective of the bank‘s size and capital structure.

45
3.4 LIMITATION OF FINANCIAL ANALYSIS

Comparative analysis of companies and business units is challenged by the frequent lack of
truly comparable data, because of differences in product/service mix, accounting choices, size
and age of the businesses, differences in the portfolio, and geographic scope. Industry
statistics available from various sources often suffer from comparability issues as well.
(Erich, 2001) Financial statements provide an assessment of the costs and not value. For
example, the market value of items may be very different from the cost figure given in the
balance sheet. Ratios need to be interpreted carefully. They can provide clues to the
company‘s performance or financial situation. But on their own, they cannot show whether
performance is good or bad. Ratios require some quantitative information for an informed
analysis to be made. (Washington State University , 2004)

46
3.5 EMPIRICAL RESULTS

3.5.1 LIQUIDITY RATIOS

a. Loan to Deposit Ratio (LDR)

Loans to deposit ratio for conventional banks indicate that they have used more of their
deposits for further advances, hence more profit for them but low liquidity. While Islamic
banks seemed reluctant to use majority of their deposits for financing purposes, so keeping
them comparatively liquid. From 2006, the ratio of Islamic banks is becoming stabilizing and
has increasing trend, while conventional banks ratio is zigzag for the entire period of 5 years.
Conventional banks‘ LDR ratio over the five years horizon shows more variability while
Islamic banks‘ ratio is moving in the range of 70% - 90%. Although mean LDR of the
conventional banks is high compared to the mean LDR of the Islamic banks, but there is no
significant statistical difference between the means and dispersions of both datasets.

Figure 3.1

Table 3.1

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks 84% 63% 77% 65% 114% 81% 0.2076
Islamic Banks 77% 72% 66% 87% 90% 78% 0.0984

47
 b. Cash & Portfolio Investment to Deposit Ratio (CPIDR)

Conventional banks‘ CPID ratio in 2004 was low showing low liquidity position as the banks
have increased significantly their loans portfolio as was shown in LDR ratio, hence left fewer
amounts for keeping in liquid form. While the ratio has improved significantly in 2005 and
stabilized further from 2006 onwards for conventional banks over 30%. While for Islamic
banks, the ratio has improved significantly from lowest of 24% in 2005 to highest 49% in
2007 whereas there is decrease of 11% to 38% at the end of 2008. There is no significant
difference in the mean CPID ratio for Conventional banks and Islamic banks.

Figure 3.2

Table 3.2

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks 35% 40% 40% 49% 16% 36% 0.1222
Islamic Banks 38% 49% 36% 24% 29% 35% 0.0929

c. Loan to Asset Ratio (LAR)

Loan to total Asset ratio has decreased for conventional banks from 73% to 54% and from
63% to 51% for Islamic banks indicating that banks have released significant portion of their
assets to liquid instruments either investments in securities or in cash while non-financial
assets are at minimum for both types of banks. The declining trend in LDR of Islamic bank

48
up to 2006 indicates the tendency of comparatively more increase in deposits than loans
(financings) and further emphasizes improved liquidity position of Islamic bank. It seems that
with the experience in the markets, increased the learning curve of the banks, thereby
managing their credit risk to their capacity. Overall result indicates that Islamic banks are
more liquid compared to conventional banks. Table 3.3 shows that the average LAR of
conventional banks is higher than that of Islamic Banks‘, however the difference in means
and dispersions is not significant.
Figure 3.3

Table 3.3

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks 54% 44% 50% 42% 73% 53% 0.1250
Islamic Banks 51% 43% 28% 64% 63% 50% 0.1506

49
3.5.2 PROFITIBILITY RATIOS

a. Return on assets (ROA)

ROA ratio is fluctuating significantly for conventional banks from positive ROA of 1% in
2004 to zero in 2007 and to -4% in 2008. The reason for this decline in the ROA is the
deterioration in the asset quality especially loan‘s portfolio, as there has been significant
provisions against NPL over the years. While Islamic banks‘ ROA has remained positive in
the overall period except in 2006 where Emirates Global Islamic started operations and had a
default on one loan. The average mean of ROA for Islamic banks is higher that of
commercial banks, where there is no difference in the dispersion from the mean in the data of
the both types of banks and statistically there is difference in the means and dispersion.

Figure 3.4

Table 3.4

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks -4% 0% -2% -1% 1% -1% 0.0194
Islamic Banks 2% 1% -1% 3% 1% 1% 0.0144

50
 b. Return on Equity (ROE)

There is significant fluctuation in the ROE of conventional banks which gives us an insight
that there has been deteriorating profit trend for conventional banks due to the bad quality of
loans while at the same time there is increasing trend of the equities of the banks from 2006
onwards due to the merger spree in the market, hence increasing equities. While at the same
time, ROE ratio for Islamic banks remained high with high overall mean and low dispersion
from the mean. The main factors for this stability in the ROE ratio for Islamic banks has
been, due to better quality asset management and making inroads in the niche market and the
Murabaha financing, being a fixed price sale on deferred payment terms, gaining momentum.

Figure 3.5

Table 3.5

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks -20% 4% -9% 4% 9% -2% 0.1201
Islamic Banks 7% 5% 9% 29% 10% 12% 0.0975

c. Earnings Per Share (EPS)

Earning per share for Conventional banks has dropped significantly from the highest 7% in
2004 to 0 in 2006 and -3% in 2008 which indicates that the conventional banks‘ emphasis
was on consolidating of their capital base and least concerned about profitability. Moreover,

51
there has been banks consolidation spree as well thereby increasing the share capital of banks
and reducing earning per share. During this period, Islamic Banks earning per share have
fluctuated in the range of -1% to 4%, with highest 4% in 2005 and lowest -1% in 2006 and
thereafter, the ratio has remained static, indicating that the Islamic Banks profits after taxes
remained in the same range while there has been increasing share capital trend due to the
State Bank capital requirement. Overall, the mean EPS of Islamic banks is higher by 1% than
that of Conventional banks with almost the same dispersion.

