Comparison of Performance of Islamic Banks & Conventional Banks in Pakistan .

1. Comparison of Performance of Islamic Banks & Conventional Banks in Pakistan .

2. Table of Contents : • Overview • Introduction • Return on Assets Ratio • Deposit to Assets Ratio • Operating Expense Ratio • Debt to Equity Ratio • Loan to Asset Ratio • Conclusion • Recommendations • References

3. Overview • In this presentation we would be comparing and evaluating the performances of Islamic Vs Conventional Banking in Pakistan. • This presentation would be focusing on different performance ratios which are used based on studies to evaluate the performances of such kind of banks and hence then come to a conclusion of which banks has a better performance in a given time period and the reasons for such a result. • Furthermore to get to a accurate finding of the results we would be using graphical material to support the findings of the financial indicators and hence then do analysis of the findings and way to improve the results and finally draw a conclusion to it. • The ratios used to evaluate the performance of both such banks are as follows : Return on Assets Ratio, Deposit to Assets Ratio, Operating Expense Ratio, Debt to Equity Ratio, and lastly Loan to Asset Ratio .

4. Introduction • Islamic Banking : Islamic Banking is a system which is based completely on the Islamic Law (Shariah ) principles and is guided by the Islamic Economics. In such a system which is practiced in most Muslims as well as some Western countries it is strictly prohibited to take any kind of Riba which is better known as interest, nor take any part in financial risk bearing business nor trade in any activities which are considered haram according to Muslims belief. In the last three decades there has been a rapid increase and advancement in the number of Islamic Banks which have been set up globally, hence gaining momentum with other types of financial banking systems. There are many aspects to such kind of banking such as Murabaha, Mudaraba,Ijara etc and such kind of banking is gaining popularity at a hasty pace which would be judged by the fact that in today’s day and age Islamic banking industry’s size is approximately worth $ 400 billion and has an astonishing growth of 15 percent per annum. Hence due to its popularity over the years many financial institutions all over the world are trying to keep pace with the growing demand for Sharia’h compliant products and services. • Conventional Banking: Conventional banking is a system which is quite popular and is practiced worldwide. It is a system which is based on collateral and is based on the principle that the more one has the more he gets. It is a banking system which offers loans to its customers, on a agreed upon interest rate and if the customers defaults on its loans , the bank is able to collect its dues by selling the clients collateral . Moreover such banks capital standards are called Basel II and offer several products such as Retail Banking, Commercial Banking etc and have assets worth over trillions of dollars. • Pakistani Banking Sector : In Today’s day and age like any other nation, Pakistan depends heavily on its financial institutions to strengthen its economy. Pakistan’s banking sector after its independence in 1947 has established several banks mostly being State run banks until the year 1992 when its first ever privatization took place. In the year 2002 Meezan Pakistan became Pakistan’s first full fledged Islamic bank and now over the years Pakistan has 6 full fledged Islamic banks and 13 Conventional Banks which have started partial Islamic Banking. As far as Conventional Banking in Pakistan is concerned it has several MNC’s in its background, Standard Chartered, Royal Bank of Scotland to name a few and this sector is growing at a rapid pace, probably more than any other industry in Pakistan and is home to a large number of educated Pakistani labor force.

