Stability between Islamic and Conventional Banking In Relation To Customer Confidence - Research Paper Example

Comparative Analysis in Islamic and Conventional Banking Stability between Islamic and Conventional Banking In Relation To Confidence Table of Contents Table of Contents 2 Introduction 3 Literature Review 4 Methodology 11 Conclusion 11 References 12 Introduction A conventional bank is regarded as a financial intermediary, which receives money and deposits, and channels those deposits into lending activities, along with paying and collecting cheques for its customers. During business activities, conventional banks offer several other services and facilities to its customers. Thus, it can be asserted as a bank links together its customers that have capital deficits and capital surpluses. Conversely, an Islamic bank consists of the principle of developing Islamic economics through banking activities. During the last few decades, Islamic banking industry has experienced a sustainable growth rate of around 10-15% per annum. At the same time, it is also observed that this industry is steadily growing towards conventional financial systems (Sole, 2007). According to the observation, it is determined that the Islamic banking industry not only operates its functions in major Muslim populated countries, but also it has operated its banking activities in low crowded Muslim countries such as the United Kingdom, Malaysia and Japan among others. Consequently, the Islamic banking industry has granted its banking license for expanding its banking operations in several countries such as India and Syria among others. Besides, it has been acknowledged that Islamic banking industry has in excess of 300 branches among 51 countries around the world where Islamic banking system is followed (Sole, 2007). In terms of key products offered to the customers in both the banks they include mortgages (home loan), car loans, personal loans along with credit facility. Regarding types of contract, it is found that in Islamic finance, contracts of charity, contracts of exchange along with contracts of investment partnership are primarily practiced (Islamic-finance, 2002). With these considerations the paper primarily intends to review and compare four consumer products i.e. credit cards, car loans, personal loans and mortgages (home loan) with respect to products offered in Islamic banks and conventional banking products. Literature Review Over the years, usually it has been observed that a bank provides facilities to its customers through credit cards, car loans, personal loans and mortgages among others. Conventional banks offer the facility of overdrawing money from account of the customer on specific rate of interest. In this context, banks usually determine the limit of overdrawing amount for customers, which is specially done through the help of credit card, where customers can meet the financial requirements without carrying cash indeed. In case of Islamic Financial Institute (IFI), credit cards facility is not available for its customers directly. Instead of providing credit card or money, IFIs usually deliver the desired commodity to its customers directly. Consequently, in case of conventional banking, a customer is charged with specific rate of interest for the credit amount from the bank after the facility availed. However, in case of IFIs, after providing or fulfilling the consumer requirements, its profit proportion remains due. Simultaneously, in case of conventional banking, a default customer is charged with high rate of interest for the extra period of time, whereas, extra charging is not applicable under IFIs. At the same time, in case of conventional banking, a customer has the opportunity of enjoying banking facility after failing to pay the due amount on time, through arranging a new interest paying agreement with the bank. Islamic Financial Institutes default customers’ do not have that much luxury after being accused as a defaulter. IFIs rather blacklist those defaulters and do not entertain them through financing facility (Hanif, 2011). Islamic Financial Institutes are taking cautious steps even after the financial crisis and Dubai debt halt, in order to fortify its mantle as a one of the fastest growing asset classes in the world economy. The IFIs have expanded their banking business in many emerging markets and introduced new standards in order to develop its products and attract investors. Apart from this, IFIs have utilised several strategies as a source of financing such as Murabaha, Ijarah, Diminishing Musharaka, Bai Salam, Bai Muajjal, Tawrraq and Istasna among others (Hanif, 2011). According to the observation, it has been revealed that in case of car loans, IFIs use a different strategy, which is not similar to conventional banks. IFIs offer car loans through utilising Ijarah agreement. In this regard, IFIs usually book the car for their customer