Risk Management Practices: A Comparison of Conventional and Islamic Banks in Pakistan

Transcription

1 American Journal of Scientific Research ISSN Issue 68 (2012), pp EuroJournals Publishing, Inc Risk Management Practices: A Comparison of Conventional and Islamic Banks in Pakistan Mian Sajid Nazir Department of Management Sciences, COMSATS Institute of IT, Lahore, Pakistan sajidnazir2001@yahoo.com Tel: Adeel Daniel Department of Commerce, University of the Punjab Gujranwala Campus Gujranwala, Pakistan adeel_daniel@yahoo.com Tel: Muhammad Musarrat Nawaz Hailey College of Commerce, University of the Punjab, Lahore, Pakistan musaratnawaz@gmail.com Tel: Abstract The purpose of the research paper is to examine and compare the risk management practices of Conventional and Islamic banks in Pakistan. A modified questionnaire on six aspects understanding risk and risk management, risk identification, risk assessment and analysis, risk monitoring, risk management practices and credit risk analysis, has been used containing 45 questions of likert scale. A total of 300 questionnaires have been distributed to collect the data on Islamic and conventional banks of Pakistan. Regression and one-way ANOVA has been used to estimate the results. The result found that Pakistani banks are efficient in credit risk analysis, risk monitoring and understanding the risk in the most significant variables of risk management. Moreover there is significant difference in risk management practices of the Islamic and conventional banks of Pakistan. Keywords: Risk management Practices, Conventional Banks, Understanding risk and risk management, risk identification, risk assessment and analysis, risk monitoring, credit risk analysis 1. Introduction In this modern world of the dynamic environment where life is full of zeal and risk with multiple shades and the dimensions of the world are changing day by day. Presently the people merely not only interested to take the risk but want to catch the optimum utility from rejecting the opportunity cost and being more critical than the ancestors. In this regards, management of risk prevalent in investment options is becoming an emerging issue not only for the academicians but also for practitioners. Only the risk has a long life in the business definition would be uncompleted without the inclusion of the

2 Risk Management Practices: A Comparison of Conventional and Islamic Banks in Pakistan 115 risk. Efficient risk management practices are the need of the time nowadays because by using the tool of the risk management techniques organization not only increase the return but competiveness of the organization will also increase in today s world and less efficient risk management practices could make the situation of the organization more worse. As the globalization increase the exposure of the risk is dire to increase on the organizations. There are two types of the risk existing in the market, the systematic risk and unsystematic risk. Systematic risk refers to the risk that is positive correlated with market and the can be minimize by using different risk management practice. On the other hand the unsystematic risk is associated with the value of the asset. Unsystematic risk cannot explain by general market moments and can be avoidable through diversification. Oldfield and Santomero (1997) describe the three standards of risk mitigation strategies Eliminate or avoid risk be simple business practices, Transfer risk to other participant and Acceptance of the risk. Today all financial institution of the world claimed that it s a business of risk and the bank become competitive by implementing the efficient risk management techniques. Carey (2001) study opened new avenue of risk management by claiming the financial risk management is compulsory for the financial institution. The main purpose of the financial institution is to increase the returns by meeting the expenses of the financial institution and maximize the wealth of the shareholders. In order to increase the wealth of the shareholder the financial institutions offer the variety of the financial services that are full of risk (Hakim & Neaime, 2005). Importance of risk management increased over the time especially after the global meltdown; liquidity crises emerged after subprime mortgage and the introduction of the BASEL II (Al-Tamimi, 2008). The author further claimed in his study the efficient risk management is not a costly process but the financial institution will suffer adverse effect like failure of the banking system if not implemented at the right time. Pakistan Financial institution avoids specific type of activities, which may incur heavy losses of risk. Pakistan bank follows the Basel II Standard of the capital adequacy ratio. This standard expresses the limit of the capital must hold with the bank as the minimum capital requirement. The BASEL II uses as a catalyst in the loaning decision and make the essence clear to efficiently manage the risk and make the financial institution more competitive. A paper of consultative were issued by the Basel Committee on banking supervision (BASEL) in 1999, claimed that most of the loan are more risky in the nature of credit (Calem & Rob, 1999). Pakistan has faced the large number of risk such as the credit risk, liquidity risk, foreign exchange risk, market risk, interest rate risk and many more because of the shaky environment of the Pakistan (Shafiq & Nasr, 2010).The major loans of the bank have more credit risk exposure of the bank. The snapshot of the credit risk is not only the loan, but the other of the financial institution have face the credit risk in Pakistani banks such as interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, the extension of commitments and guarantees, and the settlement of transactions. The growing market demand and attention given to the Islamic and commercial banking and finance industry has escalated the research interest in this area as well. Due to the relatively recent nature of the Islamic banking industry compared to its conventional counterpart, many aspects of the industry are not well investigated. Keeping in view the discussion the present study addresses the following research objectives 1. To examine the degree to which the Pakistani Banks use risk management practices and techniques dealing with different types of risks. 2. To compare risk management practices between Public and Private Bank, Local and Foreign Bank, and Islamic and Conventional Bank. 3. Based on study findings proper suggestions and recommendations to improve the weaker financial banking sector in Pakistan.