Figure 3.6

Table 3.6

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks -3% 1% 0% 3% 1% 0% 0.0199
Islamic Banks 1% 1% -1% 4% 2% 1% 0.0187

d. Profit to Expenses Ratio (PER)

PER indicates that Islamic banks have created more profit per 1 Rupee of operating expense
than conventional banks but with decreasing trend for Islamic Banks. PER of conventional
banks increased from 8% in 2004 to 38% in 2006 showing increase of 375% while afterwards
again there is decreasing trend in the subsequent years. The financial statements of the
conventional banks reveal that there has been an increase in the operating expenses of the

52
banks especially the admin expense in the last 2 years of our study due to merger activities.
After analyzing PER, operating profitability of Islamic Banks is better compared to their
counterpart conventional banks. Moreover, the mean PER of 42% for Islamic banks is
significantly higher than that of 7% for conventional banks with almost same dispersion.

Figure 3.7

Table 3.7

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks -48% -8% 38% 44% 8% 7% 0.3739
Islamic Banks 35% 42% -13% 93% 54% 42% 0.3827

53
3.5.3 RISK AND SOLVENCY RATIOS

a. Debt to Equity Ratio (DER)

Debt to equity ratio decreased from 11.14 times to 4.45 times since 2004 till 2008 while for
Islamic banks the ratio is fluctuating. There has been an increase from 8.39 times in 2004 to
9.14 in 2005, followed by a significant fall to 3.27 times in 2006, increasing in the following
years to 5.14 times in 2008 for Islamic Banks. There is noticeable decrease in the debt to
equity ratio for conventional banks which is mainly due to increase in the equity capital for
conventional due to the minimum capital requirements of the State Bank of Pakistan while
for Islamic banks there is fluctuating movement. Customer deposits constitute major liability
for any type of banks whether Islamic or conventional. Borrowed money stands second
among total liabilities for almost all conventional banks except for all Islamic banks which
are prohibited by Islamic Shari‘ah from taking or giving interest-based debts. Increasing
trend in DER for Islamic bank indicates that deposits base of Islamic bank is increasing more
than its equity base. These results indicate that Islamic Banks are more risky compared to
Conventional banks. We observed from our further analysis of the financial statements of the
group of five conventional banks that for conventional banks decreasing trend in the DER is
partly due to more reliance on equity financing as compared to debt and less deposits base.

Figure 3.8

Table 3.8
54
 2008 2007 2006 2005 2004 Mean S. D
Conventional Banks 445% 462% 707% 760% 1114% 698% 2.7229
Islamic Banks 514% 393% 327% 914% 839% 597% 2.6499
Overall mean DER for conventional banks is 7 times compared to 6 times for Islamic Banks
with almost the same dispersion of data for both data sets.

b. Debt to Total Assets Ratio (DTAR)

The DTAR follows the same pattern for both types of banks as of their respective DER over
the period of 5 years from 2004 to 2008 while the overall mean DTAR for Islamic Banks is
slightly higher than that of Conventional Banks. This ratio indicates the percentage of assets
financed by debt capital. DTAR for conventional banks show decreasing trend and has
stabilized around 66%, indicating that 66% of assets are financed by loan while for Islamic
banks DTAR started falling from 90% and stabilizing around 77% which is higher than that
of conventional banks, meaning that Islamic Banks are more risky and less solvent compared
to their counterpart Conventional Banks. The overall mean DTAR for Conventional banks is
slightly lower than that of Islamic banks, while Islamic banks showing slightly higher
dispersion.

Figure 3.9

Table 3.9
2008 2007 2006 2005 2004 Mean S. D
Conventional Banks 66% 67% 73% 70% 92% 73% 0.1061

55
Islamic Banks 77% 70% 48% 90% 89% 75% 0.1734

c. Equity Multiplier (EM)

Analysis of this measure of risk performance, equity multiplier, shows that Conventional
Banks are more risky as compared to Islamic banks. Further analysis shows that there is a
continuously decreasing trend in the EM of conventional banks from the highest of 12.14
times in 2004 to lowest of 5.45 times in 2008, meaning that conventional banks more assets
are financed by their equity that through debt capital. Whereas EM of Islamic Banks
increased initially from 9.4 times in 2004 to 10.14 times in 2005, declined significantly in
2006 to 3.45 times while showed increasing trend in the following years and closed at 6.14
times in 2008. The overall mean of the EM for Conventional Banks is 8 times and higher than
that of 6.77 times of the Islamic Banks indicating that Islamic Banks are solvent and less
risky than Conventional Banks.

Figure 3.10

Table 3.10
2008 2007 2006 2005 2004 Mean S. D
Conventional Banks 545% 562% 807% 860% 1214% 798% 2.7229
Islamic Banks 614% 473% 345% 1014% 939% 677% 2.9077

56
 d. Capital Adequacy Ratio (CAR)

Solvency position of the Islamic banks has strengthened and settled at around 29% in 2008,
which was as low as 12% in 2005, jumped significantly in 2006 to 44% due to capital
injections and less risky assets (being deposits with the State Bank and other banks),
afterwards allocating its capital to more risky assets and the ratio has decreased to 32% in
2007 and 29% in 2008 but again above the regulatory required ratio of 8%. While at the same
time CAR for conventional banks is moving above 20% except in year 2006. Higher ratio for
Islamic banks indicate that they are more solvent and less risky that their counterpart
conventional banks as shown by the overall average ratio of 24% for Islamic Banks compared
to 16% of Conventional Banks.