and hand over the car to that particular customer with an agreement of paying rental on a regular basis until the due amount is fulfilled. At that point of time, the ownership of the car remains with IFIs and after paying the entire due amount IFI hands over the ownership of the car to its customer. On the contrary, a conventional bank provides special loan to its customer for car purchasing purpose and enjoys interest along with the principle amount until the loan amount is not dissolved. Moreover, conventional banks also at times ask for security in terms of liquidity or asset before allowing the loan for car purchase purpose from its customers. Correspondingly, it can be apparently asserted that IFIs used to bear higher risk factor than that of conventional banks. During the Dubai financial crisis, several conventional banks had shelved the allowing agreements of car loan, whereas Islamic banks had continued to serve its customers through financing directly on the cars (Alzalabani & Nair, 2013). Simultaneously, in case of personal loan, Islamic Financial Institutes have utilised the theory of Tawrraq or Mudarabah agreement. Through this agreement, IFIs can reach an understanding between the bank and the customers, where customers can enjoy the funds of the bank for personal uses. Likewise, in case of conventional bank, customers also can get loan for personal purpose in exchange of security and high amount of interest rate. In case of default customers, IFIs have generally used Halal theory in order to regain its asset legitimately but in case of a delay in payment IFIs do not charge extra amount rather they use a different strategy to impose penalty on its customers. On the contrary, conventional banks used to charge more amount of money as an interest for the delayed time period from its customers (Hanif, 2011). In this regard, IFIs accept mortgage properties or assets before financing on customers’ requirements. IFIs mortgages are based on the concept of Ijarah policy in which the entire instalment for the mortgage is estimated on the ground of monthly rent and it has become one of the most successful tools for Islamic financial system since more than a decade. The mortgage policy had gradually improved the popularity of Islamic banking system. According to the observation, it has been also ascertained that the Islamic mortgage is expansive rather than conventional banking mortgage policy (Ahmad, 2008). Over the years, it has been observed that banks have the tendency of providing long-term loans to its potential customers in order to ensure maximum amount of profitability and wealth creation for future. In order to achieve that many banks have usually targeted home finance products by receiving mortgages as a security deposit. In accordance with Abdul-Rahman and Tug (2011), “a typical homebuyer borrows up to 85 to 90% of the purchase price of a home for a 30-year term” (Abdul-Rahman, & Tug, 2011). In that case, homebuyers’ hands are bound with the situation, as a result customers’ are bound to mortgage their property to the bank for home finance requirement. In accordance with observation, Islamic banking system and conventional banking system have different approaches for mortgage property from credit perspective both for the bank as well as for the customer. Both conventional banks and IFIs have identified that housing finance is a highly significant area from where profit and wealth can be maximised. Thus, both conventional banks and IFIs have secured their approaches in case of home loan. As per the observation, it has been noticed that conventional banking system provides loans to its customers for high rate of interest, while IFIs facilitate its customers’ through diminishing Ijarah. According to IFIs policy during financing on house loan, IFIs jointly purchase the house with the customer according to the financial investment proportion. And, subsequently, IFIs divide the agreed amount of rent in several parts. Customer pays the instalments on the monthly rental basis. The stake of the customer in house property increases when the customer starts to pay the IFIs investment on that particular house property. Accordingly, IFIs stake in house property becomes zero when the customer is able to dissolve the entire instalments. At that point of time, the customer becomes the 100% owner of that house and IFIs transfer the house in the name of the customer completely (Hanif, 2011; Abdul-Rahman & Tug, 2011). With regard to comparing the process from beginning till sending the file for disbursement, it is observed that both conventional and Islamic banks negotiate with several risk factors during offering house loans among customers. According to the observation, it has been revealed that several banks have faced critical difficulties in case of offering house loans amid their customers due to specific few reasons. These reasons include inflation and