3 116 Mian Sajid Nazir, Adeel Daniel and Muhammad Musarrat Nawaz 2. Literature Review In the earlier of the twenty first century the Islamic bank with respect to risk management was investigated by the Khan and Ahmed (2001). The sample size was seventeen Islamic banks across the ten different countries. The primary source of the date is questionnaire has been collected at different field level. The major finding of the study was the murabha contract which is really uncertain and cannot be hedged by using the tools which will more likely to increase the sensitivity of the risk. The high perception of risks may be an indication of the low degree of active risk management due to the absent of risk control through internal processes and control, especially in the case of operational risk(iqbal, 2007). Also, Ariffin et al (2007) indicates that credit risk in Islamic banks perceived to be the most important risk. Another study was conducted in Tanzania by Richard et al (2008) for understanding the credit risk management system for the commercial banks for the economy of less developed countries. The main finding of the paper was the component of credit risk management differs in commercial banks operating in a less developed economy than the developed economy. This implies that the environment within which the bank operates is an important consideration for a credit risk management system to be successful. Moreover, Koziol and Lawrenz (2009) about the bankruptcy and the failure of the risk. They claimed that regulation of the banking stuff matters a lot for meeting the efficient criteria of Risk management. The essence of the study was Uncover situation when the Credit manager will take financing decision. Because the major source of the earning for the bank is to lend the money(koziol & Lawrenz, 2009). They introduce the continuous- time model where banks chose the deposit volume in order to trade off the benefits of earning deposit premiums against the costs that would occur at future capital structure adjustments. Major findings suggested that the dynamic endogenous financing decision introduced an important self-regulation mechanism. The study of the Hassan (2009) shows the level of the risk management adopted by the Islamic banking in the in Brunei Darussalam. The variety of the products is differing from the conventional bank the Islamic bank so the exposure of the risk varies from conventional product and the Islamic product. Management of the Islamic banking are very much efficient of practicing the risk management technique. The major dilemma regarding risk is Foreign Exchange risk, Credit Risk and operational risk. Risk identification and risk Assessment and analysis were the most impelling variables of the today s Islamic system in Brunei. A Regression model has been developed to show the result that these variables need to attention and to tackle the alarming situation in the Islamic banking sector. Standard of Basel II Accord are not truly implemented by the Islamic banking of the Brunei Darussalam Banking Sector, resultantly shakes of the efficient risk management practices. The next study is from Pakistan by Shafiq and Nasr (2010) to explore the current risk management practices that are adopted by the Pakistani commercial banks. The study of data was collected from both of sources primary and secondary. The deduction of the study was the significant difference between the public sector and private banks. It further suggested that financial soundness indicator differ in value for each type of commercial bank. It is no doubt that there is good understanding of risk management among the employee of banks, but there is a gap of training courses which needs to be tackle for risk management. Khalid and Amjad (2012) conducted a research on the risk management in Islamic banking in Pakistan. The author use the same model suggested by Al-Tamimi and Al-Mazrooei (2007) of risk management practices. The data was collected from the primary sources with the questionnaire distributed in Islamic banks of Pakistan of 135 inclusive with very high response rate. The regression has been run to evaluate the result and finding suggests that Islamic banking system in Pakistan have a positive and significant effect on risk management practices. The most influencing and significant variable of the study was credit risk analysis, risk monitoring and understanding risk and risk management.

