Islamic banking and

Conventional banking : Risk

management and effect of
global financial crisis

NORAINI BT MANAN
MOHD NUR AZRUL BIN MOHD TARMIZI
MOHD NAZIM MAT NAWI
INTRODUCTION
 Conventional Bank : banks earn profits by
purchasing deposits from the depositors at
a low interest rate, then reselling those
funds to the borrowers at higher interest
rate, based on its competitive advantage
at gathering information and underwriting
risk.
 Islamic Bank : same role as an intermediary,
but did not receive a set interest rate and
not the borrowers who have been
appointed for the depositor, the amount of
profits based on revenue sharing
arrangement with the investors, and also
with the borrowers.
Early sixties/seventies – muslim
concern about islam (back to
religion spirit)
Dr. . Ahmed Al-Naggar -that
established as company based on
Islamic principles that known as Mit
Ghamr Local Saving Bank.
In 2009 – Islam was 2nd largest
religion in the world that has
1.57bilion adherents, making 23% of
the world population.
Islamic law and Islamic finance
The source of shariah include theAl-
Quran, As-Sunnah (hadith), Ijma’,
Qiyas and Ijtihad.
The basis that be used was :
-prohibition of collecting the interest

(riba’),
-prohibition in entering the uncertain

contract/process (gharar)
-prohibition of gambling (masir)

-prohibition of the use non-halal

product such as pork and alcohol.


The differences between
Islamic banking and
Conventional

banking
Conventional system
ØMoney is a product besides medium of
exchange and store of value.
ØTime value is the basis for charging
interest on capital.
ØInterest is charged even in case, the
organization suffers losses. Thus no
concept of sharing loss.
ØWhile disbursing cash finance, running
finance or working capital finance, no
agreement for exchange of goods &
services is made.
ØDue to non existence of goods &
services behind the money while
ØDue to inflation the entrepreneur
increases prices of his goods &
services, due to incorporating
inflationary effect into cost of
product.
ØBridge financing and long term loans
lending is not made on the basis of
existence of capital goods. Rather,
they are disbursed on the basis of
project feasibility and credibility of
the entrepreneur.
ØGovernment very easily obtains
loans from Central Bank through
Money Market Operations without
ØThe expanded money in the money
market without backing the real assets,
results deficit financing.
ØReal growth of wealth does not take
place, as the money remains in few
hands.
ØDue to failure of the projects the loan is
written off as it becomes non
performing loan.
ØDebts financing gets the advantage of
leverage for an enterprise, due to
interest expense as deductible item
form taxable profits. This causes huge
burden of taxes on salaried persons.
Thus the saving and disposable income
of the people is effected badly. This
results decrease in the real gross
domestic product.
ØDue to decrease in the real GDP, the net
Islamic system
vReal Asset is a product. Money is just
a medium of exchange.
vProfit on exchange of goods &
services is the basis for earning
profit.
vLoss is shared when the organization
suffers loss.
vThe execution of agreements for the
exchange of goods & services is
must, while disbursing funds under
Murabaha, Salam & Istisna
contracts.
vDue to existence of goods & services
no expansion of money takes place
vDue to control over inflation, no
extra price is charged by the
entrepreneur.
vMusharakah & Diminishing
Musharakah agreements are made
after making sure the existence of
capital good before disbursing
funds for a capital project.
vGovernment can not obtain loans
from the Monetary Agency without
making sure the delivery of goods
to National Investment fund.
vBalance budget is the outcome of no
expansion of money.
vReal growth in the wealth of the
vDue to failure of the project, the
management of the organization can
be taken over to hand over to a better
management.
vSharing profits in case of Mudarabah and
sharing in the organization of business
venture in case of Musharakah,
provides extra tax to Federal
Government. This leads to minimize
the tax burden over salaried persons.
Due to which savings & disposable
income of the people is increased,
which results the increase in the real
gross domestic product.
vDue to increase in the real GDP, the net
exports amount becomes positive, this
Balance Sheet Analysis of
Islamic and Conventional
Banking
 In financial risk management, there are
many method and approaches can be
adopted.
 In top-down approach, the balance sheet
analysis can be done in evaluating Islamic
as compared to conventional banking the
risks.
 The balance sheet highlights the financial
condition of a company and is an integral
part of the financial statements.
 Understanding the structure and
composition of balance sheet is important
in managing the risks associated by the
institutions.
Balance Sheet of Conventional
Banking (CB)
 The composition of liability in the balance sheet
is accepts demand and saving deposits, issues
term certificates such as certificate of deposits
(CD), and has capital.
 For the asset part, it can consists of marketable
securities, trading accounts, lending to
corporations and to consumers.
 Those assets and liabilities components can be
illustrated by the following table.

Assets Liabilities
Loans and advances to customersCustomers’ deposits
Cash and cash balances with Due to banks and other financial
other banks in associates,
Investments institutions
Other liabilities
subsidiaries
Financial and held
assets jointfor
ventures
trading Sundry creditors
Cash and cash balances with the Equity and reserves
central bank
Balance Sheet of Islamic
Banking (IB)
 Asdiscussed earlier on, Islamic banking and
conventional banking are different in nature
and thus reflect the nature of risks exposed
 The cornerstone of Islamic banking is mudarabah
contract, the use of fund available in the bank
based on some form of profit sharing between
depositors , bank and entrepreneur.
 The bank can be viewed as intermediary of
depositors and entrepreneurs in managing or
matching the fund and profit is on the services
rendered.
 Those application of funding (assets) and
sources of funding (liabilities) components can
be illustrated by the following table.