stagnation of high amount of liquidity for a longer period of time among others. For instance, conventional banks provide loan for house financing purpose during inflation. After providing loan, when that customer has surrendered its house to that particular bank, for being defaulter as a customer, then bank declares the auction notice for that house. During that phase, the conventional bank can realise that the real value of the house might have been decreased and that particular bank can subsequently suffer loss due to providing loan during inflation. Consequently, IFIs have chosen Ijarah model through which they can reduce the chances of bearing loss, avoid real estate crisis and maintain the balance of burden with its customers. On the contrary, conventional banks use traditional approaches of mortgage in case of housing finance (Hanif, 2011; Abdul-Rahman, & Tug, 2011; Aris, & et. al., 2012). In accordance with Siddiqi (2000), Islamic banks have never charged interest on loan products; whereas in order to satisfy and fulfil customers’ needs the bank make the purchase for customers (Siddiqi, 2000). From this background, it can be evidently asserted that this is a supreme facility through which customers of IFI enjoy benefits. Simultaneously, through applying this strategy IFIs have captured massive amount of customers in international market. Thus, it can be affirmed that this is also an advantage of Islamic bank. On the contrary, if customers are failing to pay the instalment then after a certain period of time IFIs used to prohibit those customers for ever. Thus, it can be asserted as disadvantage from customers’ point of view. Besides, in case of default, the clause of penalty is quite different in IFI wherein the bank might face considerable loses if the insurance company did not pay for a period of six months. The bank would also face the burden of default risk. The Sharia supervisory board has the authority to levy penalty on the defaulter and the subsequent received amount goes to charity (Siddiqi, 2000). Subsequently, in accordance with Kyriazopoulos & Petropoulos (2010), conventional banking facility is available everywhere thus individuals can experience banking facility at any point of time and it also offers several kinds of facility through providing exciting products and services such as credit card facility and automated teller machine among others. Thus, it can be asserted as an advantage from customers’ point of view. However, banks also absorb customers’ property such as car, land and home among others if customers’ are unable to pay the unpaid amount of the loan to bank. This is a disadvantage of conventional banks from customers’ viewpoint. Similarly, Conventional banks usually provide loan directly to customers, which has been observed to incorporate a high amount of risk. Thus, it can be asserted that it is the disadvantage of conventional banking systems (Kyriazopoulos & Petropoulos, 2010). According to analysis, it has been ascertained that both the conventional banks and Islamic banks carry huge volume of risks during financing in a home loan project. As per the discussion, it has been also highlighted that IFIs use Ijarah model in order to reduce the risk factor, whereas conventional banks also apply high rate of interest policy during financing on house loan. However, this high rate of interest strategy might not be suitable for inflation scenario. Hence, it has been observed over the years, a maximum number of the conventional banks have tried to avoid financing on housing projects during the inflation period or economic downfall stages. However, IFIs do not worry about inflation or economic downfall rather IFIs use their own strategies and expand their financing capabilities in order to ensure competitive advantages in the global market. Accordingly, it can be apparently asserted that in terms of risk factor related to granting loan, it lies more with conventional banks (Hanif, 2011; Abdul-Rahman, & Tug, 2011). With regard to comparing the risk management, stability and efficiency for both conventional bank and Islamic bank, it can be apparently asserted that the Islamic bank’s risk management tool is much effective than conventional banks. According to the observation, it has been found that when the value of property decreases at that point of time both IFIs and customer suffer according to their share of proportion. Thus, from this scenario, it can be evidently asserted that during banking operations, IFIs never put the entire burden on the customer’s shoulder, rather IFIs have preferred to share the burden of loan as its own responsibility along with its customers. Moreover, it has been also observed that Islamic banks were relatively unaffected by the crisis as compared to the conventional banks during the global financial crisis. Thus, in accordance with Rahim and Zakaria (2013), Islamic banking is ascertained to be more