4 Risk Management Practices: A Comparison of Conventional and Islamic Banks in Pakistan 117 Hussain and Al-Ajmi (2012) conducted a comparative analysis on risk management practices between the Islamic and conventional banking system in Bahrain. The data has been collected from the questionnaire to generalize the finding of comparative analysis. The new modified dummy variable bank type has been used to make the optimum comparison. The finding of the study was to Understanding risk and risk management, risk identification, risk monitoring, risk assessment and analysis and credit risk analysis have a positive and significant effect on risk management practices in Islamic and conventional banking of Bahrain. The comparative analysis of the study was that there is only the understanding risk and risk management got the significant difference between the Islamic and conventional banking of Bahrain. The other entire variables were not significantly different in Bahrain Islamic and conventional banking system. The above literature of all the past studies figured out the risk management practices adopted by the financial institutions from all over the world in different types of banks. There are different types of risk faced by different types of the bank. The Present study is conducted to explore the risk management practices in Pakistan adopted by the Islamic and Conventional banks and try to figure out the difference of adoption six aspects such as understanding risk and risk management, risk identification, risk assessment and analysis, risk monitoring, risk management practices and credit risk analysis. 3. Research Method Data has been collected from the banking sector of Pakistan. Target population of the study is Islamic and conventional banks of Pakistan. Only the Scheduled Bank is consider for generalizing the facts of the study with respect to the risk management. The next step is to choose the sample from the targeted population. Data has been collected from the major cities of Pakistan where Islamic banking and Conventional banks are well flourished. A total of 300 questionnaires have been distributed among all the cities of Pakistan out of 20 questionnaires were return with blank responses and 30 questionnaires were excluded because the respondents showed lack of interest to fill. All the 250 questionnaire are duly filled with 85% response rate to conducive for generalizing the findings. The questionnaires are duly filled from the credit manager of the banks directly. However some of the questionnaires send to the branch manager and the head offices and requested to give it to the concerned designated persons. The questionnaire are duly distributed to the person involve directly with the risk management practices in banking industry. The questionnaire used in the study was the same questionnaire that has been used in the study conducted in UAE banking sector by Al-Tamimi and Al-Mazrooei in (2007). These questions are asked from the respondent to check the degree of the risk management implementation in Islamic and conventional banking system. The authors developed a modified questionnaire having six aspects such as understanding risk and risk management, risk identification, risk assessment and analysis, risk monitoring, risk management practices; and credit risk analysis. In order to answer the research objectives the following hypothesis are formulated. To evaluate study purpose and the questions mentioned above, following hypotheses are formulated: H1: There is a positive relationship between risk management practices and risk assessment and analysis, understanding risk, credit risk analysis, risk identification, risk monitoring and credit risk analysis. H2: There is a difference between Islamic and conventional banks in practice of risk management practice H3: There is a difference between Islamic and conventional banks in the understanding of risk and risk management. H4: There is a difference between Islamic and conventional banks in the Practice of risk identification. H5: There is a difference between Islamic and conventional banks in practice of risk assessment and analysis

5 118 Mian Sajid Nazir, Adeel Daniel and Muhammad Musarrat Nawaz H6: There is a difference between Islamic and conventional banks in practicing of risk monitoring and control H7: There is a difference between Islamic and conventional banks in practice of credit risk analysis Following variables from the old study is extracted to generalize the finding of the Risk management practices of the different types of risk faced by Pakistan Islamic and Conventional banks. It is the same model used by Al-Tamimi and Al-Mazrooei(2007) in his study comparison of Risk management practices of UAE National and Foreign bank RMP = f (URM, RI, RAA, RM, CRA) Where: RMP = risk management practices; URM = understanding risk and risk management; RI = risk identification; RAA = risk assessment and analysis; RM = risk monitoring; and CRA = credit risk analysis. 4. Results and Discussion Reliability Analysis It was mentioned in the in methodology that there is 45 questions has been asked from the responded on 5 likert scale. There are six different variables has been used in the study to generalize the finding. Reliability analysis has been conducted to assess the chances of random error entered. Analysis will purely support the study how much variation in scores of six different variables. Cronbach,s alpha has been used for the reliability analysis and suggests that the value of coefficient greater than 0.7 would be reliable data and can be used for further statistical analysis. The overall Cronbach s alpha of 6 variables is and considered a very strong indication for the reliability of data. Table 4.1: Cronbach s alpha Questions Cronbach s alpha No. of Questions Understanding risk and risk management Risk identification Risk assessment and analysis Risk monitoring Risk management practices Credit risk analysis Descriptive Analysis Descriptive analysis will provide the summary of all the six variables with respect to the respondent such as mean, median, standard deviation and sum of the scores. The table 4.2 clearly suggests the mean and median responses on the eight-research question under the variable of Understand risk and risk management. The responses of eight questions indicate the Pakistani banking sector understand the risk and risk management. The median 4 clearly suggest that different banks of Pakistan are ensuring that banks are much better in understanding risk. Most of the respondents are agree that staff of Pakistani banking sector is understand the risk in their organization. The Banking industry of the Pakistan will give the indication that risk management practices are efficiently managed in Pakistan. All the respondent are strongly agree that success of the bank is solely depend upon the understanding of the staff towards risk. Among all most of the respondent believe that understanding and managing the risk is most important for the banks to increase the success by hitting maximum.