Figure 3.11

Table 3.11

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks 21% 24% 15% 22% 0% 16% 0.0962
Islamic Banks 29% 32% 44% 12% 0% 24% 0.1743

57
 e. Non Performing Loans to Net Loans (NPL/NL)

NPL/NL ratio indicate the quality of credit portfolio and shows deteriorating credit portfolio
of Conventional banks compared to Islamic Banks whose NPL/NL ratio is just 1% compared
to 14% of Conventional Banks. NPL/NL ratio has increased significantly to 21% in 2006,
with decrease of 7% in 2007 and again increased to 19% in 2008. NPL/NL ratio of Islamic
banks has remained very low as the significant portion of its financing portfolio is composed
of Murabaha and Ijara which are short terms products. Another indicating feature is that
Islamic Banks have adopted more prudent and conservative approach in their financing
activities while Conventional Banks have been aggressive in their lending making them more
risky and less solvent. Over mean NPL to NL ratio for Conventional banks is higher than that
of Islamic banks.

Figure 3.12

Table 3.12

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks 19% 14% 21% 13% 0% 14% 0.0825
Islamic Banks 2% 0% 0% 2% 0% 1% 0.0109

58
3.5.4 EFFICIENCY RATIOS

a. Asset Utilization (AU)

The trend analysis of AU ratio for both types of banks indicate that Islamic Banks‘ performed
well in terms of asset utilization over the time horizon of 5 years and the ratio has been
consistently higher than that of Conventional Banks. Conventional Banks‘ revenue has been
3% or 4% of their total assets over the period while that of Islamic Banks‘ has been 3%, 4%
and 5% in the given time period. Indicating that Islamic Banks have utilized their assets
efficiently and generated more revenue per Rs of Asset invested therein compared to
Conventional Banks. The overall average AU ratio of Islamic Banks is 4% compared to 3%
of Conventional Banks with dispersion of data in almost the same range.

Figure 3.13

Table 3.13

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks 4% 4% 3% 3% 3% 3% 0.0064
Islamic Banks 5% 4% 3% 5% 3% 4% 0.0087

59
 b. Income to Expense Ratio (IER)

Figure 3.14 shows that IER of conventional banks is well above that of Islamic Banks except
in year 2008, where it has decreased 11% from that of Islamic Banks. The ratio for
Conventional banks indicates that their management has efficiently used their resources and
controlled their variable expenses. For every one Rupee of operating expense conventional
banks generated revenue of Rs. 1.26 in 2004, Rs. 1.37 in 2005, Rs. 1.17 in 2006, Rs. 1.08 in
2007 and Rs. 0.84 in 2008 while Islamic Banks generated revenue below one Rupee for each
Rupee of operating expenses except in 2005. Conventional banks have been more efficient in
managing their expenses and generating revenues with overall mean of 114% compared to
85% of Islamic Banks.

Figure 3.14

Table 3.14

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks 84% 108% 117% 137% 126% 114% 0.2047
Islamic Banks 95% 85% 70% 107% 69% 85% 0.1614

c. Operating Efficiency (OE)

Operating efficiency shows that the entity incurred how much expense to earn one unit of
revenue. As shown by AU ratio, Islamic Banks again showed efficiency in revenue
generation per Rupee expense. Except in 2004, where efficiency ratio was high compared to
60
that of Conventional Banks, Islamic Banks have performed well over the period with overall
mean of 167% compared to 295% of the Conventional banks. Difference in efficiency
performance was huge in 2006 between both types of banks, but the difference narrowed
significantly in 2007 and widened a bit in 2008. Operating efficiency ratio analysis indicates
that Islamic Banks have been more efficient in controlling their operating expenses in
generating revenues.

Figure 3.15

Table 3.15

2008 2007 2006 2005 2004 Mean S. D

Conventional Banks 157% 117% 1005% 118% 79% 295% 3.9775
Islamic Banks 110% 111% 376% 94% 144% 167% 1.1830

61
Table 3.16 Comparison of Islamic Banks' and Conventional Banks'
Financial Ratios

Conventional Banks Islamic Banks

Performance Measure Mean S. D. Mean S.D.

LIQUIDITY
LDR 81% 0.2076 78% 0.0984
CPID 36% 0.1222 35% 0.0929
LAR 53% 0.1506 50% 0.1506
PROFITABILITY
ROA -1% 0.0194 1% 0.0144
ROE -2% 0.1201 12% 0.0975
EPS 0% 0.0199 1% 0.0187
PER 7% 0.3739 42% 0.3827
RISK AND SOLVENCY
DER 698% 2.7229 597% 2.6499
DTAR 73% 0.1061 75% 0.1734
EM 798% 2.7229 677% 2.9077
CAR 16% 0.0962 24% 0.1743
NPL/NL 14% 0.0825 1% 0.0109
EFFICIENCY
AU 3% 0.0064 4% 0.0087
IER 114% 0.2047 85% 0.1614
OE 295% 3.9775 167% 1.1830

62
CHAPTER 4 CONCLUDING REMARKS

4.1 SUMMARY OF FINDINGS

The following points came out while analyzing the empirical findings of this study;

