“PERFORMANCE OF ISLAMIC

BANKING AND CONVENTIONAL

BANKING IN PAKISTAN: A

COMPARATIVE STUDY”

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MASTER DEGREE PROJECTPerformance of IslamicBanking and ConventionalBanking in Pakistan:A Comparative StudyMaster Degree Project in FinanceSyed Adeel AkbarSupervisor: Miss NosheenExaminer: _____________________1

ACKNOWLEDGEMENTVery first I would like to thank my ALLAH Almighty who gave me the courage,

health, and strength to complete my work in due time and without whose help this

study which required too much effort would have not been possible to complete

within the period.

Inspiration, support, guideline, corrections, advises are the key factors required from

the supervisor to be pinned down and complete a project of a good standard and a

quality within the specified time. I will feel pleasure to extend my gratitude and give

due respect to my supervisor Miss Nosheen who is always been there in need of time

and who gave me all these key elements to complete my project within the time

frame.

My thanks are also due to my examiner ____________________ whose precious

comments and advices made a vast contribution in improving my project.

Last but not least, I am very thankful to my entire family for moral support and pray

for my health and successful completion of my report within time limits.

Syed Adeel Akbar

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ABSTRACT

Islamic banking and finance in Pakistan started in 1977-78 by removing interest

according to the Principles of Islamic Shari’ah in Islamic banking practices. Since

then, changings in financial system to allow the issuance of new interest-free tool of

corporate financing, announcement of ordinance to permit the organization of

Mudaraba companies and flowing of Mudaraba Certificates, constitution of

Commission for Transformation of Financial System (CTFS), and the organization of

Islamic Banking Department by the State Bank of Pakistan are some of the key steps

taken place by the governments.

The purpose of this study is to examine and to assess the performance of the Islamic

banks in Pakistan, i.e. Meezan Bank Limited (MBL) and Bank Islami in comparison

with that of a group of 3 Pakistani conventional banks. The study evaluates

performance of the Islamic banks in profitability, liquidity, risk, and efficiency for the

period of 2007-2009.

Financial ratios (15 in total) such as Return on Asset (ROA), Return on Equity (ROE),

Yield on Earning Assets, Cash to deposit to deposits ratio, Asset Utilization (AU), and

other major ratios are used to evaluate banking performances. Finally policy

recommendation also given in order to how to improve performance of respective

banks.

TABLE OF CONTENTS

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1 INTRODUTION1.1 INTRODUCTION OF THE STUDY1.2 SCOPE & OBJECTIVE OF THE STUDY1.3 STATEMENT OF PROBLEM1.4 LIMITATION OF THE STUDY

2 EVOLUTION OF BANK2.1 EVOLUTION OF ISLAMIC BANKS2.2 ISLAMIC BANKING2.3 PRELIMINARY ISLAMIC BANKING MODELS

2.3.1 PERSONAL BANKING MODEL2.3.2 ISLAMIC BUSINESS FINANCIAL MODEL2.4 EVOLUTION OF CONVENTIONAL BANKS

3 INDUSTRY OF ISLAMIC BANKS3.1 AN OVERVIEW3.2 ISLAMIC BANKS IN PAKISTAN3.3 ISLAMIC BANKING SECTOR3.3.1 OPERATING PERFORMANCE3.3.2 OUTREACH EXPANSION3.3.3 ASSET QUALITY3.3.4 FINANCING PRODUCTS3.4 ISLAMIC BANKING NEWS

4 DATA & METHODOLOGY4.1 RESEARCH DESIGN4.2 SAMPLE OF RESEARCH4.3 SOURCE OF DATA4.3.1 PRIMARY DATA4.3.2 SECONDARY DATA4.4 RESEARCH TECHNIQUE

5 LITERATURE REVIEW5.1 RESEARCH IN ISLAMIC BANKS IN PAKISTAN5.2 INTERNATIONAL RESEARCH

6 FINANCIAL ANALYSIS

1. INTRODUCTION

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1.1 INTRODUCTION TO THE STUDY:

Islamic banking emerged as a practical reality and started functioning in 1970s. Since

then it has been growing continuously all over the world. Presently, Islamic banking

industry has reached US$1.0 trillion US dollars by the end of 2008. International

Rating Agency, Standard & Poor estimates that Islamic financial industry has

potential to grow to US$4.0 trillion over medium term. It is surprising to note that

global conventional banks like HSBS, Standard Chartered Bank, Deutsche Bank,

Citibank, etc, have also set up separate Windows/Divisions to structure Islamic

financial products and are offering Islamic banking services to their Muslim clients

and even to those non-Muslim clients who are interested in profit and loss sharing

(PLS) financial instruments. UK, France, China, Singapore and many other countries

have developed special regulatory to facilitate the working of Islamic banking. The

speed of the growth of Islamic banking all over the world including Pakistan has been

expedited since 2002.

