One of the most common features characterizing all aspects and elements across all industries and sectors is the acute dynamism culminating into advancements across all the industrial sectors in the world. One vital sector in the global economy is definitely the banking and finance sector. In this research, efforts will be made to evaluate the effects and the extent of advancement in this sector from an international perspective. The research lays specific emphasis on comparing the advancements with respect to the lending policies between the Islamic and non-Islamic banks. This report provides a definitive literature review on the same issue and analyses the differences between these lending policies and their impact on financial crises. The results show that despite their differences, both Islamic and conventional banks have over the years grown relatively immune to monetary policy and as such, they could have devastating implication on financial crises as governments have lost the power to control the money that is injected into the global economy through this channel.
Table of Contents
1 Introduction 4
1.1 Research Question and Objectives 5
1.2 Background 5
1.2.1 Lending Policies 6
1.2.2 Lending Policies in Conventional Banks 6
1.2.3 Lending Policies in Islamic Banks 7
1.2.4 Similarities 7
1.2.5 Differences 7
1.2.6 Impact of Lending Policies on Bank Performance 8
1.2.7 Contribution of Bank Lending Policies to Global Financial Crises 8
2 Literature Review 8
3 Methodology 13
3.1 Results and Discussion. 14
3.2 Limitations of the Research 18
4 Conclusion 18
The world economy has since the great depression of the 1930s been characterized by financial crises, which were sparked by economic recessions. While economic cycles are unavoidable, it is well within the power most governments to control and prevent the occurrence of financial crises. The recent global financial crisis served as a wakeup call to governments across the globe about the significance of regulation in financial sectors. While this crisis provided invaluable insights into the possible solutions to future economic challenges, several countries are still largely affected by the ongoing Eurozone and Crimean crises. One of the lessons that was learnt from the recent housing bubble that sparked the global financial crisis was that the major contributing factor to the crisis was the failure in various policies across the banking and financial sectors (De Nicoló, et al., 2003). This sector incorporates a number of sub-sectors that could have easily contributed to the financial crises aforementioned. In light of this, this research will help to determine how the various characteristics of conventional and Islamic banks contribute to financial crises.
The bulk of literature on financial crises focuses on the weaknesses of the individual banking systems in a bid to determine viable solutions to these crises. The fact that, these two banking systems have entirely different mechanisms and yet they both manage to effectively serve the financial requirements of their clients could be to the Key to p2utting an end to financial crisis in future. This is because apart from the internal weaknesses of each individual system, a comparison between the two systems could help to reveal unique challenges inherent in each system that would otherwise not have been identified if the two systems were analysed independently. Additionally, a comparative analysis could facilitate the generation of effective solutions to these unique challenges resulting in greater efficiency of both systems. Moreover, their operations could be benchmarked against each other to facilitate better management strategies and promote efficiency. Better yet, the analysis could result in the formulation of a hybrid system, which is immune to all the challenges in both systems. Ultimately, an increase in shared characteristics between the two systems would result in greater global financial integration, which would in turn enhance financial intermediation and increase cross-border transactions in the global financial sector. While this can be perceived as a positive step towards global economic development, it would make the global economy more vulnerable to financial contagion and exacerbate the impacts of a potential financial crisis. It is evident from the foregoing that this research will not only make significant contributions in the field of banking and finance but also create a foundation for further research.
1.1 Research Question and Objectives
This research should help in answering the following research question
What are the similarities and differences between lending policies in Islamic and conventional banks and how does each banking system contribute global financial crises?