1. Examination of Liquidity measures of performance indicate that though there is no

significant difference in the liquidity position of both types of banks, but Islamic
Banks are comparatively more liquid than their counterpart sample of 5 conventional
banks as shown by Loans to Deposit Ratio (―LDR‖) and Net Loans to Total Assets
Ratio (―LAR‖) while Cash & Portfolio Investment to Deposit Ratio (―CPID‖) indicate
that Conventional banks have more liquid instruments than held by Islamic Banks.
Findings also show that LDR of Conventional Banks show more fluctuation than that
of Islamic Banks which decreased from 90% in 2004 to 77% in 2008. This increasing
trend in the LDR of Islamic banks is due to the level playing field provided by the
State Bank of Pakistan to the nascent Islamic banking industry started in the aftermath
of 9/11 hence increasing their deposit base and financing portfolio while at the same
time consolidation and merger activities were witnessed in the Conventional Banking
industry thereby also taking them at par. After analysis of the financing portfolio of
the Islamic Banks, it came to attention that Islamic Banks started their operations with
Murabaha and Ijarah as their main products with expanding portfolio to Diminishing
Musharaka in housing and Salam and Istisna in the later years.
2. Profitability of the both types of Banks indicate that Islamic banks are more profitable
compared to their comparable conventional banks. This profitability of conventional
banks decreased as they carry a significant amount of non performing loans in their
portfolio hence provision against those bad loans have increased over the years,
cutting down the profits for the equity holders of the banks. While all the four
profitability ratios i.e. ROA, ROE, EPS and PER indicate that Islamic Banks have
been profitable in all these years except in 2006, where they were in overall loss. This
profitability of Islamic Banks indicates that they have been managed effectively,
using more prudent approach in their financing activities and overall operations
controlling expenses. These results indicate that Islamic Banks will outperform in the
coming years by adopting the same conservative approach to lending activities.

63
3. Having analyzed the overall profitability and liquidity ratios of both types of banks,
Islamic Banks though started their operations few years but have surpassed their
counterpart conventional banks in profitability and liquidity maintenance. Also risk
and solvency measures of performance indicate that Islamic Banks are less risky and
more solvent comparatively than their competitors in conventional banking industry.
Of the five risks and solvency ratios, only Debt to Total Assets Ratio (―DTAR‖)
shows that the debt component has increased for Islamic Banks more than that of their
counterpart Conventional Banks. As customer deposits is the significant portion of
total liabilities of banks, and Islamic Banks were able to attract significant deposits
over the years. Solvency position of the both types of banks has strengthened over the
years as shown by Capital Adequacy Ratio (―CAR‖). Major support came for
increased CAR came mainly from capital injections to meet the enhanced minimum
capital requirement, as required under the State Bank of Pakistan regulations. Further,
the process of mergers & consolidation in the banking system also extended hand to
strengthen the solvency of the banking system. CAR of both types of banks is well
above the regulatory threshold of 8%, hence shows the strong solvency position,
while at the same time, Islamic Banks‘ CAR ratio is higher than that of Conventional
Banks. Non Performing Loans to Net Loans Ratio (―NPL/NL‖) for Conventional
Banks is on the higher side, showing that almost one fifth of their loans portfolio is in
trouble, making them more risky. Islamic Banks have managed to maintain quality
portfolio of assets, giving strong risk management indications. The difference in these
performance measures is not statistically significant, which suggests that both types of
banks are falling within same category of risk and solvency position while individual
year wise performance indicate that Islamic Banks are less risky and solvent.

4. Like in liquidity and risk & solvency performance measures, Islamic banks are found
to be statistically different and more efficient in terms of utilization of their assets, in
generating income, and managing their expenses as compared to Conventional banks.
Asset Utility (―AU‖) and Operating Efficiency (―OE‖) suggest that Islamic banks are
efficient whereas Income over Expense Ratio (―IER‖) indicate that Conventional
banks generated revenue 1.14 times of their operating expense compared to Islamic
Banks. This gives us some insight regarding Islamic bank‘s improvement in

64
 generating income, utilization of assets, and effective management in controlling
expenses.
5. Our empirical findings on the performance measurements of Islamic banks in
Pakistan are different and at times mixed in comparison to the results drawn from the
similar studies done in different parts of the world. For example, (Kader & Asarpota,
2007) found in their study that UAE Islamic banks are relatively more profitable, less
liquid, less risky, and more efficient as compared to the UAE conventional banks.
(Samad & Hassan, 1999) revealed in their study that BIMB (Bank Islam Malaysia
Berhad) is less profitable, relatively less risky and more solvent as compared to
conventional banks of Malaysia.
6. (Suyanto, 2005) in his study on the comparison of Bank Muamalat Indonesia (BMI)
with the Conventional banks found that BMI appears statistically less liquid compared
to the conventional banks, risk and insolvency measure between BMI and the
commercial banks found that BMI does not show (statistically) any difference in
DTAR and NPL performance with the commercial banks.

4.2 CONCLUSION
The difference in results in most of the countries is largely due to the fact that Islamic
banking has longer history in those countries as compared to Pakistan where full-fledged
Islamic banking started merely few years back. While conventional banking has a longer
history, wider base, vast experience of learning from the financial markets mechanisms, and
larger share in the Pakistan financial sector. Considering these factors and the results of our
study, Islamic Banking seems to have a promising future and will outperform the
conventional banking in few years time despite human resource constraints, training and
development deficiency, weak learning curve of experience in the market.

65
4.3 RECOMMENDATIONS

As Islamic banks are new in the market and so are the various tools and processes are in the
infancy but the learning curve will increase with time and experience in the market.
1. Islamic banks should target the niche untapped markets to expand their deposit base
as well as extend their financing services as most of the people keep their money in
liquid form either in their homes or with other people.
2. Well articulated marketing and education program should be launched to aware and
educate the people about the Islamic Banking and various modes of finance available.
3. Hiring and developing of efficient employees, not just anybody spirited by the virtue
of Islam, but with education and experience in Banking, economics and finance.
4. A well developed secondary market should be developed for the efficient utilization
of the excess liquidity available with the Islamic Banks.