Application of funding Sources of funding
Cash balances Demand deposits (amanah)
Financing assets (murabaha, Investment accounts
salam, ijara,assets
Investment istisna) (mudarabah)
Special investment accounts
(mudarabah,
Fee-based musharakah)
services (ju’ala, (mudarabah, musharakah)
Reserves
kafala, and soassets
Non-banking forth) Equity capital
(property)
Comparison of the Balance
Sheets
 Evaluating of the CB balance sheet, it can
be seen that the first risk easily observed
is the asset-liability mismatch.
 Fund from the depositors are not pre-set
liability to be match to thee types of usage
in the asset column.
 Thus it may create mismatch of asset-
liability that can cause uncertainty in
meeting risk-return profile of the
depositors.
 Even after it is matched, then the maturity
of the asset-liability expose the bank to
the risk of maturity mismatch.
 As fund from the depositors consider as
short-term in nature, it is used to finance
 Therefore, the bank is exposed to liquidity risk in
meeting future obligation of withdrawal from
depositors.
 Some other risk associate by the bank are
market risk, credit risk and rate of return risk.
 In contrast with IB, the nature of its balance
sheet is to pass and manage the fund from
depositor to entrepreneur.
 It able to resolve mismatch issues of asset-
liability of CB.
 However, some other issues need to be address
such as estimation and accrual of ex-post
returns and the treatment of intra-period
withdrawal of deposits (Hennie van Greuning,
 Conventional bank make use of fixed
income that provide low credit risk debt
securities.
 Islamic banking assets are investments
backed by real assets as opposed to paper
assets like conventional banking.
 Thus, it reduce its exposure to risks such as
interest rate risk.
 The current innovation of sukuk provide
alternative for Islamic banking to diverse
its portfolio.
 In Islamic bank, the asset and financing are
coupled together as compared to
conventional bank that separated asset
and loan that financing its from
 Itcan be seen in the asset column of Islamic
bank where there is lack of liquid
securities due to short of shariah-
compliance instrument available.
 Perhaps in future, those Islamic financial
instruments will be available.
 Due to prohibition of interest, Islamic bank
will not use interest-bearing debt to
finance assets.
 As the result, the bank will not have
leveraging issues that can effect one the
financial crisis occur.
 The issues will be discussed in the next part.
Effect of Global Financial Crisis :
Islamic Banking versus Conventional
Banking
 Itis the current debate that Islamic finance
provide s more stability due it main
principles adopted.
 For the recent financial crisis occurred,
many try to compare and evaluate
Islamic finance and how Islamic banking
effected by the crisis.
 Researchers try to provide answers or
proof for the subject matter.
 Arguments such as Islamic banking is
insulated from the crisis, experience
positive impact and so on.
 Research studies prior to recent global
financial crisis have generally concluded
 that the performance of Islamic banks
have been better than conventional
 Islamic banks did delivered better in
profitability and were higher capitalized than
conventional banks over the period of 2006
to 2009. (Sat Paul Parashar , Jyothi
Venkatesh, 2010).
 However from the same studies, it is also found
that during crisis, Islamic banking suffered
more in terms of capital adequacy and
leverage while conventional banking suffered
more in terms of return on average assets
and liquidity.
 The empirical studies to various Islamic
countries like Egypt and Malaysia and almost
all of them, have concluded that Islamic
banking performance is relatively better than
its conventional counterparts (Zineldin, M.,
1990).
 Islamic bank in some ways do actually
have positive correlation toward what
happen to conventional bank.
 The profits of Islamic banks could be
affected by the international financial
crisis, but not the capital, which is
protected by Islamic banking unlike
conventional banks
 It also because Islamic banks do not deal
in debt trading and avoid the market
speculation that takes place in European
and American banks.
 There is a strong rationale behind the
prohibition of interest as it will make the
financial system healthier and more
stable by injecting greater discipline into
it (Dr. M. Umer Chapra, 2007).
Conclusion
 Islamic finance does demonstrate good
banking behavior .
 Islamic financial institutions work on a
philosophy of prohibiting transactions
considered immoral and promoting greater
social justice by sharing risk and reward.
 It help to promote the industry not to be too
greed as it will cause instability in the
financial system.
 It is believed that the recent financial crisis
has help to uphold and promote the
Islamic banking and Islamic finance as
well as.

 Balance sheet analysis: Islamic vs.
conventional, Hennie van Greuning,
Zamir Iqbal, 2009,
http://www.newhorizonislamicbanking.com


 http://www.islamic-foundation.org.uk/Islamic


 Zineldin, M. (1990). The economy of

money and banking: a theoretical and
empirical study of Islamic interest-free
banking, Stockholm: Almquist and
Wiksell international.

ISLAMIC BANKING IN THE PREVAILING


INTERNATIONAL FINANCIAL PERSPECTIVE, Dr.

M. Umer Chapra*, 2007, Islamic Research
and Training Institute, Islamic Development
Bank Jeddah, Saudi Arabia,
www.muchapra.com
 www.learnislamicfinance.com
Competitive conditions in Islamic and


conventional banking: A global perspective.

Rima Turk Ariss, 2010, Review of Financial
Economics VOL 19, page 101–108

Liquidity Risk Management: A comparative study
between Conventional and Islamic Banks of Pakistan .
Muhammad Farhan Akhtar, Khizer Ali, Shama Sadaqat
.Hailey College of Commerce, University of the
Punjab, Lahore, Pakistan. Jan 2011.
Interdisciplinary Journal of Research in Business
Vol. 1, Issue. 1, (pp.35-44)