Conventional Banking and Islamic Banking: Do the Different Philosophies Lead to Different Financial Outcomes?

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1 Conventional Banking Banking: Do Different Philosophies Lead to Different Financial Outcomes? Da Jia Qian1, Sivakumar Velayutham2 1,2 Faculty Business, Nilai University ABSTRACT Banking (IB) is a contemporary segment finance that has become increasingly significant in many Muslim countries. Malaysia is one countries that has adopted a dual system. Conventional Banks (CBs) borrow money from depositors at a low interest rate lend m to borrowers at a high interest rate. In contrast, interest is forbidden in Islam refore banks enter into prit-sharing arrangements with both depositors borrowers. This study seeks to determine wher differing arrangements based on different philosophies lead to different outcomes. Several previous studies have compared pritability, liquidity risk performance two systems, but few studies have focused on revenue distribution between two types systems. Secondary data from annual reports 10 banks with both windows for five years was used. We used financial ratios to process data, such as prit return to depositors ratio, net prit ratio, risk ratio so on. independent sample test was used to analyse se ratios. Our findings indicate that depositors get higher returns from than from. In contrast, banks appear to have a higher taxation cost, operating cost net prit margin. In area pritability risk performance, banks perform better, while banks are more liquid. Keywords: Banking, Conventional Bank, Financial Outcomes INTRODUCTION (IB) has seen rapid growth in last few years, more than doubling between ( size-islamic-finance-market-vs-finance/). banks, in contrast to banks, operate on a Prit-Loss-Sharing (PLS) principle, Correspondence: sivakumar@nilai.edu.my Journal Wealth Management & Financial Planning 3

2 that is based on principle Hasan & Dridi, 2010; Ryu, Piao & Nam, law, also known as Shariah, since 2012), but few studies have focused law forbids interest (Abdullah, on Sidek, & Adnan, 2012). lead to different revenue distribution money bank at interest a lower borrows from customers loans m to borrowers at a high interest rate (Santos, 2000). major financial objective system is to achieve maximization shareholder s wealth through interest differential. Although interest is not used in transactions, different philosophies outcomes. Malaysia is one country that has implemented a dual system. most significant income banks is interest income, which is different from prit sharing which is basis. Consequently, financial ratios are used to determine if different philosophies lead to different revenue distribution outcomes. banks have products services that rest paper is organized are similar to banks, i.e., as follows: Section Two provides an saving deposit accounts, loan, credit overview card or financial products. All se products services must abide key with Shariah (Abdullah, Sidek, &. Section Three identifies Adnan, 2012). bank uses methodology sample two pre-determined prit sharing contract groups banks. Section Four identifies for depositors borrowers instead main findings study. This is pre-determined interest rate followed by a discussion findings used by bank (Zaher conclusion in Section Five. & Hassan, 2001). Several recent studies main, differences features highlighting with LITERATURE REVIEW concerning How is Kuran, 2004). One way answering above question is to determine if different practices based on different philosophies lead to different financial outcomes. Several previous has have, however, raised questions Banking (El Gamal, 2006; Khan 2010; developed as a major alternative to in many countries around world, particularly in countries with a Muslim majority population. combined balance sheets banks grew from $150 billion studies have compared pritability, liquidity risk performance two systems (Samad, 2004; Rashwan, 2010; 4 wher in 1990 to about $1 trillion in 2010, with more than 300 Shariah-compliant institutions operating in 80 countries (Cevik & Charap, 2011). Journal Wealth Management & Financial Planning