66
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71
APPENDIX A TABLES OF RATIO ANALYSIS

A. LIQUIDITY RATIOS
Loan to Deposit Ratio (LDR) = Loans / Deposits
2008 2007 2006 2005 2004
Standard Chartered Bank 72% 67% 83% 60%
NIB Bank 77% 70% 102% 93% 114%
Atlas Bank 110% 60% 89% 37%
Samba Bank 63% 37% 43% 62%
KASB Bank 100% 79% 68% 72%

Conventional Banks Mean 84% 63% 77% 65% 114%

Dubai Islamic Bank 71% 70%

Emirates Global Isl. 92% 58%
Dawood Islamic Bank 111% 129%
Bank Islami Pak. 52% 40% 54%
Meezan Bank 57% 63% 78% 87% 90%

Islamic Banks Mean 77% 72% 66% 87% 90%

CPID = Cash & Portfolio Investments / Deposits

2008 2007 2006 2005 2004
Standard Chartered Bank 30% 38% 37% 42%
NIB Bank 43% 44% 31% 34% 16%
Atlas Bank 25% 46% 48% 89%
Samba Bank 47% 39% 53% 49%
KASB Bank 31% 31% 33% 33%

Conventional Banks Mean 35% 40% 40% 49% 16%

Dubai Islamic Bank 22% 31%

Emirates Global Isl. 34% 72%
Dawood Islamic Bank 49% 59%
Bank Islami Pak. 58% 53% 47%
Meezan Bank 29% 30% 25% 24% 29%

Islamic Banks Mean 38% 49% 36% 24% 29%

LAR = Net Loans / Total Assets

2008 2007 2006 2005 2004
72
 Standard Chartered Bank 47% 47% 53% 45%
NIB Bank 45% 46% 67% 61% 73%
Atlas Bank 71% 40% 46% 10%
Samba Bank 37% 23% 30% 39%
KASB Bank 68% 64% 55% 56%

Conventional Banks Mean 54% 44% 50% 42% 73%

Dubai Islamic Bank 56% 53%

Emirates Global Isl. 60% 29% 1%
Dawood Islamic Bank 59% 54%
Bank Islami Pak. 34% 27% 24%
Meezan Bank 47% 51% 58% 64% 63%

Islamic Banks Mean 51% 43% 28% 64% 63%

B. PROFITABILITY RATIOS

ROA = Net Profit after tax / Total Assets

2008 2007 2006 2005 2004
Standard Chartered Bank 10% 11% 6% 8%
NIB Bank -8% -1% 0% 0% 1%
Atlas Bank -8% -3% -2% 0%
Samba Bank -8% -7% -14% -8%
KASB Bank -8% 0% 0% -4%

Conventional Banks Mean -4% 0% -2% -1% 1%

Dubai Islamic Bank -1% -2%

Emirates Global Isl. -2% -1% -4%
Dawood Islamic Bank 9% 6%
Bank Islami Pak. 0% 0%
Meezan Bank 2% 2% 2% 3% 1%

Islamic Banks Mean 2% 1% -1% 3% 1%

ROE = Net profit after tax / Shareholders' equity

2008 2007 2006 2005 2004
Standard Chartered Bank 61% 63% 40% 104%
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 NIB Bank -37% -3% 3% 3% 9%
Atlas Bank -60% -15% -10% 1%
Samba Bank -23% -23% -74% -44%
KASB Bank -44% -2% -1% -43%

Conventional Banks Mean -20% 4% -9% 4% 9%

Dubai Islamic Bank -3% -8%

Emirates Global Isl. -6% -2% -5%
Dawood Islamic Bank 22% 10%
Bank Islami Pak. -1% -1%
Meezan Bank 23% 28% 23% 29% 10%

Islamic Banks Mean 7% 5% 9% 29% 10%

EPS = Net profit after tax / Average number of shares

2008 2007 2006 2005 2004
Standard Chartered Bank 7% 7% 4% 21%
NIB Bank -4% -1% 0% 0% 1%
Atlas Bank -4% -2% -1% 0%
Samba Bank -1% -2% -4% -3%
KASB Bank -10% 0% 0% -4%

Conventional Banks Mean -3% 1% 0% 3% 1%

Dubai Islamic Bank 0% -1%

Emirates Global Isl. -1% 0% -4%
Dawood Islamic Bank 2% 1%
Bank Islami Pak. 0% 0%
Meezan Bank 3% 4% 3% 4% 2%

Islamic Banks Mean 1% 1% -1% 4% 2%

74
PER = Profit before tax / operating expenses
2008 2007 2006 2005 2004
Standard Chartered Bank 209% 234% 344% 430%
-
NIB Bank 135% -48% 2% 4% 8%
Atlas Bank -78% -82% -46% 7%
Samba Bank -67% -149% -116% -142%
-
KASB Bank 171% 6% 6% -82%

Conventional Banks Mean -48% -8% 38% 44% 8%

Dubai Islamic Bank -15% -39%

Emirates Global Isl. -41% -21% -105%
Dawood Islamic Bank 214% 219%
Bank Islami Pak. -22% -20% -22%
Meezan Bank 37% 72% 88% 93% 54%

Islamic Banks Mean 35% 42% -13% 93% 54%

C. RISK AND SOLVENCY RATIOS

DER = Total Debt / Shareholders' equity

2008 2007 2006 2005 2004
Standard Chartered Bank 519% 493% 512% 1228%
NIB Bank 351% 385% 972% 660% 1114%
Atlas Bank 692% 343% 468% 420%
Samba Bank 202% 233% 439% 489%
KASB Bank 463% 854% 1147% 1000%