The underlying objective of this study is to investigate the phenomenon that

conventional banking, which has been operating for the last three centuries on strong

footing, have started tumbling steeply in the last few decades while Islamic banking

has been expanding all over the world particularly in Muslim countries with fast

speed

Although, Islamic banking in Pakistan started around three decades ago with an

initiative of removing of interest from the operations of specialized institution and

commercial banks in 1977-78, but the serious steps have been the part of recent past

only when in January 2000, State Bank of Pakistan (SBP) constituted a Commission

for Transformation of Financial System (CTFS) to introduce Shari’ah compliant

modes of financing, and, on 15 September 2003,6 when the State Bank of Pakistan

(SBP) established the Islamic Banking Department. As an outcome of these efforts,

Islamic banking is now playing an important role in financing and contributing to

different economic and social sectors in the country in accordance with the principles

of Islamic Shari’ah in Islamic banking practices.

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To give a real increment to Islamic banking operations in Pakistan, in an historic

beginning, in January 2002, Meezan Bank Limited was granted first Islamic Banking

License by the State Bank of Pakistan to be treated as first full-fledged Islamic bank

in Pakistan.

Islamic banks in Pakistan are only six in total and majority of these Islamic banks

started their operations recently except Meezan Bank Limited which is in operation

for last more than 6 years. On the other side, conventional commercial banks in

Pakistan are comparatively large in size and number, and majority of these banks are

present in Pakistan for more than a decade.

1.2 THE SCOPE OF THE STUDY:

The scope and objective of the study is to examine and analyze the experience with

Islamic banking to assess the Islamic banks’ performance in comparison with the

group of 3 conventional banks in Pakistan.

Since MBL and Bank Islami have network over 100 branched and experienced

domestic private Islamic banks in Pakistan, it will give us some room to generalize

our results with the consideration of performance assessment of Islamic banks in

Pakistan. The study will also provide us some understanding about the performance of

Islamic banking in comparison to conventional banking in the country.

Another important reason for selecting MBL and Bank Islami is the data availability

and the fact of vast network of branches in Pakistan. This also stems reason for

choosing latest 3 years (2006 to 2008) to accomplish our analysis.

Moreover, 3 conventional have been selected on merit in that these banks, at large,

duly represent private banking sector of Pakistan.

Government possessed banks and privatized banks have not been made part of this

community due to the fact that most of government possessed banks and all privatized

banks are quite old and large as compared to the private sector banks in Pakistan.

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Cause for not selecting foreign bank, whether Islamic or conventional, is to look on

financial performance of domestic banks only.

1.3 RESEARCH QUESTION:

“The main theme of this study is to investigate the phenomenon of Islamic banking and compare it with the conventional banking in the

perspective of overall operational framework of banking sector in Pakistan.”

1.4 LIMITATIONS OF THE STUDY:

There are two basic limitations of this study, which are;

1. In KPMG Banking Survey, Pakistani banking sector has been bifurcated into

three segments: large size banks, medium size banks and small size banks on

the basis of their size, assets, deposits, loans, and financing of banks. Islamic

banks have been included into small size banks, because they are new and take

time to become big banks and we are going to examine these new small size

Islamic banks with large size conventional banks having strong system from

many centuries.

2. Among different instruments and techniques different authors used as

performance measure, financial ratios found to be commonly used in the

literature. For the study, we used financial ratios to measure and compare

Islamic bank and conventional banks performances in the profitability,

liquidity, risk & being solvent, and efficiency.

The ratios analysis is one of the most powerful tools of financial management.

Though ratios are simple to calculate and easy to understand, they suffer from serious

limitations.

Limitations of financial statements: Ratios are based only on the

information which has been recorded in the financial statements. Financial

statements themselves are subject to several limitations. Thus ratios

derived, there from, are also subject to those limitations. For example,

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non-financial changes though important for the business are not relevant

by the financial statements. Financial statements are affected to a very

great extent by accounting conventions and concepts. Personal judgment

plays a great part in determining the figures for financial statements.