3 emerged due to general refore re is supposed to be no guidelines in Qur an hadıth compensation for its use; however, when as to what are are not permissible combined with or resources, money forms economic activity according becomes capital so deserves fair to Islam. Qur an bans riba (usually compensation. In short, In Islam, one translated as interest or usury but also does not lend to make money one with literal meaning excess or does not borrow to finance business (El increase [see, e.g., Ayub, 2002, p. xxxi]) Gamal, 2000). also requires all practising Muslims to avoid financial transactions that involve excessive ghar ar (uncertainty, i.e., where outcome is uncertain), maysir (outright gambling) har am (religiously forbidden) products. Engaging in trade is encouraged but, ideally, prits must be result assuming a proportionate share risk involved in transaction by taking an equity stake in it; prits must not be earned risk-free by making a collateralized loan. This was summarized by a publication Research Training Institute Development Bank as follows: most important feature is that it promotes risk sharing between provider funds (investor) on one h both financial intermediary ( bank) user funds ( entrepreneur) on or h. In, all this risk is borne in principle by entrepreneur (Iqbal et al., 1998). Money is generally held to have zero opportunity cost (Ayub, 2002) From a more practical perspective, El Hawary et al., (2004) defines IB as a system that adheres to following four principles: 1. Risk sharing: terms financial transactions need to reflect a symmetrical risk/return distribution among each participant to transaction, 2. Materiality: all financial transactions must have material finality, i.e., be directly linked to a real underlying economic transaction; thus, options most or derivatives are banned, 3. No exploitation: neir party to transaction should be exploited, 4. No financing sinful activities: transactions cannot be used to produce goods banned by Qur an (e.g., alcohol, pork products, gambling, etc.). difference between can be summed up as former is largely debt-based, allows for risk transfer, while latter is asset-based, centres on risk sharing (Table 1). Journal Wealth Management & Financial Planning 5

4 Table 1: Risk Sharing Risk Transfer Banking (IB) Risk Sharing Conventional Banking (CB) Risk Transfer Sources funds: Investors (prit sharing investment account (PSIA) holders) share risk return with bank. return on PSIA is not guaranteed depends on bank s performance. Sources funds: Depositors transfer risk to bank, which guarantees a pre-specified return. Uses funds: IBs share risk in Mudharabah Musharakah contracts conduct sales contracts in most or contracts. Uses funds: Borrowers are required to pay interest independent return on ir project. CBs transfer risk through s e c u r it i z a t ion or c r e d it de f au l t s wa p s. Financing is debt-based. From above table, one can forms are Mudharabah (a sleeping observe that crux IB is partner contributes capital or banks as predominantly risk-taking expertise/knowledge) Musharakah institutions committed to long-term ( financier takes a direct stake in productive investment on a partnership venture) (Khan, 2010) (Table, 2). or equity basis (Mills & Presley, 1999) since prit--loss-sharing (PLS) (i.e., equity participation) is at core Banking (Zaher & Hassan, 2001). Thus banks are supposed to act as venture capital providers, investing in worthy firms financing promising ideas in exchange for a share prits, rar than lending on basis cash-flow collateral, forcing firms into liquidation to recover loans that had gone bad through no fault borrower (Khan, 2010). This form financing is frequently referred to as Shariah-based products main However, equity participation available. may be done on basis something or than equity participation. re are actually two types finance (IBF): prit loss sharing (PLS) non-prit loss sharing (non-pls) (Obaidullah, 2005). PLS, as name suggests, is participatory (direct equity stake or a partnership), or financier may choose to be nonparticipatory not take an equity stake. Virtually every IBF advocate Table 2: Shariah-Based Shariah-Compliant Products Shariah-Based Shariah-Compliant Musharaka Murabaha Mudaraba Bai Muajjal Ijara Bai Salam Istasna Qard al Hasana 6 is not sole means financing Journal Wealth Management & Financial Planning