Conventional Banks Mean 445% 462% 707% 760% 1114%

Dubai Islamic Bank 533% 389%

Emirates Global Isl. 306% 134% 4%
Dawood Islamic Bank 135% 87%
Bank Islami Pak. 268% 276% 101%
Meezan Bank 1327% 1077% 875% 914% 839%

Islamic Banks Mean 514% 393% 327% 914% 839%

75
DTAR = Total debt / Total Assets
2008 2007 2006 2005 2004
Standard Chartered Bank 16% 17% 16% 8%
NIB Bank 78% 79% 91% 87% 92%
Atlas Bank 87% 77% 82% 81%
Samba Bank 67% 70% 81% 83%
KASB Bank 82% 90% 92% 91%

Conventional Banks Mean 66% 67% 73% 70% 92%

Dubai Islamic Bank 84% 80%

Emirates Global Isl. 75% 57% 4%
Dawood Islamic Bank 57% 46%
Bank Islami Pak. 73% 73% 50%
Meezan Bank 93% 92% 90% 90% 89%

Islamic Banks Mean 77% 70% 48% 90% 89%

EM = Total Assets / Total shareholders' equity

2008 2007 2006 2005 2004
Standard Chartered Bank 619% 593% 612% 1328%
NIB Bank 451% 485% 1072% 760% 1214%
Atlas Bank 792% 443% 568% 520%
Samba Bank 302% 333% 539% 589%
KASB Bank 563% 954% 1247% 1100%

Conventional Banks Mean 545% 562% 807% 860% 1214%

Dubai Islamic Bank 633% 389%

Emirates Global Isl. 406% 234% 104%
Dawood Islamic Bank 235% 187% 100%
Bank Islami Pak. 368% 376% 201%
Meezan Bank 1427% 1177% 975% 1014% 939%

Islamic Banks Mean 614% 473% 345% 1014% 939%

76
CAR = Total Regulatory Capital / Risk weighted Assets
2008 2007 2006 2005 2004
Standard Chartered Bank 10% 11% 10% 16%
NIB Bank 20% 3% 12% 17%
Atlas Bank 10% 27% 16% 45%
Samba Bank 55% 65% 29% 22%
KASB Bank 9% 12% 7% 8%

Conventional Banks Mean 21% 24% 15% 22% 0%

Dubai Islamic Bank 21% 23% 56%

Emirates Global Isl. 30% 50%
Dawood Islamic Bank 45% 52%
Bank Islami Pak. 40% 26% 62%
Meezan Bank 10% 11% 14% 12%

Islamic Banks Mean 29% 32% 44% 12% 0%

NPL/ NL = Non performing Loans / Net loans

2008 2007 2006 2005 2004
Standard Chartered Bank 10% 10% 7% 1%
NIB Bank 28% 16% 3% 0%
Atlas Bank 7% 0% 6% 0%
Samba Bank 32% 40% 83% 56%
KASB Bank 18% 4% 7% 10%

Conventional Banks Mean 19% 14% 21% 13% 0%

Dubai Islamic Bank 2% 0%

Emirates Global Isl. 0% 0% 0%
Dawood Islamic Bank 1% 0%
Bank Islami Pak. 3% 0%
Meezan Bank 5% 2% 0% 2% 0%

Islamic Banks Mean 2% 0% 0% 2% 0%

D. EFFICIENCY RATIOS

77
AU = Total Revenue / Total assets
2008 2007 2006 2005 2004
Standard Chartered Bank 9% 9% 6% 7%
NIB Bank 4% 1% 3% 3% 3%
Atlas Bank 3% 2% 1% 2%
Samba Bank 5% 2% 0% 2%
KASB Bank 2% 4% 4% 3%

Conventional Banks Mean 4% 4% 3% 3% 3%

Dubai Islamic Bank 5% 5%

Emirates Global Isl. 3% 4% 1%
Dawood Islamic Bank 5% 3%
Bank Islami Pak. 5% 3% 3%
Meezan Bank 5% 5% 4% 5% 3%

Islamic Banks Mean 5% 4% 3% 5% 3%

IER = Total Income / Total operating expenses

2008 2007 2006 2005 2004
Standard Chartered Bank 182% 183% 275% 327%
NIB Bank 84% 121% 124% 117% 126%
Atlas Bank 39% 58% 73% 109%
Samba Bank 54% 51% 2% 36%
KASB Bank 59% 124% 111% 98%

Conventional Banks Mean 84% 108% 117% 137% 126%

Dubai Islamic Bank 94% 68%

Emirates Global Isl. 59% 81% 11%
Dawood Islamic Bank 94% 68%
Bank Islami Pak. 90% 86% 79%
Meezan Bank 137% 120% 121% 107% 69%

Islamic Banks Mean 95% 85% 70% 107% 69%

OE = Total operating expenses / Total operating

revenue
2008 2007 2006 2005 2004

78
 Standard Chartered Bank 55% 55% 36% 31%
NIB Bank 120% 82% 81% 85% 79%
Atlas Bank 255% 171% 137% 92%
Samba Bank 186% 195% 4681% 279%
KASB Bank 171% 81% 90% 102%

Conventional Banks Mean 157% 117% 1005% 118% 79%

Dubai Islamic Bank 106% 147%

Emirates Global Isl. 171% 124% 918%
Dawood Islamic Bank 87% 83%
Bank Islami Pak. 111% 116% 127%
Meezan Bank 73% 83% 83% 94% 144%

Islamic Banks Mean 110% 111% 376% 94% 144%

Source: Financial statements of the banks from their respective websites (See Websites)

79
APPENDIX B COMPARATIVE ANALYSIS OF ISLAMIC FINANCING PRODUCTS

FEATURES MURABAHA MUDARABAH MUSHARAKAH ISTISNA'A IJARA

Construction /
Trade Financing Equity Financing -Combining Equity Financing - Manufacturing Lease Financing
Nature of Financing
Capital and Knowledge Work Partnership Based
Pre-Financing

