Islamic banks are a key source to earn profit without Riba(interest) . According to Islamic law Riba(interest) is prohibited in Islam and in any trading activities. "The funds of the customers are placed in profit sharing investment and also interest is not paid on the customers deposits a/c in Islamic banking" (Archer & Karim, 2006). There are a large number of risks which are involved in commercial banks with Islamic banking and also banks without Islamic fianacing. This paper analyze the two major risks of the bank, credit risk and liquidity risk. Those convential banks which are using islamic financing have considerable less credit and liquidity risk as comapre to other convential banks which are not using islamic mode of financing (How, Karim, & Verhoeven, 2005). This article provide the results regarding islamic banks and conventional banks. This paper articulate the risks in islamic banks and conventional banks, also provide the psychoanalysis between these two sector. It also contribute to the vast prose on the determinents of bank risks by the simplification of preceding observed findings with respect to a country that acquire a dual banking structure. Our results show that conventional banks in pakistan are more risky than the islamic bank, which have low credit risk and liquidity comparativly.
The remnants of this article is consisting the structure and model of the banks. Which tell the numerical figures related to the risks of conventional banks and islamic banks.
"Islamic banks do not pay interest on customers' deposit accounts. Instead, customers' funds are placed in profit sharing investment accounts" (Archer & Karim, 2006)
Literature Review
Islamic banks offer financial instruments that are consistent with the religious beliefs and cultural characteristics of Muslim societies. The essential feature of Islamic banking is that it is interest-free. 3 Islam prohibits Muslims from taking or giving interest (riba), defined as any predetermined or fixed return from financial transactions including both deposits and loans, regardless of the purpose for which such loans are made or how low the rate of interest charged is. The prohibition of riba is mentioned in four different revelations in the Qur'an,4 which also declares that those who disregard the prohibition of interest are at war with God and His Prophet. Some scholars have also put forward economic reasons as to why interest is banned
in Islam. The main problem of all these financial institutions is the manipulative character of interest. As the financial system in Islam is based entirely on equity basis i.e. the investor of the capital and the entrepreneur shares in the profit as well as loss, the Islamic banks are also conducting their business on the same pattern. I.e. profit and loss sharing principal (Iqbal,Z. 1999). There are a large number of theories on the determinents of risks in islamic banking and conventional banking.
Even in ancient times, people were well aware of risk factor...while taking financial and monetary decision, they knew that lending their money to a person with good background is much safer investment than lending their money to a bankrupt. However, risk is one of the important tools of decision making and now it can also be measured and different values can be assign (ALi & ALgeri, 2003).
Those who advocates the intrest concept in financing holds that intreset factor encourages and motivate the investors to invest thier capital insted of spending the money on consumption (Rabooy, 1991)
There is very genuine book (M.Ali)which consist the difference table between conventional financing and islamic financing.
Table 1.1 Differences between conventional financing and Islamic financing
Conventional finance
Islamic finance
Primarily based on Interest rate
Facilitate financial activities
Structured and formalised
Stress on financial efficiency
Restricted moral dimension
Highly systematised in terms of risk
management, accounting and other standards
Existing set of legislations to deal with legal issues
Highly developed banking and financial product market
Existence of conventional money market
Availability of inter-bank funds
Strong and developed
secondary market for securities
Existence of short-term money market
Interest is prohibited
Facilitate social, economic and
financial activities
Unstructured and still informal in
many ways
Stress on social, ethical and financial
efficiency
Strong moral dimension
Standards for risk management, accounting and other activities are still developing
Legal support still in development with several legal areas under doubt
Developing banking and financial product market
Non-existence of significant Islamic money market
Non-availability of inter-bank funds
Non-existing secondary market for securities
Non-existence of short-term money market
Islamic Banking System in Pakistan
Islamic banking system in Pakistan has been established in 1980s. A large number of products have been introduced by Islamic banks, which facilitate the customers to buy those products with easy conditions. These products are basically having five Islamic financing arrangements: Mudarbah, Murabaha, Al-Ijarah, Musharakah, And Sukuk.