Comparative study required: Ratios are useful in judging the efficiency of

the business only when they are compared with past results of the

business. However, such a comparison only provide glimpse of the past

performance and forecasts for future may not prove correct since several

other factors like market conditions, management policies, etc. may affect

the future operations.

Ratios alone are not adequate: Ratios are only indicators; they cannot be

taken as final regarding good or bad financial position of the business.

Other things have also to be seen.

Problems of price level changes: A change in price level can affect the

validity of ratios calculated for different time periods. In such a case the

ratio analysis may not clearly indicate the trend in solvency and

profitability of the company. The financial statements, therefore, be

adjusted keeping in view the price level changes if a meaningful

comparison is to be made through accounting ratios.

Lack of adequate standard: No fixed standard can be laid down for ideal

ratios. There are no well accepted standards or rule of thumb for all ratios

which can be accepted as norm. It renders interpretation of the ratios

difficult

2. EVOLUTION OF ISLAMIC BANKING AND CONVENTIONAL BANKING

2.1 EVOLUTION OF ISLAMIC BANKS:

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The first modern experiment with Islamic banking was undertaken in Egypt under

cover, without projecting an Islamic image, for fear of being seen as a manifestation

of Islamic fundamentalism which was anathema to the political regime. The

pioneering effort, led by Ahmad El Najjar, took the form of a savings bank based on

profit-sharing in the Egyptian town of Mit Ghamr in l963. This experiment lasted

until l967 (Ready l98l), by which time there were nine such banks in the country.

These banks, which neither charged nor paid interest, invested mostly by engaging in

trade and industry, directly or in partnership with others, and shared the profits with

their depositors. Thus, they functioned essentially as saving- investment institutions

rather than as commercial banks. The Nasir Social Bank, established in Egypt in l97l,

was declared an interest-free commercial bank, although its charter made no reference

to Islam or Shariah (Islamic law).

The IDB was established in l974 by the Organization of Islamic Countries (OIC), but

it was primarily an inter-governmental bank aimed at providing funds for

development projects in member countries. The IDB provides fee- based financial

services and profit-sharing financial assistance to member countries.

2.2 ISLAMIC BANKING:

Islamic banking is the system of banking consistent with principles of Islamic law

(Shari’ah) and guided by Islamic economics. Islamic economics is referred to that

body of knowledge which helps realize human well-being through an allocation and

distribution of scarce resources that is in conformity with Islamic teachings without

unduly curbing individual freedom or creating continued macroeconomic and

ecological imbalances (Chapra 1996). A key element of Islamic economics is

distribution of equitable rewards to the different factors of production. Islamic

economic system seeks system of Redistributive justice where concentration of wealth

in a few hands is countered and flow of money into the economy is fluent. Islamic

banking is, therefore, seen as a lynchpin to achieving the economic and social goals of

the Islamic economic system

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As system of Islamic banking is grounded in Islamic principles and all the

undertakings of the banks follow Islamic morals so it could be said that financial

transactions within Islamic banking are a culturally-distinct form of ethical investing.

Two basic principles behind Islamic banking are the sharing of profit and loss and,

significantly, the prohibition of Usury, the collection and payment of interest, also

commonly called Riba in Islamic discourse. Although collecting and paying interest is

not permitted under Islamic law, revenue-sharing arrangements are generally

permitted.

Riba is forbidden by the Qur'an. For example:

“And that which you give in gift (loan) (to others), in order that it may increase (your wealth by expecting to get a better one in return) from other people’s property, has no increase with Allâh; but that which you give in Zakât (sadaqa - charity etc.) seeking Allâh’s Countenance, then those, they shall have manifold increase. Sura Ar-Rum (30:39).”

“That they took riba (usury), though they were forbidden and that they devoured men’ssubstance wrongfully – We have prepared for those among men who reject faith a grievous punishment. Sura An-Nisa (4:161).”

However, this does not mean that Islam prohibits any gain on principle sums. In

Islam, profit is the recognized reward for capital. When capital employed in

permissible business yields profit that profit (excess over capital) becomes the rightful

and just claim of the owner of the capital. As a corollary, the risk of loss also rests

exclusively with the capital and no other factor of production is expected to incur it.

Another important element of Islamic finance is that profit or reward can only be

claimed in the instance where either risk of loss has been assumed or effort has been

expended. Profit is therefore received by the provider of capital and

wages/remuneration by labor/manager. A depositor in an Islamic bank can therefore

make earnings on his or her deposit in several ways:

Through return on his capital when that capital is employed in a business

venture.