Type of Financing Deferred Sale Joint Venture - Profit Deferred Sale Leasing
Trustee -Profit Sharing
Sharing
Long-Term : 3 to 10
Short-Term to
Short-Term: 1 month to 2 years Mid-Term: 1 to 3 years years except
Tenure Long term: 6
Diminishing Mid-Term: 2 to 5 years
months to 7 years
Musharaka

Yes, This may take the form of real

property mortgage, liens on deposit
Collateral
accounts, salary transfer, assignment of property
income or farm income etc..
Commercial finance requires various modes of
Insurance Need
insurance such as insurance against fire, theft,
damage, accidents, liability or natural disaster.
Management and Control and Management and control on
Role of Bank in Management Control on the use of Finance No management by the Bank control which can be follow-up which
the use of Finance
delegated can be delegated

Business or venture Customer's cash flow(lease

Customer's cash flow Mudaraba cash flow Project's cash flow
cash flow rentals)

2nd way out is

2nd way out is Net asset value of 2nd way out is Net repossession of 2nd way out is repossession
Sources of Payment 2nd way out is repossession of sold goods asset value of
Mudaraba contracted of leased assets
Musharaka
assets

3rd way out is the Mudarib's 3rd way out is customer's

3rd way out is customer's collaterals 3rd way out is
personal assets if any incase of collaterals
customer's
breach of contract or

80
 mismanagement collaterals

In the event of In the event of breach of

In the event of breach of
Legal Recourse Mudaraba contract,
In the event of non-payment and breach of contract
mismanagement and negligence
In the event of breach breach of Istisna'a contract and excessive
of Musharaka contract,
contract and poor damage to leased assets
mismanagement and
negligence quality and/or non- payment

Viable and profitable

business or venture; Customer's strong
Viable and profitable business or Customers capabilities, credit rating;
Customer's strong credit
venture, Customers capabilities, qualifications and Customers
qualifications and experience; experience in the capability and rating; Customer's capability
Customer's strong credit rating; Adequate Customer's strong credit rating; related business; experience; and experience; Technical
Financing Criteria
collaterals Excellent & effective management Customer's strong Technical know- know-how; Excellent
of the business; Excellent credit rating; Excellent how; Excellent management; Adequate
customer track record; Technical & effective management; collaterals
know-how management of the Adequate
business; Excellent collaterals
customer track record;
Technical know-how.
Upon signing the Leased Assets are property
Ownership is transferred to the customer after he Mutual Ownership of Mudaraba Equity Ownership of contract the of the bank during the
Asset Ownership
buys the goods from the Bank Fund the Musharaka customer owns the financing period, then to the
specified asset customer at the end of the
contract
Profit / Loss sharing as
per Musharaka Agreed mark up
Sharing of Profit as per Mudaraba
contract. This include or rental income Rental income and residual
Rate of Return Agreed markup as per Murabaha contract contract with full bearing of value of Leased Assets as
annual dividend and as per the Istisna'a
losses by Rabun Mal per Ijara contract
capital appreciation if contract
any

81
Islamic and Conventional banking; comparative analysis – Pakistan’s perspective

APPENDIX C GLOSSARY OF TERMS

Bai Salam ( ): Salam means a contract in which

advance payment is made for goods to be delivered later on. The
seller undertakes to supply some specific goods to the buyer at a
future date in exchange of an advance price fully paid at the time
of contract. According to normal rules of the Shari’ah, no sale can
be effected unless the goods are in existence at the time of the
bargain, but Salam sale forms an exception given by the Holy
Prophet (SAW) himself to the general rule provided the goods are
defined and the date of delivery is fixed. It is necessary that
the quality of the commodity intended to be purchased is fully
specified leaving no ambiguity leading to dispute. The objects of
this sale are goods and cannot be gold, silver or currencies because
these are regarded as monetary values exchange of which is
covered under rules of Bai al Sarf, i.e. mutual exchange is hand to
hand without delay. Barring this, Bai Salam covers almost
everything which is capable of being definitely described as to
quantity, quality and workmanship.

Gharar ( ): It means any element of absolute or excessive

uncertainty in any business or a contract about the subject of
contract or its price, or mere speculative risk. It leads to undue loss
to a party and unjustified enrichment of other, which is prohibited.
Halal ( ): Anything permitted by the Shari‘ah.
Haram ( ): Anything prohibited by the Shari‘ah.
Ijarah ( ): Letting on lease. Sale of a definite usufruct of any
asset in exchange of definite reward. It refers to a contract of
land leased at a fixed rent payable in cash and also to a mode
of financing adopted by Islamic banks. It is an arrangement
under which the Islamic banks lease equipments, buildings or other

82
Islamic and Conventional banking; comparative analysis – Pakistan’s perspective

facilities to a client, against an agreed rental. Ijarah-wal-Iqtina‘

( ): A mode of financing, by way of Hire-

purchase, adopted by Islamic banks. It is a contract under which
the Islamic bank finances equipment, building or other facilities
for the client against an agreed rental together with a unilateral
undertaking by the bank or the client that at the end of the lease
period, the ownership in the asset would be transferred to the
lessee. The undertaking or the promise does not become an
integral part of the lease contract to make it conditional. The
rental as well as the purchase price are fixed in such a manner that
the bank gets back its principal sum along with some profit, which
is usually determined in advance.

Istisna’a ( ): It is a contractual agreement for

manufacturing goods and commodities, allowing cash payment
in advance and future delivery or a future payment and future
delivery. A manufacturer or builder agrees to produce or build a
well described good or building at a given price on a given date in
the future. Price can be paid in installments, step by step as agreed
between the parties. Istisna‘a can be used for providing the facility
of financing the manufacture or construction of houses, plants,
projects, and building of bridges, roads and highways.