5 argues that equity desirable is risk performance two non- systems but few studies have focused participation alternative participatory finance, sometimes referred on to as trade-based financing modes, is lead to different revenue distribution acceptable only as an interim measure outcomes. For example, Ryu, Piao or for situations where participatory Nam (2012) found that Malaysia s IBs finance is clearly unsuitable, such as have lower risks better pritability very small or personal consumption than CBs. In contrast, Samad (2004), loans found no significant difference in (Usmani, 2002; Ayub, 2002; wher philosophies Sundarajan & Errico, 2002; Zaher & liquidity Hassan, 2001). This form financing CBs IBs. Hasan Dridi (2010) is frequently referred to as Shariah- examined IBs CBs during compliant main recent global crisis by looking at forms include Murabaha ( mark-up or impact crisis on pritability, cost-plus sale), ijara (lease), bay salam/ credit asset growth, external istisna (deferred delivery), bai muajjal ratings in a group countries where (deferred payment), jo alah (service fee), two types banks have significant qard al hasana (charity/beneficence market share. findings suggest that loan) (Khan, 2010) (Table, 2). IBs were affected differently than CBs. products Chong Liu (2009) show that only 0.5% financial institutions utilize PLS products in business transactions. dominance non-pls transactions like Murabaha Ijara in has led to questions different pritability between Factors related to business model IBs helped limit adverse impact on pritability in 2008, while weaknesses in risk management practices in some IBs led to a larger decline in pritability in 2009 compared to CBs. concerning How is revenue depicted in income Banking Khan (2010) supported statement both critics IBF (El Gamal, 2006; Kuran, banks are allocated to five 2004). parties. se include prit return This study does not seek to answer that question but rar identify wher based on different philosophies, lead to different financial outcomes between. Several previous studies have compared pritability, liquidity to depositors, taxation cost, net prit return to shareholders, operating cost allowance for impairment loan. But appellations for sharing revenues to se five parties in income statements two systems are different. In order to figure m out better, y are illustrated in Table, 3. Journal Wealth Management & Financial Planning 7

6 Table 3: Revenue Distribution in Two Banking Systems Revenue Distribution Conventional Banking Banking Prit Return to Depositors Interest Expense Income Derived from Investment Depositors Funds Taxation Cost Taxation Taxation Zakat Banking Operating Cost Or Operating Expense Or Operating Expense Allowance for Impairment Loans Allowance for Impairment Loans Allowance for Impairment Loans Net Prit Return to Shareholders Net prit for Financial Year Net Prit for Financial Year To observe wher in following research hyposes were tested:. H1, re is a significant difference in prit return to depositors between H2, re is a significant difference in taxation cost between risk performance between RESEARCH METHODOLOGY A quantitative approach was applied in.. this study where secondary data was collected analysed using SPSS. All data used in this study were obtained from selected samples full-fledged banks banks H3, re is a significant difference in Malaysia. required data came in net prit return to shareholders from annual reports selected between banks.. in operating cost between. included income position found in annual reports 2010 to In Malaysia, some banks operate with an window a Non- H5, re is a significant difference in se statements, statements financial H4, re is a significant difference pritability between performance. 8 H7, re is a significant difference different philosophies lead to different outcomes, window ( bank), while ors are eir purely banks or purely banks. For this study, only banks with both a an window H6, re is a significant difference were chosen for better comparability. in liquidity performance between re are a total 11 banks in Malaysia with both a. Journal Wealth Management & Financial Planning

7 Table 4: Selected Banks Conventional Bank Groups Bank Groups Affin Bank Affin Bank Alliance Bank Alliance Bank AmBank Am Bank CIMB Bank CIMB Bank Hong Leong Bank Hong Leong Bank HSBC Bank Malaysia Berhad HSBC Amanah Malaysia Berhad OCBC Bank Malaysia Berhad OCBC Al-Amin Bank Berhad Public Bank Public Bank RHB Bank RHB Bank Stard Chartered Bank Malaysia Berhad Stard Chartered Saadiq Berhad Source: Bank Negara Malaysia, 2015 Table 5: Formulae for Financial Ratios Ratio Conventional Banking H1: Prit return to depositors (Interest (riba) ratio) H2: Taxation cost (Taxation ratio) H3: Net prit return to shareholders (Net prit ratio) H4: Banking operating cost (Or operating expense ratio) Banking Income attributable to depositors / Interest expense / Interest Income derived income from investment depositors funds (Taxation + Zakat) Taxation / (Interest income + / Total attributable Or operating income) income Taxation/ Prit before (Taxation + Zakat) / taxation Prit before taxation Net prit for Net prit for financial year / (Interest income + financial year / Total Or operating income) attributable income Or operating Overheads / (Interest expense / Total income+ Or operating attributable income income) Pre-Tax Prit / Total Assets Average. Pritability Performance (Pre-Tax Prit on Assets Ratio, PreTax Prit / Shareholders' Funds Tax Prit on Shareholders Ratio) Liquidity performance (Total Deposits to Total Assets Ratio) Pre-Tax Prit / Total Assets Average Risk performance (Net Impaired Loans Ratio) Net Impaired Loans / Net Total Loans Average an window, which 10 were selected for this study (Table 4). One Table 5 above describes formulae for financial ratios computed. bank was omitted because data was not complete. Journal Wealth Management & Financial Planning 9