5. Return on Assets Ratio

6. Return on Assets Ratio (continued): • The above figure demonstrates that Islamic banks have a poor return on assets ratios as compared to Conventional banks. The figure exhibits that the highest return on assets ratio was 1.37 % in the year 2005 and the lowest was negative 68.55 % in the year 2006.Where on the other hand Conventional banks did a bit better than their counterparts, however their figures weren’t as impressive either as expected by many. There return on assets ratio could not surpass a mere 2.03 % in the year 2005 to 2009 .By evaluating both the figures one could come to a conclusion that the ROA of Conventional banks is better than ROA of Islamic banks but by a small difference of just 0.10 % and hence both such banks in Pakistan by evaluating the figures one could come to a similar conclusion that both such banking sectors are experiencing profitability issues. • There could be several reasons for such a result such as the global crisis and political instability in Pakistan which could have led to such low profitability of both firm and if one does a deeper analysis of both such banks to find out the difference in the return on assets ratios one could come to several different conclusion as well. Islamic banks whose return on assets ratios are so low could be due to the fact that such banks are more focused on growth as well as expansion strategies which could deviate their attention from profit oriented strategies as well as in such banks there is a lack of management as well which could be another prime reason for them to be doing so poorly in such a ratio analysis. Whereas Conventional banks have just done better then Islamic banks could be because Conventional banks main aim is to earn high profits for their shareholders and hence make better investment decisions which results in them earning higher earnings on their assets, but however this is one department both banks should be concerned about and should use better strategies to have a more profitable ROA.

7. Deposit to Assets Ratio

8. Deposit to Assets Ratio(Continued) • According to this figure Islamic Banks had an intermittent deposit to asset ratio. Customers had a large amount of deposit in such banks in the year 2005 which was about 74 % of total assets to such banks and the lowest was in the year 2006. Whereas on the other hand, Conventional Banks deposit to asset ratio was never below 75% which indicates to the fact that had heavy reliance on assets to pay up their customers deposits. The mean deposit to assets ratio for both banks was at 71.11 % for Islamic banks as compared to 78.05 % of Conventional Banks, hence indicating that Islamic Banks were just little better than Conventional Banks when it came down to the liquidity performances of both such banks. • Such heavy reliance on assets to deposit ratio for both banks is not a good sign for either institutions. Firstly in the advent of crisis such the global crisis of 2009, if individuals rush to the banks to withdraw their deposits due to lack of money, it could cause liquidity problems for both such banks and hence they would either have to borrow from other banks called overnight loans or rush to the central bank in an attempt to be able to fulfill the regulations laid down by the Basel II in order to survive in such a crisis. Another problem especially for Conventional Banks could be, there heavy reliance on deposit when it comes to keeping their assets afloat could lead them to have issues when it comes to expanding their business and be able to earn more profits for their shareholders. Hence, it is very important for both banks to have a solid deposit to asset ratio which would enable them have less reliance on customers’ deposits and be able to stay afloat in the financial market and survive shocks which might occur in the economy which could lead to individuals withdrawing their money from the banks.

9. Operating Expense Ratio

10. Operating Expense Ratio(Continued) • The Operating Expenses Ratio displays the Management quality of any financial institution. In the following graph from the year 2005 to 2009 one could easily identify the fact that the management quality of Conventional banks as well as Islamic banks has been quite different to each other. In the year 2005 the operating expense ratio of Islamic Banks was a surprisingly 1.37 % which indicates the fact that they had amazing management style which led to such respectable figures. However such a performance of Islamic banks was short lived as in the year 2006 their operating expenses rose to an astonishing 73% which indicated a disastrous management quality , and moreover also indicated that their about ¾ of their income was spent on operational expenses. Nonetheless, over the years there has been an improvement in the management style of such banks as the Islamic banks have had less operating expenses ratio in the year 2007 to 2009 indicating better profits for the investors in the last three years of the above study. On the other hand the graph indicates a mix display of operating to expense ratio of Conventional Banks, in the year 2005 Conventional Banks displayed a weak management style, whereas their best year was the following year of 2006 when its operational expenses were at its lowest. The mean operational expenses ratio of both banks was at 33% for Conventional banks, to a 48% Islamic Banks, hence indicating that Conventional Banks did better than their counterparts in such a study. • A deeper analysis of such a graph could indicate several factors which could have led to such a result. Firstly it is very important to note that Islamic Banks are still new to the Pakistani Banking sector and hence lack the expertise as well as experience to overcome their counterparts in such a department. Due to lack of expertise for Islamic banks they could have not being able to fully utilize the opportunities to captivate on better technological advances which could have led them to reduce their maintance expenses. Moreover, as they are still comparatively new to such an industry they would be getting less assistance from the government level as compared to established Conventional banks which already have a solid base and hence have better opportunities to make better use of opportunities offered both at the government as well as private level. Whereas Conventional banks have done way better than their counterparts is simply because of more expertise and knowledge in such a department, with superior long term planning which enables them to do fairly well then their corresponding opponents in such a department as well has having more skilled labor as compared to Islamic Banks. Hence, Conventional Banks did way better then Islamic Banks in the operational expense ratio, but as the Islamic Banks are growing at a rapid pace it won’t be long before they would be able to take to utilize their skills to the maximum and be able to compete with Conventional Banks in such a study.