To this end, it will focus on the following objectives:
• To investigate the lending policies in Islamic and non-Islamic banks
• To evaluate the underlying similarities and differences between the lending policies in the two banking systems
• To find out how the lending policies in each system contribute to global financial crises
• To identify possible solutions to future financial crises
Today’s world is characterized by intense globalization and international business operations. Movements across the world have, as a result, become a common trend to people in all nations, cultures and religions notwithstanding. In light of this, most businesses especially those in service industries such as the banking and finance sector have been prompted to diversify their operations and business strategies in order to comprehensively meet the diverse needs and expectations of their international clientele. However, major challenges in the banking and financial sector arising from this development are the acute differences between Islamic and non-Islamic banking systems (Dakhlallah & Miniaoui, 2013). In a bid to shed light on this challenge, this research will focus on the lending policies in the two banking systems. This will be achieved through a comprehensive literature review. However, before that it is also important to understand the core concepts behind these lending policies. The section that follows will briefly discuss the different lending mechanisms in conventional and Islamic banks.
1.2.1 Lending Policies
Lending policies entail the rules and regulations that are employed by financial institutions to determine eligible borrowers for approved loans. These policies are generally characterised by two components; rule making and enforcement. First, in order to enhance profitability and minimize default risk, banks have to formulate certain internal rules and regulations to govern their lending practices. Moreover, the bank has to ensure that these rules and regulations are followed to the letter and that they are applied equally to all borrowers.
Apart from the internal rules and regulations, lending policies are also determined by the prevailing legal environment and as such, they are country specific. The government in most countries formally defines the obligations and privileges of financial institutions and the reciprocal duties and obligations owed by bankers and the government to each other through a set of predetermined rules and regulations stipulated by the general law of the land. Additionally, some of these rules and regulations are dynamic because they are influenced by monetary policies, which depend on the prevailing economic conditions in the country. Nevertheless, most countries across the globe are affected by more or less similar government regulations relating to the banking and financial sectors.
1.2.2 Lending Policies in Conventional Banks
Lending policies in conventional banks require borrowers to meet several requirements such as job tenure, a certain minimum age, a debt to income ratio lying within a predetermined range, usually not more than 38% and collateral, which is valued at a level that supports the loan amount through an appraisal or book value comparison. Conventional banks also carry out background checks on borrowers and liaise with other institutions such as credit rating bureaus to determine their credit worth. While it is only prudent to verify the credit worthiness of a borrower before allocating them any form of credit, this practice restricts the level of lending in most commercial banks and ultimately the amount of money circulating in the economy. Nonetheless, regardless of the eligibility of the borrower, the ultimate lending decisions by most conventional banks is determined by capital adequacy, the probability of lending and the cost of raising equity.
1.2.3 Lending Policies in Islamic Banks
Unlike ordinary commercial banks, Islamic banks are governed by unique rules and regulations which reflect sharia laws. The establishment of Islamic banks dates back to slightly over a quarter a century ago and as such, they are not as developed as conventional banks. Nevertheless, they have since been established in several parts across the globe including non-Muslim countries, with attempts to overhaul conventional banking in some countries in favour of financial systems founded solely on Islamic principles. Examples of such countries include Pakistan, Sudan and Iran (Iqbal, 2001, p. 2).
Sharia laws emphasize on religious, social, ethical and moral factors that promote equality and fairness for the overall wellbeing of the society. Money is therefore not supposed to earn interest and as a result Muslims are forbidden from receiving or paying interest, commonly referred to as riba. These laws also discourage speculation (gharar), the oppression of contracting parties (zulm) and the production of goods and services that contravene Islamic norms and customs (haram). Another unique feature fostered by sharia laws is Islamic tax (zakat).
Despite the fact that they have slightly different business models, like most organizations, the main objective for both Islamic and conventional banks is profit maximization. For this reason, they both employ various management strategies in a bid to enhance their competitive advantage over other players in the industry.
The main difference between lending policies in Islamic and conventional banks is the absence of interest on Islamic loans and the root cause of this difference is the sharia law. While the business model in Islamic banks is founded on the principles of sharia, conventional banks are generally based on capitalism. Moreover, while Islamic banks promote risk sharing between investors and entrepreneurs, conventional banks guarantee a return on capital. For this reason, it is considered to be relatively easy to borrow from a conventional bank compared to an Islamic bank. This is because Islamic banks have to go an extra mile to ensure that the borrower is credit worthy as opposed to conventional banks that charge interest to cover default risk and offer compensation for the time value of money.