8 Table 6: Descriptive Analysis for All Ratios FINDINGS Table 6 summarizes descriptive SPSS was utilized to run result output as objective for this study was to compare outcome banks banks in Malaysia from year 2010 to statistics calculated for nine financial ratios. sample size for Net Impaired Loans ratio is less than 50, because some data for Net Impaired Loans was negative. To make Levene's test for equality Table 7 summarizes results variances independent sample t-test independent sample test conducted (2-tailed), we chose a significance level using Levene's test for equality (α= 0.05) for equality variances. variances, t-test for equality means. Table 7: Independent Sample Test for Group Mean Difference Levene's Test for Equality Variances 10 F Sig. Interest (riba) Ratio Tax on Income Ratio Tax on Pre-tax Prit Ratio t-test for Equality Means Sig. (2-tailed) "P-Value" t df * Journal Wealth Management & Financial Planning

9 Continued from Table 7 Net Prit on Income Ratio Expenses on Income Ratio Pre-tax Prits on Assets Ratio Pre-tax Prit on Shareholders Ratio Total Deposits on Assets Ratio Net Impaired Loans Ratio *Indicates P-value is not significant From above results one can which is smaller than in observe that only ratio with no banks. mean Tax significant difference is Tax on on Pre-tax Prit Ratio Pre-tax Prit Ratio. In summary, all banks is is, however larger null hyposis can be rejected. than in above findings highlight that banks. Unlike difference in Tax on philosophical between Income Ratio which is significant, difference in Tax on Pre-tax prit ratio lead to significant differences is not significant. mean expense in financial outcomes distribution on income ratio banks is revenues to different stakeholders which is smaller than differences Table 6 highlights means each ratio for both banks banks. mean Interest (riba) Ratio in banks is , which is bigger than banks. in banks, meaning that compared to banks, or operating expense in banks consume a smaller part total revenue. Tables 6 7 also highlight banks significant differences in Net Prit share more ir prits with ir on Income Ratio, with depositors than banks. banks showing a smaller percentage Compared to low interest saving (18%) in comparison to that 27% account in banks, for banks. higher Prit--Loss Sharing (PLS) paradigm Net Prit on Income Ratio in banks is more favourable banks is also reflected to depositors. in higher Pre-Tax Prit on Assets So, this means Similarly, mean Tax on Income Ratio banks is , Ratio banks (15%) in comparison to banks Journal Wealth Management & Financial Planning 11

10 (10%) also in higher Pre-Tax reasons for significant Prit on Shareholders' Funds Ratio differences are however difficult to banks (19%) in explain. For example, why is Tax on comparison to banks (15%). Income Ratio lower for banks? This difference could be attributed to or interesting finding is higher percentage paid to depositors higher return to depositors in banks. In summary, windows in comparison banks appear to pay a bigger to depositors portion ir revenue to depositors, while returns to window having a better control shareholders. operating cost taxation cost. statistics also indicate that liquidity banks is better (0.8869) in comparison to banks (0.8372), Impaired Loan Ratio banks (0.0073) is however higher than that banks (0.0035). findings indicate that banks probably have better windows risk management practices. This lower probably occurs because depositors windows windows are different, but shareholders both windows are same, ir returns is an aggregate total returns from both window, window i.e., depositors depositors. Similarly, it is also difficult DISCUSSION AND CONCLUSION to explain why Expense to Income As highlighted in introduction more complicated. One possible reason literature review, dominance is misallocation expenses to non-pls transactions have two windows. Similarly, why is Net raised Impaired Loans Ratio higher for questions is concerning Banking? Ratio banks is lower although transactions are much How This study sought to determine if different practices based on different philosophies lead to different financial outcomes. findings strongly suggest that different practices based on different philosophies do indeed lead to different financial outcomes, as all seven hyposis tested indicate significant differences in all banks? study probably has raised as many questions as it has answered also highlighted difficulties in measuring performance or financial outcomes versus when two are operated by same parent bank are frequently in same branch financial outcomes. 12 are subsidizing window Journal Wealth Management & Financial Planning

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