11. Debt to Equity Ratio

12. Debt to Equity Ratio(Continued) • In this graph the Islamic Banks displayed a ratio of 1.1033 which is was slightly higher than the ideal 1.0 figure. Such a figure would give an impression that Islamic bank primary financed their day to day operations primary by using their depts. However the ratio has significantly decreased to 0.6487 in year 2006 as well as 0.2403 in year 2007. However in the year 2008 and 2009 the figures have increased by a little amount but however still remain below 1 which is a good sign for such Islamic banks .On the other hand, Conventional banks D/E ratio has been always greater than one in the four years of study , but has shown a slight improvement during the four years , with 2.1889 in the year 2005 which was considered as the riskiest position for such banks and the safest was in the year 2009 at a steady 1.0724.The mean D/E ratio for both banks during the period of 2005-2009 is 0.5459 for Islamic banks whereas 1.5377 for conventional banks. • If one goes into a deeper analysis of such a result one could draw several conclusions for such a figure to arise. Firstly Islamic banks have a low D/E ratio could be because on the facts that they have taken a safer method of operations and have been able to finance their operations through more on equity rather than on debt. Such a manner of operations guarantees less risk and better returns for the shareholders for such banks. On the other hand, Conventional banks have a greater percentage of D/E ratio is because of the prime fact that they rely more on debt financing and if D/E ratio is greater than 1 for such banks then the volatility as well as risk of returns in such a case increases. By looking at the graph one could analyze the policies both such banks have used when it comes to their D/E ratio. Islamic Banks have pursued a safer strategy and hence have low liquidity problems. On the contrary Conventional Banks have used more aggressive techniques as far as the D/E ratios are concerned and believe in the policy of higher risk would yield to higher returns. Such a position could have both its pros as well as cons. The pros of such a strategy would be fruitful in a stage when interest rates are high which could lead to higher returns for the shareholders and the con is that when the interest rates are low it could lead to bankruptcy for such banks.

13. Loan to Asset Ratio

14. Loan to Asset Ratio(Continued) • Loan to Asset Ratio exhibits a bank’s financial liquidity and hence can be calculated by simply dividing the banks total loans by its total deposits. In the figure, one could easily analyze that LAR of Islamic banks is showing an increasing trend whereas the LAR of Conventional Banks show a steady movement of their ratio in between 59% to 64 %. If one does an analysis of such a figure it could be simply evaluated that Islamic Banks have taken excessive loans, indicating that they hence hold less liquid assets. The figures of the LAR indicates that Islamic banks figures have risen from 51.47 from the year 2003 to the year 66.3 in the span of just four years while the conventional banks LAC has shown just a slight increase from 59.57 in year 2003 to 59.78 in year 2007.If one goes into greater depth, Murabaha has been the most commonly used method of financing, followed by Ijara. However, if one looks at the overall figure , the figures are quite different then what was early assumed as Conventional Banks LAR is slightly higher as compared to Islamic Banks, however the difference is quite low at a mere 5 % significance level. • Having such a high Loan to Asset Ratio has lots of negative implications for such financial institutions. It not only limits their borrowing capacity but also adds the risk for such financial firms to have more chances of defaulting their loans. In such a situation it is very important for banks to have a solid LAC and be able to improve their financial position otherwise they could end up being finically bankrupt. There are several ways such financial institutions could improve their LRC’s by having a good internal management system, hire good financial analyst who could predict such problems and take corrective measures to improve such a position and more over they could also reduce the amount of money to they give to other people, in an attempt to make sure they have enough liquidity that they can sponsor their day to day operations.

