The effect of financial crisis on Islamic banking Compared with non-Islamic banking in Gulf council countries (GCC).
In the early 1970s, Islamic banking system was developed. The first Islamic bank to be developed in the United Arab Emirates was the Dubai Islamic Bank. This led to the development of the International Islamic Development Bank found in Jeddah Saudi Arabia. After the establishment of these two banks, many commercial and semi private banks were developed in Sudan, Egypt, Kuwait, Molyneux, Iqbal and Bahrain (Al-Jarrah, & Molyneux, 2003). Consequently, Islamic banking started to extend its services to other Islamic nations such as Pakistan, Bangladesh and Iran.
In Iran, the Islamic bank was supposed to establish minimum and maximum rates of return for various industries. This enabled many Islamic banks in financing their operations and maximizing their profits while they were still observing the Shariah requirement. According to Alkassim (2005), this Shariah requirement stated that no interest is supposed to be charged. There are various approaches used by Islamic banking in accommodating the sharing of loss and profits. The first approach is partnership known as Musharaka. This is a distribution of investments by the Islamic bank without it being in the management team.
The second approach is Mudrabah. This is basically based on the leasing contract mark-up that is referred to as ijara, whereby many non-Islamic banks work on interests. Operating these banks in this manner really increases the banking system stability. This is because the system encourages the bank in diversifying their investments to increasing profits and minimizing risks. Alkassim (2005) stated that more investors are attracted by these procedures. They assist the banks in operating more efficiently. The practices of Shariah banking are operated in four business laws that are no the same. The first law is the principle of the borrower and the lender sharing in the latter is loss and profit. The second business law is fix charges implemented beforehand. The third business law is assessing no interest while the last law is a collaboration of the lender and the borrower (Akhtar, 2010).
Also, in case of sharing profits and losses, two principles are implemented. The first one is Mudrabah that is recognized as an agreement made by any two groups. In the case of banking, a particular group will supply funds while the other group will use the funds in the business. When profits are made, the business that used the loan would divide a portion of its profit to the supplier. This is based on the pre-agreed formula. In case a loss experienced due to any normal operation, the bank would accept all the financial loss, while the user will have lost his efforts and time (AlKhathlan & Malik, 2010). These transactions would be similar to profit ventures in the non-Islamic banks whereby one party provides the experiences while the other provides funds. The second principle is called Musharaka which is a partnership done by two parties for project participation.
Financial Sector Background
In Islamic banking, the bank gives the capital and business provides the project management. If profit is gained, the two parties will divide it as stated in the previous agreement. On the other hand, in case of a loss, both parties would share equally as stated in the agreement. This kind of transaction is the same as joint ventures done in non-Islamic banks whereby profits and losses are divided equally as in the agreement. The other Islamic banking principle is the practice of interests versus fixed bank charges. In Arabic, this concept is referred to as Murabaha based basically on adding the fixed finance costs to the costs of services and goods (AlKhathlan & Malik, 2010). Additionally, Murabaha is a contract whereby the sales persons let the buyers know the prices of the goods and services then talks over the profit margin later.
This kind of transaction is the same as rent-to own arrangements in non-Islamic banks. The other tool used in the Islamic banks is Bai-Mua’jjal. This is a delayed payment sale that has no extra charges. This type of transaction is similar to delayed payment sale in non-Islamic banks whereby the two parties agree on the delayed payments. Ijara an Arabic name for leasing is the main contract used for this activity. AlKhathlan & Malik (2010) assert that the owner of the goods makes them obtainable for use by another group. When the payment is done, the client can own the goods. This type of concept is the same as non-Islamic banking leasing practices with buying options.
Additionally, the Qurad is found in the charge-free categories. The borrowers return the principal amounts to the creditor without adding any extra money. Other categories of principle in use in the Islamic banking are Rhan referred to pledge and Wadiah referred to trusteeship. These principles are the same as saving accounts in the non-Islamic banks. Islamic banking adheres to the Mudaraba principle in case of investment deposits and savings. The person depositing has no knowledge on the yields to be achieved by the investment beyond the profit sharing ratio agreed by the borrower and the lender. Additionally, a repayment is to be done to the Islamic bank if there are higher profits than the one agreed by the bank or the depositor’s profit (Al-Jarrah, & Molyneux, 2003).
The principle of sharing profit and loss in the bank is applied by the use of two tools. The Mushararka whereby the business and the bank contributes a given amount of capital and agrees on a precise profit ratio. As stated by AlKhathlan & Malik (2010), many of the investments made are high risk ventures whereby all bankers are advised to be cautious. Moreover, Islamic banks have to increase their competition with non-Islamic banks by trying to fund projects having lower risks. In the Islamic banks, loan interests were prohibited because it would generate capital with no corresponding effort. Increase in incomes is supposed to come from labor, investments or other activities. It is not necessary for using investor’s fund by a debtor rather, than the correlation between debtors and creditors is primary, not the bottom line of the creditor. When practicing, the two parties share any profits and risks. This is done at the agreed rate as an alternative of a fixed rate done in the non-Islamic banking.