1.2.6 Impact of Lending Policies on Bank Performance
While lending policies contribute to the overall profitability of conventional banks by providing additional income in the form of interest charges, it is also considered as a door opener for other opportunities such as investment banking (Ewert, et al., 2000). In fact, due to increased competition in the financial services sector, which has in the recent past forced conventional banks to charge extremely low interest rates on their loans, most bankers nowadays perceive lending as a problematic yet necessary venture because of its potential to attract more business for their banks
1.2.7 Contribution of Bank Lending Policies to Global Financial Crises
The recent global financial crisis was sparked by poor lending policies that sought to increase home ownership. These policies had been occasioned by the overvaluation of subprime and other mortgages because investors thought that real estate investments would always be characterised by an upward trend. The result was a housing bubble that was followed by a bust that left millions of borrowers bankrupt and contributed to the collapse of many firms in the financial services sector. During the crisis it was observed that conventional banks were more affected than Islamic banks because of the unique characteristic of the latter.
2 Literature Review
Over the years, only the conventional banking system was widely known and publicly applied (Berger, 2008). However, several authors have pointed out that Islamic banks are a growing worldwide phenomenon (Beck, et al., 2010; Zahee, et al., 2012; Iqbal, 2001). Beck (2010) observed that the Islamic banking and financial system has in the recent past grown in such a rapid rate, incorporating many clients and expanding in many countries across the world. Although this kind of banking is mostly prominent in South East Asia and the Middle East, it has also become significant in several other Western countries such as in the United States, supports Borio and Drehmann (2009). According to Zahee, et al., (2012) Islamic banking is one of the fastest growing segments of the global financial sector, with a growth rate of 20% per annum. In fact, in some countries the market share controlled by Islamic banks has increased significantly to a point of offering a full-fledged alternative to the conventional banking sector. For this reason, it has become increasingly important to appreciate the mechanism behind the operation of Islamic banks.
The financial systems between the Islamic and the non-Islamic banks are specifically different with respect to their lending policies, argues Boumediene and Caby (2009). Basically, the resulting differences are founded on religious backgrounds. In light of this, under the non-Islamic financial system, banks lend money with an aim of making profit from the interest charged on the principal amount lent to borrowers, writes Boyd (2006). The payment of interest happens in instalments with a fraction of each instalment servicing the loan while the remaining fraction repays the principal, explains Kaleem and Isa (2003). On the other hand, the Islamic financial system is not interest based according to Čihák (2007). Instead of using interest for loan purposes, the financial institutions incorporate the concept of buying assets on their borrowers’ behalf, and reselling it to them, at a profit.
Nonetheless, Beck, et al., (2010), argued that there are very few significant differences between Islamic and conventional banks. They postulated that many of the financial products offered in conventional banks can be redrafted as sharia compliant products to minimize the differences between Islamic and conventional banks. Consequently, a comparison between the two banking systems in terms of their business orientation, efficiency and stability reveals that there are very few significant differences. The authors point out that even though Islamic banks are perceived to be more cost-effective than conventional banks, when they are considered from a cross country perspective, the converse is true within countries that have both conventional and Islamic banks. However, when majority of the market share in such countries is controlled by Islamic banks, the conventional banks have a higher cost effectiveness but a lower stability. Like most authors, Beck, et al., (2010) attribute the resilience of Islamic banks to higher capitalization as opposed to higher efficiency and effectiveness
From the above differences, various stability issues are set to befall the financial sector in general, writes Hesse and Čihák (2008). First, the stability of the sector is affected by the absolute difference, as illustrated by Hasan and Dridi (2010). Even with this understanding, both non-Islamic and Islamic banks have tried leveraging but are still incapable of solving the resulting instability, reckon Boumediene & Caby (2009). There are many critics who argue that the problem is more established in the Islamic system, such as Beck (2010), but as long as globalization is concerned, the problem exists in both systems since none should be considered more important than the other. With respect to the above, many researchers have come to agree that the instability resulting from incorporating these different strategies plays a significant role in fuelling the global financial crises, notes Chong and Liu (2009). More so, due to the different lending policies, it is relatively hard to regulate the financial situation where both Islamic and non-Islamic banking and financial systems is present, adds Hasan and Dridi (2010).