stable as compared to conventional banks with regard to risk management (Rahim & Zakaria, 2013). Islamic finance is grounded on the basis of “Shariah” or “Islamic law”. Shariah provides the guidelines for characteristics of Muslim life. It suggests politics, economics, banking, business, law and religion for Muslim life. Consequently, it can be referred as principles which imitate the Islamic law. Islamic financial institutes offer typical shariah-compliant products, which are developed and supervised by the shariah supervisory board (Ilias, 2010). Correspondingly, shariah compliment products conform to the Islamic commercial rules as well as Islamic ethics. Apart from this, from research, it has been revealed that shariah compliment financial intermediary has been divided into two segments such as product and advice. According to Islamic philosophy, the products are developed according to the financial need and the advices are given in order to maintain the financial sustainability and conform to ethics. Subsequently, it can be apparently ascertained that Shariah-compliant Products fit with the traditional picture of a bank as financial intermediary (Mahdi, 1995). According to World Islamic Banking Competitiveness Report 201314, it is found that Islamic banks’ annual growth rate during the last four financial years was around 17.6% (Ernst & Young, 2013). Methodology The qualitative research method has been chosen for this assignment. The entire research primarily relies on the review of pertinent literature. Moreover, qualitative method is conventionally considered as an appropriate method for conducting this research study, which is related with the banking business. During data collection, secondary sources such as journals and articles have been used. Besides, Islamic and conventional bank’s online websites along with other relevant business reports have been reviewed in order to understand their marketing strategy. Conclusion From the comparative analysis in between Islamic and conventional banking systems, it has been quite prominently revealed that IFIs have shown tremendous effectiveness in recent years rather than conventional banks. Besides, it has been also observed that during economic downfall IFIs do not lose their stability rather they have grown rapidly as can be evidenced from the global financial crisis. Moreover, IFIs have also maintained the risk factors efficiently. Thus, it can be affirmed that IFIs are comparatively better than that of conventional banks in terms of its stability, efficiency and risk maintenance capabilities. References Abdul-Rahman, Y. K. & Tug, A. S., 2011. LARIBA (Islamic) Mortgage Financing in the United States. The President and Fellows of Harvard College, pp. 295-298. Ahmad, W., 2008. Islamic Banking in the United Kingdom: Opportunities and Challenges. Kingston Business School. [Online] Available at: http://www.alislam.org/library/articles/Islamic-Banking-in-the-UK.pdf [Accessed May 23, 2014]. Alzalabani, A. & Nair, R. D., 2013. Financial Recession, Credit Crunch and Islamic Banks: A Case Study of Al Rajhi Bank in the Kingdom of Saudi Arabia. Journal of Economics and Business, Vol. 16, No. 1, pp. 15-36. Aris, N. A. & et. al., 2012. Islamic house financing: Comparison between Bai’ Bithamin Ajil (BBA) and Musharakah Mutanaqisah (MM). African Journal of Business Management, Vol. 6, No. 1, pp. 266-273. Ernst & Young, 2013. World Islamic Banking Competitiveness Report 2013–14. Index. [Online] Available at: http://www.mifc.com/index.php?ch=28&pg=72&ac=58&bb=uploadpdf [Accessed May 23, 2014]. Hanif, M., 2011. Differences and Similarities in Islamic and Conventional Banking. International Journal of Business and Social Science, Vol. 2, No. 2, pp. 166-175. Ilias, S., 2010. Islamic Finance: Overview and Policy Concerns. Federation of American Scientists. [Online] Available at: http://www.fas.org/sgp/crs/misc/RS22931.pdf [Accessed May 23, 2014]. Islamic-finance, 2002. Types of Contract. Resources. [Online] Available at: http://www.islamic-finance.com/item13_f.htm [Accessed June 03, 2014]. Kyriazopoulos, G. & Petropoulos, D., 2010. What are the Advantages and Disadvantages That Lead Banks into Mergers and Acquisitions? Is Altman’s Z-Score Model for Bankruptcy Motivate Banks for Mergers and Acquisitions? Evidence from the Greek Banking System. International Conference on Applied Economics, pp. 447-458. Mahdi, M. A., 1995. Islamic Banking Modes for Building Financing. Islamic Development Bank, pp. 1-285. Rahim, S. R. M. & Zakaria, R. H., 2013. Comparison on Stability between Islamic and Conventional Banks in Malaysia. Journal of Islamic Economics, Banking and Finance, Vol. 9 No. 3, pp. 131-149. Siddiqi, M. N., 2000. The Comparative Advantages of Islamic Banking and Finance. Harvard University, pp. 183-188. Sole, J., 2007. Introducing Islamic Banks into Conventional Banking Systems. International Monetary Fund, pp. 1-26. Read More