6 Risk Management Practices: A Comparison of Conventional and Islamic Banks in Pakistan 119 Risk Identification is important predicator of risk management. Risk identification comprises of six research questions on 5 point likert scale (1 SDA, 2 DA, 3 N, 4 A, 5 SA). Table 4.2 shows the mean, median, standard deviation and sum of the responses taken from the banking sector. The descriptive analysis clearly defines that the Pakistani Banking sector are well aware of identify the risk with the given objectives and aims of the bank. The mean of 3.73 suggest that the Pakistani banking sector has aware about the potential risk which is affected the banks. Most of the responses are refer to the acceptance that the risk. Some of the respondent believe the bank of Pakistan don t have any confusion to prioritize the bank which give the identification that Pakistani bank are efficient in identification the risk. Eight Research Questions has been asked from the respondent under the aspect of Risk Assessment and analysis. The table shows the mean, median and standard deviation of respondent on risk assessment and analysis. The combined mean of all the 8 questions is 3.81 which refer of the level of agree towards risk assessment and analysis. It is suggest that most of the banks are adopted the Quantitative techniques for accessing the potential risk face by the banking industry of Pakistan. Table 4.2 illustrate that risk monitoring is the integral part of management reporting. The efficient risk monitoring is very much conducive to detect the mistake at the early stage. Questionnaires include the 6 questions with explaining the variable on risk monitoring. The mean of 3.93 clearly suggest the effective monitoring of the risk practices will lead to the highest performance of the Pakistani banks. Mostly the Pakistani banks are literate with respect to monitoring the risk created and implementation of the risk techniques. The median of 4 tells us that risk monitoring is important tool, which should be practice by the banks in Pakistan. The integral part of risk management is refers to the practice, which is adopted by the bank. It is not the case at all that most of the banks may sophisticate method of understanding the risk, clearly identify the risk, proper procedure of assessment and analysis are still not clear that banks are efficient in risk management practices. Ten research questions have been asked from the respondent on the aspect of risk management. In table 4.2 combined mean of all the ten research questions is 3.93 and it seems that Pakistan financial institution is very much conducive for risk management practices. Seven research questions have been asked from the respondent to align the risk management practices with Credit risk analysis. The highest mean of 3.98 show in table 4.2 of among all the six aspect is credit risk analysis which suggest that the Pakistani banks are very much sharp before sanctioning the loan either it is Conventional or private. The CIB report contains all the details has been prepared in the system of central bank in Pakistan for calculating the debt burden. Table 4.2: Descriptive Statistics Variables Mean Median Standard Deviation Sum Understanding risk and risk management Risk identification Risk assessment and analysis Risk monitoring Risk management practices Credit risk analysis Hypothesis 1: There is a positive relationship between risk management practices and risk assessment and analysis, understanding risk, credit risk analysis, risk identification, risk monitoring and credit risk analysis the OLS technique has been run to test the hypothesis. The first assumption to run the OLS model is to find multicollinerity between the explanatory variables. The explanatory variables more than.70 correlated each other suggest that the model is not god fitted because of positively correlated with each other. Present study uses the Pearson correlation instead of spearman because our level of data is interval. Table 4.3 suggests that there is no potential multicollinerity between the explanatory variables that could affect the results. It is because the value of correlation is less than 0.70.