Several research studies have analysed the differences between Islamic and conventional banks. More often than not, the focus of these analyses has been to determine which system is more efficient, profitable or resilient to external shocks. Not surprisingly, there have been inconsistent findings largely because of the varying perspectives which were used in the analyses. There are however a few instances where the same concept has been used to analyse the two banking systems and yet inconsistent results were produced. While some authors believe that Islamic banks are more efficient following the resilience of countries dominated by these banks to the global financial crisis, others posit that these countries were only able to withstand the global financial crisis, in most cases due to their rich foreign exchange reserves.
A recent research study that was carried out to determine the performance of Islamic and commercial banks in Europe revealed that the Islamic Bank of Britain (IBB), which is the first full-fledged standalone Islamic bank in Europe, was technically inefficient due to its small size and other managerial problems. The bank however had promising future prospects amid challenging economic times in the UK. Other reasons that explain the bank’s technical inefficiency include the fact that other banks in the UK were larger, had greater profitability and loan intensity, and acquired less debt and had lower market shares on average.
Futhermore, Zahee, et al., (2012) raised concerns about potential negative impact of the burgeoning number of Islamic banks on the transmission of monetary policy. A study that was aimed at investigating the differences in the responsiveness of banks with varying characteristics to monetary policy shocks in Pakistan between 2002 and 2010 revealed that Islamic banks were less responsive to monetary policy. This conclusion was based on the observation that Islamic banks, like large commercial banks maintained their lending irrespective of their liquidity positions. In contrast, commercial banks of similar sizes were forced to cut their lending in response to monetary contraction ceteris paribus. This implies that Islamic are less responsive to monetary policy compared to conventional banks similar sizes.
On the other hand, an analysis carried out by Zaheer & Farooq (2014, 1) revealed that “Islamic banking branches are less prone to the risk of withdrawal during the bouts of liquidity stress.” The authors also opined that Islamic banks attracted more deposits compared to their conventional counterparts due to religious branding. Like Zahee, et al., Zaheer & Farooq observed that Islamic banks maintained their lending irrespective of their liquidity positions. The latter however perceived this reduced sensitivity to changes in deposits a sign of better economic wellbeing and stability in the financial systems.
Even though there is a lot of controversy surrounding the question of the superior banking system between Islamic and conventional banks, most authors will agree that the lending policies in both banks regardless of their differences have a significant impact on the overall profitability of the banks and the performance of the economy. Recent studies on the effect of bank lending rates on the performance of commercial banks have confirmed that lending rates and monetary policy rates have significant impacts on banks performance (Okoye & Eze, 2013)
A number of studies and industry reports also suggest that lending policies in both Islamic and conventional banks have an impact on business cycles (Morris & Sellon Jr., 1996; Bikker & Hu, 2002; Ismail & Sulaiman, 2005; Chang & Jansen, 2005; Rahman, 2009; Zhang, 2009; Gambetti & Musso, 2012; Tabak, et al., 2011). Theoretically, interest rates, which are the main determinants of commercial bank lending have a great influence on the amount of money circulating in the economy. Commercial banks however do not assume the role of controlling the amount of money circulating in the economy. Instead, they are more concerned about their overall profitability, which should be maximised even at the expense of having excess money in the economy. For this reason, the bulk of literature on bank lending policies has focused on the responsiveness of commercial bank lending to various attempts by the government to control the availability of credit through monetary policy.