Al- Kafalah (Suretyship) ( ): Literally, Kafalah means

responsibility, amenability or suretyship, Legally in Kafalah a
third party become surety for the payment of debt. It is a pledge
given to a creditor that the debtor will pay the debt, fine etc.
Suretyship in Islamic law is the creation of an additional liability
with regard to the claim, not to the debt or the assumption only of a
liability and not of the debt.

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Khiyar ( ): Option or a power to annul or cancel a

contract.

Maisir ( ): An ancient Arabian game of chance played

with arrows without heads and feathering, for stakes of slaughtered
and quartered camels. It came to be identified with all types of
hazard and gambling.

Mudaraba ( ): A form of partnership where one party

provides the funds while the other provides expertise and
management. The latter is referred to as the Mudarib. Any profits
accrued are shared between the two parties on a pre-agreed basis,
while loss is borne by the provider(s) of the capital.

Murabaha ( ): Literally it means a sale on mutually agreed

profit. Technically, it is a contract of sale in which the seller
declares his cost and the profit. This has been adopted by Islamic
banks as a mode of financing. As a financing technique, it can
involve a request by the client to the bank to purchase a certain item
for him. The bank does that for a definite profit over the cost which
is stipulated in advance.

Musawamah ( ): Musawamah is a general kind of sale in

which price of the commodity to be traded is bargained between
seller and the purchaser without any reference to the price paid
or cost incurred by the former.

Musharaka ( ): Musharaka means a relationship

established under a contract by the mutual consent of the parties
for sharing of profits and losses in the joint business. It is an
agreement under which the Islamic bank provides funds which
are mixed with the funds of the business enterprise and others.
All providers of capital are entitled to participate in management,
but not necessarily required to do so. The profit is distributed among
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the partners in pre-agreed ratios, while the loss is borne by

every partner strictly in proportion to respective capital
contributions.

Qard (Loan of fungible objects) ( ): The literal meaning of

Qard is ‗to cut‘. It is so called because the property is really cut
off when it is given to the borrower. Legally, Qard means to give
anything having value in the ownership of the other by way of
virtue so that the latter could avail of the same for his benefit with
the condition that same or similar amount of that thing would be
paid back on demand or at the settled time. It is that loan which
a person gives to another as a help, charity or advance for a
certain time. The repayment of loan is obligatory. The Holy
Prophet is reported to have said ―…..Every loan must be
paid……‖. But if a debtor is in difficulty, the creditor is expected
to extend time or even to voluntarily remit the whole or a part of
the principal. Qard is, in fact, a particular kind of Salaf. Loans
under Islamic law can be classified into Salaf and Qard, the former
being loan for fixed time and the latter payable on demand.
(see Salaf)

Qimar ( ): Qimar means gambling. Technically, it is

an arrangement in which possession of a property is contingent
upon the happening of an uncertain event. By implication it
applies to a situation in which there is a loss for one party and a
gain for the other without specifying which party will lose and
which will gain.

Riba ( ): An excess or increase. Technically, it means an

increase over principal in a loan transaction or in exchange for a
commodity accrued to the owner (lender) without giving an
equivalent counter-value or recompense (‗iwad) in return to the
other party; every increase which is without an ‗iwad or equal

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counter-value.

Al- Rahn ( ): Pledge, Collateral; legally, Rahn means to

pledge or lodge a real or corporeal property of material value, in
accordance with the law, as security, for a debt or pecuniary
obligation so as to make it possible for the creditor to recover the
debt or some portion of the goods or property. In the pre-Islamic
contracts, Rahn implied a type of earnest money which was
lodged as a guarantee and material evidence or proof of a
contract, especially when there was no scribe available to put it
into writing. The institution of earnest money was not accepted
in Islamic law and the common Islamic doctrine recognized
Rahn only as a security for the payment of a debt.

Shari’ah ( ): The term Shari‘ah refers to divine guidance

as given by the Holy Qur‘an and the Sunnah of the Prophet
Muhammad (PBUH) and embodies all aspects of the Islamic faith,

including beliefs and practice. Shirkah ( ): A contract

between two or more persons who launch a business or financial
enterprise to make profits. In the conventional books of Fiqh, the
partnership business has been discussed under the option of
Shirkah that, broadly, may include both Musharaka and Mudaraba.
Sunnah
Wakalah ( ): A contract of agency in which one person
appoints someone else to perform a certain task on his behalf,
usually against a certain fee.
*********************************
(Source: SBP Publication, ‗Islamic Banking and Finance:
Theory and Practice‘ by Muhammad Ayub, Sr. J.D. IBD, SBP)

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WEBSITES

Insurance Association of Pakistan: www.iap.net.pk/

State Bank of Pakistan: www.sbp.org.pk

Securities and Exchange Commission of Pakistan: www.secp.org.pk

Meezan Bank Limited: www.meezanbank.com

Bank Islami Pakistan: www.bankislami.com.pk/

Dawood Islamic Bank Limited: www.dawoodislamic.com

KASB Bank Limited: www.kasbbank.com

NIB Bank: www.nibpk.com

Samba Bank Limited: pak.samba.com

Standard Chartered Bank (Pakistan) Limited: www.standardchartered.com.pk

Atlas Bank Limited: www.atlasbank.com.pk

Emirate Global Islamic bank Limited: www.egible.com

Mutual Funds Association of Pakistan: www.mufap.com.pk

Dubai Islamic Bank Pakistan Ltd. www.dibpak.com/

Pakistan Economist
http://www.pakistaneconomist.com/database2/pakbanks.asp

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