15. Conclusion • Conclusion: It is very difficult to conclude this presentation by evaluating which of these two banking sectors has performed better than the other in the selective time frame. In some ratios the Islamic banks has done better than its counterparts, while in some cases Conventional banks have had an edge over Islamic banks while in other instances they have both have performed at a equal level. Moreover it is worth mentioning that in such a study all ratios or figures aren’t exhibited in such an analysis which would give us a better picture to evaluate this study. Furthermore, one should also keep in mind the time period of this study as well as the fact that Islamic Banks are still new to the banking sector in Pakistan, as compared to Conventional Banks which have been performing in Pakistan for several years now. Another reason which could not give us an accurate picture of this finding could be because of Political instability in Pakistan during the above mentioned era as well as the global crisis of 2007 which could also have had its impact on such a study. Another major reason which could not give us an actual picture to evaluate the performance of both such banks are that the number of banks that operate in Pakistan are quite different with Islamic banks being less in number. In addition, the strategies both such banks adopt are quite different to another which would also hinder in evaluating the real picture of the performances of such kinds of banks. Hence to conclude this presentation, I would I like to say that in some instances Islamic banks have done better than its counterparts while in other’s Conventional banks have had its advantages over Islamic banks but would also like to point out that in such a study only limited ratios are presented and the time period of study is just a mere five years and hence to give an exact position of which bank is doing better than the other performance wise would be an unfair evaluation and thus in order to rightly assess the actual comparison of which bank is better then the other performance wise we need to look at the bigger picture and evaluate the performances over a longer period of time and then only we could come to the actual finding of which bank is better than the other .I would like to conclude the presentation by stating the above mentioned fact that in some instances Islamic banks have performed better then Conventional banks while in other instances Conventional banks have done better than its counterparts.

16. Recommendations • Recommendations: After a close study and a deeper analysis of the above mention study I would like to give several recommendations which could help such banks to improve their performances. The recommendations that I would like to give would be on a general level which both such banks could adopt which would help improve the performances of both such financial institutions. Firstly such financial institutions could interpret their company’s goals and visions into measurable operational goals which should be communicated to the employees of such banks in a more efficient manner. Individuals working in such banks should be given individual tasks which are linked to the company’s goals and reward such individuals who are able to achieve the task which would further motivate them and hence the company’s vision could be fulfilled as well. The banks should furthermore set short term goals for its institutions which are correlated to the long term goals of such banks and by achieving the short term goals they would eventually be able to achieve the long term goals and hence it would help improve the overall performance of both such banks. Furthermore, the communication level between the top management and lower management should be good as well which would able them to better communicate with each other and hence improve the performances of such banks. Lastly the firm should determine their strengths and therefore work more on them and improve their weakness which would also help to improve the overall performances of such banks and also establish monitoring methods which would be able to evaluate the performance of such banks and hire external auditors and consultants which would help such banks to improve their overall performances of such banks. These are some of the recommendations I would like to present which would help improve the performances of both Islamic as well as Conventional banks.

17. References : • http://en.wikipedia.org/wiki/Bank • http://www.scribd.com/doc/17116904/Islamic-Banking-vs-Conventional-Banking • http://journalofbusiness.org/index.php/GJMBR/article/viewFile/454/403 • www.divaportal.org/smash/get/diva2:113713/FULLTEXT01 • http://www.iub.edu.pk/jer/JOURNAL/BRM_Research_Article.pdf