Although Islamic banks have been criticised for their relative unresponsiveness to monetary policy, Morris & Sellon Jr., (1996) found little evidence supporting the fact that lending in conventional banks is constrained by monetary policy. This was attributed to the evolution of the banking business model. Banks were for instance able to offset declines in the liquidity levels by selling securities and issuing managed liabilities, Additionally, Morris & Sellon Jr. also argued that periods of monetary tightening had a very little impact on the supply of credit by commercial banks and as such, they concluded that the structural change in the banking system had affected the ability of commercial banks to transmit monetary policy. Bikker & Hu, (2002) also pointed out that even though lending fluctuates with business cycles, it is primarily determined by demand as opposed to supply factors such as the availability of capital. Ismail & Sulaiman (2005) also arrived at a similar conclusion. Furthermore, Gambetti & Musso (2012) suggest that recent developments in the banking industry especially in the wake of the global financial crisis have amplified the impact loan supply shocks on economic activity. All in all, it is evident that monetary policy does not have a significant impact on lending policies in both conventional and Islamic banks. For this reason, the amount of money injected into the economy through the banking channel is mainly determined by these lending policies rather than monetary policy.
This research utilized a case study research design to analyse the differences between lending policies in conventional banks in a bid to determine their individual impacts on global financial crises. This research design will enable the researcher to compare and contrast the case of Islamic banks and conventional banks across the globe. Despite the fact that the research is empirical in nature and as such, more of a quantitative research than a qualitative research, a qualitative research design was selected because it entailed an in-depth analysis of the various characteristics of Islamic and conventional banks. The literature review was the main source of this information. Moreover, the fact that the research was confined to secondary data justifies the case study research design, because the data would simply be obtained by comparing different research studies and industry reports as opposed to actual data collection.
Other than that, this method was specifically preferred because of the limited time and resources available for the research. The main advantage of this design is that it is characterise by a holistic approach that will provide valuable insights into the nature of the lending policies in Islamic and conventional banks. Additionally, it will bring to light several other issues about these two banking systems and therefor spark questions for further research. On the other hand, it is subject to bias because the results will mainly depend on the researcher’s personal opinion and interpretation of the data sources.
As aforementioned, secondary data will be collected from a wide range of credible sources including industry reports and previous research studies. Consequently, for the success of the research project, it is advisable to apply the most relevant techniques to acquire the necessary data (Uhde & Heimeshoff, 2009). In light of this, cross country data observation is the best method to carry out the research on this topic. Under this technique, it is important to ensure that the cross country data is collected and treated with care so as to preserve its accuracy and relevance (Turk-Ariss, 2010). Using this method of data collection also calls for the researchers to understand the fact that different countries bear different and specific characteristics. More so, due to the differences in regional and developmental advancements across various countries. The researcher has therefore endeavoured to include an index or constant with which to unify the collected cross country data (Dowdy, et al., 2004). Successful use of this method will ensure substantial control and consideration of the heterogeneity across the involved countries therefore resulting in reliable data and meaningful conclusions (Karwowski, 2009).
3.1 Results and Discussion.
The purpose of the research as entailed in this proposal is clearly defined in the research question and the in research objectives. Therefore, one of the key expected results is the contribution of different lending policies in the Islamic and non-Islamic financial systems in fuelling global financial crises. Also, branching from the above result, the research shall be able to increase the understanding on the extent into which these differences led to the global financial crises. More so, by the end of the research, there shall be up-to-date data reflecting on the expansion and growth of the Islamic financial system across the world, with the underlying factors leading to that growth. In addition, it is expected that the research will stand a chance of clearly outlining the important features and changes that should be added and implemented in the pursuit of reducing the instability of operating under these two different lending policies, and in the process reducing the occurrences of global financial crises.
It was pointed out early in the literature review that Islamic banks are spreading across the world at a very high rate. Industry reports support this notion and further identify the opportunities available for the establishment of Islamic banks. Moreover, it is evident from the results that conventional banks generally have more assets and are therefore bigger than Islamic banks (A.T. Kearney, 2012). This is the case even in South East Asia where Islamic banks are very prominent. Despite the fact that they are vastly growing across the globe, Islamic banks have off late been characterised by a declining profitability growth rate which suggest that there has been a decline in Islamic banks assets and an increase in the cost income ratio.