Al-Jarrah, & Molyneux (2003) revealed that the Islamic banking assesses fixed charges or commissions for the rendered services. These services include loan processing. In these ways, beyond profit sharing, bank finance costs and increase profits. Al Shamsi, Aly, & El-Bassiouni (2009) stated that these Islamic banks contract for bigger profit proportions than the debtors since the bank is taking a greater risk. In loans having longer terms, investors are needed to retain their funds accessible to the debtor until the contract period is over. This type of feature exposes Islamic banking to high liquidity risks in case the investment fails. In current years, Islamic banking experienced a constant growth.
A report issued by the International Monetary Fund stated that in 2005, Islamic banks increased from seventy five institutions to three hundred institutions worldwide. At 2007, the total Islamic banking industry asset was estimated to be $250billion, whereas the growth rate of Islamic banking was close to 15% yearly. This growth rate is nearly three times the growth rates found in the traditional non-Islamic banks. The growth rate of Islamic banking assets through 2007 was between 25-40% (Al-Jarrah, & Molyneux, 2003). Additionally, there were almost here hundred Islamic financial institutions worldwide that had nearly $500 billion in assets. There have been tremendous increases in Islamic banking assets by 29% through 2009. Through 2009, the Islamic banking assets were estimated to have values of $882 billion. By 2015, Islamic banking assets are estimated to reach $4trillion (Al-Tamimi, 2010).
Different studies have been carried out on the Islamic banking system efficiency. This fact differs with the overabundance of such studies for non-Islamic banks. Various researchers tried to measure liquidity, profitability, solvency and risk in the Islamic banking sector. These researchers thought that liquidity ratios in the Islamic banks could be high in the early stages of operation and Islamic banking growth depends on increase in public awareness like banks and the financial tools they implement. Two different periods were used in comparing and employing the accounting ratios that were divided into liquidity, solvency, risk and profitability. These periods were 1990 to 1997 and 1984 to 1989 (Al-Jarrah, & Molyneux, 2003).
Institutions that were committed to the Islamic community were also measured and it was revealed that Islamic banking had more liquidity than non-Islamic banking. This was in terms of cash deposits. Islamic banking had cash deposit ratios of .02 in comparison to .01 for the non-Islamic banking. During their developments, any Islamic banks experienced increased risks even though these banks were found to be less risky than non-Islamic banks with performances in serving the community properly similarly to non-Islamic banks.
Al-Tamimi (2010) stated that the efficiency of the Islamic banking system was examined by a specific analyst called Yudistira in eighteen banks for over three years. This analyst used DEA as a comparative measure in the efficiency of the various banks. It was found that an efficient bank could score one in efficiency. This most efficient bank did not necessarily produce the maximum output level from the inputs given. Subsequently, data from balance sheets and nonconsolidated income statements were collected. These data were both obtainable from International bank Credit Analysis, Ltd based in London. The time period put into consideration was 1998 to 1999 when there was financial crisis worldwide.
The variables used were changed to United States dollars and later collapsed by the consumer price index of every nation. This was to allow any changes in the economy that could take place. Al-Jarrah, & Molyneux (2003) stated that three outputs and inputs were examined. The inputs examined were fixed assets, total deposits and staff costs. On the other hand, the outputs examined were other incomes, liquid assets and total loans. After being analyzed, these Islamic institutions were found to be less effective in 1998 and 1999 as matched by 1997 to 2000 (Al Shamsi, Aly, & El-Bassiouni, 2009).
In 1998, the inefficiency revolved out to be more attributable to clean technical inefficiency rather than scale efficiency. It was also found out that the Islamic banks found in the Middle East were not as much of efficient as the Islamic banks found in other parts worldwide. Important findings claimed that Islamic banks remained to be 10% more efficient than non-Islamic banks in the same given period. Likewise, the purpose of the studies was conducted to reveal that the financial systems in the Islamic banking performed properly in other periods. The data issued by Yudistira stated the importance of acquisitions and mergers for the medium sized and small Islamic banks. Yudistira also examined that the markets in the Middle East were not shown to have any substantial impacts of the Islamic banks’ efficiency (Al Shamsi, Aly, & El-Bassiouni, 2009).