Mr. Muhammad Ali Jinnah emphasized the virtues of Islamic principles, and in his address at the inaugural ceremony of the state bank of Pakistan, he said, "I shall watch keenness the work of your organization in evolving banking practices compatible with Islamic ideas of social and economic life. We must work our destiny in our own way and present to the world an economic system based on true Islamic concept of equality manhood and social justice. (Azam, 1 july 1948) "
There are five major Islamic banks in Pakistan AL Baraka Islamic bank, Bank Islamic Pakistan limited, Dubai Islamic bank Pakistan limited, Emirates Global Islamic bank limited, Dawood Islamic bank limited, and Meezan Islamic bank limited.
There are large numbers of commercial banks which provide Islamic and non Islamic finance products and some are the conventional banks which only provide the non Islamic financing.
According to the Islamic Banking Bulletin of state bank of Pakistan, that Islamic financing banks are increasing in number and volume which shows the effective and better response of these banks compare to the conventional banks.
Data analysis and Methodology
Hypothesis
In this article, we build up hypothesis on the relationship between Islamic financing with two most important risks, which are credit risk and liquidity risk. Different aspects of these risks are presented in this article to analyze the impact of these risks and also find the measure regarding these important risks.
Credit quality problems can result in bank insolvency or in a significant drain on bank capital and net worth. We expect Islamic banks to conduct "credit" checks and perform feasibility studies before entering into a new venture. Banks with more dealings in derivative contracts are expected to have higher credit risk. (How, Karim, & Verhoeven, 2005)
H0: There is no difference in risk between islamic financing and non islamic financing banks.
H1: Banks with islamic financing has lower risk than the non islamic financing banks.
Data description
Our sample consists of three banks with Islamic and three banks with non Islamic financing. We surveyed different banks reports of different banks and found their four year data from 2005 _ 2008. To find out the relationship of credit risk and liquidity risk by their assets and Equity, which give us the detail regarding the banks with and without Islamic financing. Data gathered from the annual reports from the sites of these banks, and also from the site of state bank of Pakistan. Total Assets, Equity are the independent variables and meanwhile credit risk and liquidity risk are dependent variables.
Descriptive statistics on islamic banks in pakistan, 2005-2008
Period
Credit Risk
total assets
Equity
2005
0.4933
21644708
2684223
2006
0.00403
43246940
5311067.7
2007
0.00257
58371715
5956019.7
2008
0.0048
64128099
5888889.3
Descriptive statistics on conventional banks in pakistan, 2005-2008
year
Credit Risk
total assets
Equity
2005
2.02
268197787
24933457
2006
2.613
436826565
32159341
2007
3.06
537529091
14706172
2008
3.16
535628398
735287038
For Islamic Banks
Y = Bo + B1 X1 + B2 X2 + E
When
X1 is Total Assets
X2 is Equity
Dependent is Credit Risk
After analysis results show that the value of R = 0.995 which shows that there is positive impact of total assets and equity on credit risk.
The results show that the value R2 = 0.991 which shows that 99.1% of the variation in the credit risk is explained by the variation in the total assets and equity.
For Conventional (Non-Islamic) Banks
Y = Bo + B1 X1 + B2 X2 + E
When
X1 is Total Assets
X2 is Equity
Dependent is Credit Risk
In this case results show that the value of R = 0.999 which shows that there is positive impact of total assets and equity on credit risk.
The results show that the value R2 = 0.991 which shows that 99.1% of the variation in the credit risk is explained by the variation in the total assets and equity.
Conclusion
The results of this research show that there is positive relationship between dependent variable and independent variables in both of the cases whether it is in Islamic Banks or Conventional Banks. The results suggest that the degree of correlation is high in Islamic Banks than Conventional Banks.
The pakistani banking system is highly diversified, it has both the conventional and islamic financing system performing their duties side by side. The study examines through the vast literature review of the risk determinants from the previous studies of different researchers.
We used three conventional and three Islamic financing banks for our analysis and take out the data of four years, 2005-2008. To allow for possible interaction between the independent variables, we run different test on the gathered data ,to find out the relationship of risks. The results show that Islamic financing has low credit risk than the non islamic financing banks. They have low credit risk ,that may be the cause of profit sharing principle of Murabaha type financing in Pakistan.
The banks with Islamic financing growing and establishing day by day due to their rules and regulations and also interest free system in niche market. Unique quality can be the competitive edge for any bank but the most important thing is to retain that quality and position in the fast growing market, and have to take precautionary measure to prevent from the heavy risks and losses. They need to analyze their few risks and control those risks.
Author: sehrish
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