Figure 3: Islamic banking assets breakdown (A.T. Kearney, 2012)
Figure 1: Banking Asset Outgrowth (A.T. Kearney, 2012)
Figure 2: Cost Income Ratio (A.T. Kearney, 2012)
Table 1: Islamic Banking Markets (A.T. Kearney, 2012)
Established Emerging Untapped
Kuwait KSA UAE Malaysia Pakistan Turkey Indonesia India China
Muslim Population (Million) 3 27 6 17 175 73 209 162 22
GDP per Capita ($) 40,517 23,201 59,533 15,022 2,516 13,150 42,250 3,408 7,544
Islamic Assets ($ Billion) 62 142 94 86 6 28 10 – –
Islamic Assets as a % of Total Assets 40% 38% 22% 17% 7% 50% 3% – –
(A.T. Kearney, 2012)Figure 4: Average Size of Assets (A.T. Kearney, 2012)
The key findings of the 2013-2014 World Islamic Banking Competitiveness Report revealed that the Islamic banking assets with commercial banks across the globe amounted to US$1.54 trillion in 2012 and were characterised by an annual growth of 17.6% (Ernst & Young., 2013). Qatar, Indonesia, Turkey, UAE, Saudi Arabia and Malaysia were identified as the Rapid-Growth Markets for Islamic banks, which would together with Bahrain be central in the internationalization of the Islamic banking industry. The six countries exhibited a five year compound annual growth rate of 16.4% between 2008 and 2012. The profitability of the top 20 Islamic banks was characterised by an average return on Equity of 12.6% while that of conventional banks amounted to 15%. Additionally, the customer base for Islamic banks was 38 million globally with an average product holding of 2.1 and a potential upside in future.
Consistent with numerous research studies, the main difference between Islamic and conventional banks is the absence of interest on Islamic bank loans. It is however evident that the lending policies in both Islamic and big conventional banks are more or less equally unresponsive to monetary policy. Only small conventional banks appear to be affected by monetary policy. This limits the ability of central banks to control the amount of money circulating in the economy. This could have negative implications during economic crises because governments might not in a position to provide a viable solution through monetary policy.
3.2 Limitations of the Research
As expected in any research project, there were a few shortcomings in the process of carrying out the research (Sundararajan & Errico, 2002). First, the differences in the lending policies between the two financial systems turned out to be quite difficult and requiring professional insight to comprehend (Errico & Farahbakh, 1998). In addition, cross country data was not easy to acquire. The research was therefore based on secondary data which was prone to misinterpretation (Dowdy, et al., 2004). Lastly, the ethical provisions protecting data on the operations of financial institutions limited the amount of data available for the research (Sundararajan & Errico, 2002).
To conclude the major difference between conventional and Islamic banks is the fact that Islamic banks are based on Sharia laws while conventional banks are based on capitalism theory. In spite of their salient differences, both banks are established primarily to generate profits. Despite the fact that commercial banks charge an interest on their loans while Islamic banks do not, increased competition in the conventional banking sector has over the years eroded the income generated from bank lending to an extent that bank lending is nowadays mere used to attract more business opportunities for bankers. Consequently, both Islamic and conventional banks have grown immune to monetary policy. The lending policies in both banks therefore have a significant influence on financial crises. Because Islamic banks are still at their infant stages, it still too early to determine, which banking system is superior between the two. However, it is clear at this point that the government should make deliberate efforts to come up with better strategies of controlling the amount of money injected into the economy through the banking channel. Further research is needed to satisfactorily determine the best mix of characteristics and features from the two banking systems that would be used to formulate an ultimate banking system that best serves the needs of the global market while at the same time being resilient to global financial crises.
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