Islamic Banks vs Conventional Banks

(Reproducing the article which i had sent to IIM Shillong for their Finance Magazine "Niveshak", though this was never published:P)

Industry forecast suggest that Islamic Banking assets with commercial banks globally, will reach $1.1 trillion in 2012 (2010: $826 bn). If we consider only the Middle East and North African Countries(MENA), which constitute a major share of Islamic Banking industry, Islamic banking assets increased to $416bn in 2010, representing a five year CAGR of 20% compared to less than 9% for leading conventional banks. But Islamic Banking Industry is still fragmented with most Islamic banks holding less than $13bn assets – yet to achieve scale, facing pressure on profitability.

If we compare the performances of IBs with CBs then Islamic Banking industry’s ROE now appears to be stabilizing around 10% down from 23% in 2006. Inspite of having higher financing income, higher provisions and operating costs have contributed to the steep decline in profitability of Islamic banks.

Also if we compare Staff cost/operating expenses(2010), it is 60% in Islamic Banks compared to 54% in conventional banks and the ratio of Staff Cost and Deposits(2010) is 3% and 0.8% respectively. Higher Staff Costs should translate to better performance but Islamic Banks lag behind their conventional peers which again indicates a lack of operational efficiency. A study done by Ernst & Young (‘A Brave New World of Sustainable Growth’ ) suggests that Operational efficiency can improve the Profitability of Islamic Banks by 25%

Comparing IBs and CBs during the Financial Crisis

To assess the impact of the crisis, there was a study carried out by IMF and it used bank-level data covering 2007−10 for about 120 IBs and CBs in eight countries—Bahrain (including offshore), Jordan, Kuwait, Malaysia, Qatar, Saudi Arabia, Turkey, and the UAE and the evidence showed that in 2008, IBs fared better in all countries, except Qatar, the UAE, and Malaysia. In Saudi Arabia, Bahrain offshore, Jordan, and Turkey, the change in profitability was significantly more favorable for IBs. The picture was reversed in 2009, with IBs faring clearly worse in three countries. In Bahrain (including offshore), and the UAE, the profitability of IBs declined significantly more than that of CBs, while in Qatar the increase in IB‘s profitability was significantly lower than that of CBs

Factors related to IBs‘ business model helped contain the adverse impact on profitability in 2008, while weaknesses in risk management practices in some IBs led to larger decline in profitability compared to CBs in 2009. In particular, adherence to Shariah principles precluded IBs from financing or investing in the kind of instruments that have adversely affected their conventional competitors and triggered the global financial crisis. The weak performance in some countries was associated with sectoral concentration and, in some cases, was facilitated by exemptions from concentration limits, highlighting the importance of a neutral regulatory framework for IBs and CBs and strengthening risk management in some banks.

Despite higher profitability during the pre-global crisis period (2005–07), IBs‘ average

profitability for 2008–09 was similar to that of CBs, indicating better cumulative (pre- and post-crisis) profitability and suggesting that higher pre-crisis profitability was not driven by a strategy of greater risk taking. Large IBs have fared better than small ones. Better diversification, economies of scale, and stronger reputation might have contributed to this better performance. This suggests that developing the industry and increasing competition should be achieved through establishing large and well managed IBs that can compete with existing banks. Also IBs‘ credit and asset growth were at least twice higher than that of CBs during the crisis, suggesting a growing market share going forward and larger supervisory responsibility.

While the global crisis gave IBs an opportunity to prove their resilience, it also highlighted the need to address important challenges. The crisis has led to greater recognition of the importance of liquidity risks, and the need for efficient bank resolution framework. Hence, building a well-functioning liquidity management infrastructure is a key priority.

Moreover, regulators and standard-setters for IBs should ensure that the supervisory and legal infrastructure, including for bank resolution, remain relevant to the rapidly changing Islamic financial landscape and global developments. Reform efforts in this regard should interface with the global reform agenda. Greater convergence and harmonization of regulations and products and offering a greater variety of Products consistent with Shariah principles is needed to facilitate an efficient and sustainable growth of the industry.