Different researchers stated that many Islamic banks achieved the same risks like the non-Islamic banks. These Islamic banks got many risks because they were unfamiliar with all the financial tools used in assisting them. They also lacked experience. The higher costs seen in these Islamic banking systems were derived from the need to pay and have Shariah compliance board in overseeing compliance of important Islamic laws. These requirements led to additional legal costs, complex financial products and additional salaries used in keeping these banks competitive with non-Islamic banks. Any strategic positioning chose by an Islamic bank is typically needed in seeking greater efficiency across the value chain. Like the other Gulf council countries, the key areas to be implemented include efficiency in operations, performance management and sales effectiveness. For these Islamic banks to improve their productivities, they need to focus more on their customers. The number of products used in banks and revenue per every customer in the Gulf council countries is still low compared to the markets that have developed. For these banks to reduce heir financial crisis, satisfaction of the customer is vital (Al-Tamimi, 2010).
Kuwait Finance Institution
Islamic banking is a procedure of banking mainly using the principles of Islamic. Essentially, in Islamic banking, an individual is not allowed to receive or pay any interest but these payments and interests are centered on profit sharing. Kuwait finance house, an Islamic bank, mainly focuses on generating investments returns by using tools of investments that follow Sharia law. The mission of this bank is to take the finance and Islamic banking to greater achievements by focusing mostly on innovation (Kuwaitfinancehouse –Bahrain, 2013).
On the other hand, this mission desires to deliver excellence in all things done by the financing institution including developments and offering of integrated and broad range of services and products that follow the principles of sharia (Kuwaitfinancehouse –Bahrain, 2013). Supportive advancements, Gulf Cooperation Council growth and other factors in which the Kuwait Finance Institution invests in and financing structures used globally in Islamic banking systems. The commitment and mission of this financing institution are supported by robust financial positions and long heritage of integrity, leadership and ingenuity.
Mostly, this financing institution follows the Islamic law that guides the Islamic economies. The Islamic economy is realistic because the rules used fulfill the needs required in life. This bank does not disallow any transactions made except for those having injustices. The Islamic economy is also ethic based because many people make profits by carrying out businesses. For an investment to be legal, the outcomes of the investment are supposed to fulfil the investment transactions. This enables the Islamic bank in stating what are expected in making profits (Kuwaitfinancehouse –Bahrain, 2013).
One should invest in Kuwait Finance House because it is an old financing institution which was developed in 1977. On the other hand, it is the biggest and oldest Islamic lender. The ratings done by various ratings agency affirm that the short-term Issuer Default Rating of Kuwait Finance Institution is F1 while the long-term is A+. the downgrade in the ratings of this institution were due to the exposures the bank faced from investment companies which led to the bank getting high loan impairment provisions in 2008. Additionally, Kuwait Finance Institution has developed independent banks in Malaysia, Turkey and Bahrain. It has also ventured in different Islamic banks (ArabianBusiness.com, 2013).
Various studies conducted have revealed that may Gulf council countries banks do not consider customer satisfaction at all. For these banks to improve their focus on customers, they must prepare their sales people properly and give them understanding of the bank products (Arthur, 2009). This is even shown in Islamic banking whereby many customers need explanations of Sharia biddable product structures. On the other hand, customers need to receive vital information on a given product. They also need to have limited website and call center service options (Al Shamsi, Aly, & El-Bassiouni, 2009).
A small number of Islamic banks have these service options for their customers. Many processes carried out in the banks in the Gulf council countries are manual. In Islamic banking, this is particularly cumbersome because asset transfers are mainly involved. Growth achieved over the years produce optimism for the Islamic banking future. This means that the Islamic banking systems have a lot of work to do. The Islamic banks that have taken time in considering strategic choices and addressing operational fundamentals will be stronger in capturing unexploited market opportunities.
Al-Jarrah, I. and Molyneux, P. (2003). Efficiency in Arabian Banking, paper presented at the International Conference on Financial Development in Arab Countries, Abu Dhabi, UAE.
Akhtar, M. (2010). X-Efficiency analysis of Pakistani commercial banks, International Management Review, 6(1), 12-23.
Alkassim, F. (2005). The Profitability of Islamic and Conventional Banking in the GCC Countries: A Comparative Study.
AlKhathlan, K & Malik, S. (2010). Are Saudi banks efficient? evidence using data envelopment analysis (DEA), International Journal of Economics & Finance, 2(2), 53-58.
Al Shamsi, F., Aly, H., & El-Bassiouni, M. (2009). Measuring and explaining the efficiencies of the United Arab Emirates banking system, Applied Economics, 41(27), 3505.
Al-Tamimi, H. (2010). Factors influencing performance of the UAE Islamic and conventional national banks. Global Journal of Business Research (GJBR), 4(2), 1-9, http://southWesternfinance.org/conf-2010/C8-1.pdf
ArabianBusiness.com. (2013, March 27). Kuwait Finance House-Kuwait. Arabian business. Retrieved March 27, 2013, from http://www.arabianbusiness.com/companies/kuwait-finance-house-kuwait-66643.html
Kuwaitfinancehouse –Bahrain. (2013, March 27). Islamic Banking. Retrieved March 27, 2013, from http://www.kfh.bh/en/kuwait-finance-house/islamic-banking1.html