7 120 Mian Sajid Nazir, Adeel Daniel and Muhammad Musarrat Nawaz Table 4.3.1: Pearson Correlation Name of Variables URM RI RAA RM RMP CRA URM 1 RI RAA RM RMP CRA The next step is to evaluate the regression result and the value of R Square in table 4.4 which is.522 supports the study of all the explanatory variables such as understanding risk and risk management, risk identification, risk assessment analysis, risk monitoring and credit risk analysis explains 52% variation in risk management practices. Global testing of hypothesis 1 that there is positive relationship of RMP with URM, RI, RAA, RM and CRA confirm it with high significance. The test statistic of global testing is F statistic with 5% level of significance in Table of shows the computed value from the F Test is higher than the critical value and concluded that there is significant and liner relationship between the Risk management practices with all the explanatory variables. The next step of the multiple regression analysis is to check significance of all the 5 explanatory variables such as URM, RI, RAA, RM, CRA with the Risk management practices (RMP) individually. The test statistics has been for individual testing is T. The Coefficients of all the 5 explanatory variables in the table credit risk analysis, risk monitoring and understanding risk and risk management are the most significant effect with risk management practices in Islamic and conventional banks. Table 4.3.2: Regression coefficient Result Variables Unstandardized Coefficients Standardized Coefficients β Std. Error β t-value Sig. (Constant) URM RI RAA RM CRA F-Value= , R 2 = 0.522, R 2 -Adjusted= In table 4.4 confirms second hypothesis that There is a difference between Islamic and conventional banks in the understanding of risk and risk management. The results of p value in table 4.4 shows that p-value is and indicate that there is no difference in understanding risk and risk management between the Islamic and Conventional banks. The study is conducted to check any difference on the basis on Conventional type and Islamic type in the perspective of understanding risk and risk management. Based on the findings study do not reject null hypothesis and concluded that there is no difference in understanding risk and risk management. Staff of both Islamic and conventional banks is well equipped with the understanding of risk in Pakistan. The findings enclosed in table 4.4 shows p value to take the decision for third hypothesis There is a difference between Islamic and conventional banks in the Practice of risk identification. It is a technique followed by both of the bank i.e. Islamic and Conventional banks. Based upon the finding in table 4.4, p value is and concluded that risk identification is not different in Islamic and conventional bank. The fourth hypothesis of the study is There is a difference between Islamic and conventional banks in practice of risk assessment and analysis.once the risk is identified the next step is to assess the desired and risk and make the analysis of the risk. On the basis of the finding the p value is in the table 4.4 suggests that the assessment method and analysis method are same on

8 Risk Management Practices: A Comparison of Conventional and Islamic Banks in Pakistan 121 both types of bank operating in Pakistan. The procedure of assessment is the same in both of the banks such as Islamic and conventional banks. Fifth hypothesis of study is There is a difference between Islamic and conventional banks in practicing of risk monitoring and control. The method of risk monitoring is purely followed by the risk management practices. It s a review system and access that the risk management techniques are efficiently worked. The statistical analysis shows the p value in table 4.4 suggest that there is significant difference between the method of risk monitoring followed by the Islamic and the Conventional banks of Pakistan. The method of risk monitoring is quite different from each other but it is proved from the study that there is difference between the Islamic and Conventional Bank of Pakistan. The sixth hypothesis of the study is There is a difference between Islamic and conventional banks in practice of risk management practice.one of the key aspects of the variables and it contains 10 questions on the risk management practices. The finding of the Study strongly in the favour that there is no difference in risk management practices in Pakistan between the Islamic and Conventional banks of Pakistan. The findings of the p-value shows the Risk management practice have a very small difference but it is negligible and concluded that there is not much difference between practicing the risk management between the Islamic and Conventional Banks in Pakistan. The last hypothesis of the study is There is a difference between Islamic and conventional banks in practice of credit risk analysis. Pakistani Banking system is full of credit risk and the method used in analysis is credit scoring in Pakistan. The findings p-value in table 4.4 is shows that credit risk analysis with respect to difference between Islamic and Conventional banks do not reject the null hypothesis and concluded that there is no difference in doing the credit risk analysis and give the identification that both the banks are using the same method for analysis. 5. Conclusion The major results from the finding that most significant variables credit risk analysis, risk monitoring and understanding risk management in the perspective of risk management practices in Islamic and conventional banks operating in Pakistan. The second dimension of the study is to identify the difference in Islamic and conventional banks with respect to six aspects understanding risk and risk management, risk identification, risk assessment and analysis, risk monitoring risk management practices and credit risk analysis and it is concluded in the study that there is only the method of risk monitoring is different in conventional and Islamic banks operating in Pakistan. It is suggested from the study that Islamic and conventional banks should be different in risk credit risk analysis. But due to little innovation in credit risk assessment in Islamic banks the most of Islamic banks has adopted the same procedure that is adopted by the Islamic banks. The new techniques of assessing the credit risk analysis should be introduced in Islamic banks that must be different from the conventional banks. The study covers the most important aspect of the risk management but unfortunately did not address the credit risk management, Basel Accord and the degree of efficiency of the banks. The study can also be done in the most of the developing countries of Asia to find some interesting result because risk management practices are mainly depend upon factor economic conditions, competition and regulations. Table 4.4: One Way ANOVA of Islamic and conventional bank Variables Sum of Squares DF Mean Square F p- value URM Between Groups Within Groups Total RI Between Groups Within Groups Total

9 122 Mian Sajid Nazir, Adeel Daniel and Muhammad Musarrat Nawaz Table 4.4: One Way ANOVA of Islamic and conventional bank - continued RAA Between Groups Within Groups Total RM Between Groups Within Groups Total RMP Between Groups Within Groups Total CRA Between Groups Within Groups Total References [1] Al-Tamimi, H. A. H. (2008). Implementing Basel II: an investigation of the UAE banks' Basel II preparations. Journal of Financial Regulation and Compliance, 16(2), [2] Al-Tamimi, H. A. H., & Al-Mazrooei, F. M. (2007). Banks' risk management: a comparison study of UAE national and foreign banks. Journal of Risk Finance, The, 8(4), [3] Ariffin, N. M., Archer, S., & Karim, R. A. A. (2007). Transparency and Market Discipline in Islamic Banks. ISLAMIC ECONOMICS AND FINANCE, 153. [4] Calem, P., & Rob, R. (1999). The impact of capital-based regulation on bank risk-taking. Journal of Financial Intermediation, 8(4), [5] Carey, A. (2001). Effective risk management in financial institutions: the Turnbull approach. Balance Sheet, 9(3), [6] Hakim, S., & Neaime, S. (2005). Profitability and Risk Management in Banking: A Comparative Analysis of Egypt and Lebanon. Money and Finance in the Middle East: Missed Oportunities or Future Prospects, 6, [7] Hassan, A. (2009). Risk management practices of Islamic banks of Brunei Darussalam. Journal of Risk Finance, The, 10(1), [8] Hussain, H. A., & Al-Ajmi, J. (2012). Risk management practices of conventional and Islamic banks in Bahrain. Journal of Risk Finance, The, 13(3), [9] Iqbal, Z. (2007). Challenges Facing Islamic Financial Industry. Journal of Islamic Economics, Banking and Finance (JIEBF), 3. [10] Khalid, S., & Amjad, S. (2012). Risk management practices in Islamic banks of Pakistan. Journal of Risk Finance, The, 13(2), [11] Khan, T., & Ahmed, H. (2001). Risk management: an analysis of issues in Islamic financial industry: Islamic Development Bank, Islamic Research and Training Institute. [12] Koziol, C., & Lawrenz, J. (2009). What makes a bank risky? Insights from the optimal capital structure of banks. Journal of Banking & Finance, 33(5), [13] Oldfield, G. S., & Santomero, A. M. (1997). The place of risk management in financial institutions. Center for Financial Institutions Working Papers. [14] Richard, E., Chijoriga, M., Kaijage, E., Peterson, C., & Bohman, H. (2008). Credit risk management system of a commercial bank in Tanzania. International Journal of Emerging Markets, 3(3), [15] Shafiq, A., & Nasr, M. (2010). Risk Management Practices Followed by the Commercial Banks in Pakistan. International Review of Business Research Papers, 6(2),