Through sharing of profit when his capital is par of capital is employed in a

partnership

Through rental earnings on an asset that has been partially financed buy his

capital.

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2.3 PRELIMINARY ISLAMIC BANKING MODEL:

The people having savings or valuable articles, used to keep them under the custody

of trusted persons who were known for their trustworthiness and having capability to

discharge their obligations promptly whenever demanded. The underlying objective

was to keep small savings in the shape of deposits with trusted persons for

safekeeping and not for earning profit. This was the early shape of deposit-taking

which is one of the functions of modern banking. Similarly, the wealthy people

supplied funds to honest and experienced traders to finance their trade ventures and

earn profit. The traders used to purchase commodities from the areas where they were

abundant and sold where they were scarce and whatever the profit they earned they

handed over to the owner of capital after charging their fee and traveling expenses.

This was the early model of financing which is the core business of modern banking.

This kind of financing is known in Islamic financial literature as “Modarba

transaction”.

Now we quote practical examples from the history of Islam to illustrate early Islamic

banking model

2.3.1 EXAMPLES OF PERSONAL BANKING MODEL:

The people of Makka used to deposit their money and valuables with the Holy

Prophet (PBUH) because he was the most honest and commonly known as Amin

(trustworthy) even before the declaration of his prophethood. These deposits and

valuables remained under his custody until his emigration from Makka to Medina.

Before, his departure, the Holy Prophet handed over these deposits and valuables to

his cousin and son-in-law, Hazrat Ali for their onward return to their owners.

2.3.2 EXAMPLES OF ISLAMIC BUSINESS FINANCING MODEL:

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As mentioned above that the family of the Holy Prophet, Muhammad (MPUH) was

prominent in business circle of of Makkah, His father, Abdullah, was also a leading

business figure. But he was died when he was returning from a business trip of Syria

at 25 years of age. in the young age. The grandfather of the Holy Prophet, Abu

Mutlib, was also a leading businessman of Makka but he was also died when the child

was at 8. His uncle, Abu Talib, brought him up and oftenly accompanied him in his

business tours.

His honest business practice popularized him as a man of high integrity. Khadija bint

Khuwailid, a wealthy and noble widow of Macca hired his services for his business.

He made handsome profits for her. She was very much happy and impressed by the

honesty and dedication of the Holy Prophet and later was married to the Holy Prophet

when he was at the age of 25 while she was at 40 in 595 A.D.

This example illustrates the fact that an entrepreneur can avail financing from a

wealthy woman for his business venture and form partnership with her.

2.4 EVOLUTION OF CONVENTIONAL BANKING:

Early conventional banking had its origins in Italy. The profession grew out of the

trade boom of the so- called commercial revolution of the High Middle Ages (1000–

1350). By the early modern period, however, banking spread throughout Europe and

became complex and increasingly involved in credit transactions.

By the late thirteenth and fourteenth centuries there were three types of banks:

1. International merchant banks;

2. Local deposit banks, and

3. Pawn broking establishments

These categories were not exclusive: the same businessmen sometimes engaged in

two or all three types simultaneously. Although the Florentine banking system fell

into crisis in the sixteenth century, yet Italians remained active in international

banking into the seventeenth century. In the meantime, banking on the Italian model

grew in southern Germany and other parts of Europe. The most notable of the firms

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was the great Fugger Banking Companies of Augsburg named after Hans Fugger, a

renowned trader of fourteen century weaver. These banks were engaged in a range of

activities, including speculation in the money market and trade in commodities. The

conventional banking system that was originated in Italy moved to Spain and then to

Holland, until it settled in England. The commercial activity in England was

motivated by a group of Lombardian traders emigrated from Italy in the 14th century

A.D. The new comers settled in that part of London which is known today as the

famous Limbard Street. With their arrival in London, the most important part of

banking operations, the documentary credit and lending operation of usury were

commenced. Most of these emigrants were Jews.

3. INDUSTRY OF ISLAMIC BANKS IN PAKISTAN

3.1 AN OVERVIEW:

Let us begin with the view of Quaid-e-Azam Muhammad Ali Jinnah (the founder of

Pakistan) on Islamic Banking he expressed on the occasion of the Opening Ceremony

of The State Bank of Pakistan on July 1, 1948:

“We must work our destiny in our own way and present to the world an economic system based on true Islamic concept of equality of manhood and social justice. We

will thereby be fulfilling our mission as Muslims and giving to humanity the message of peace which alone can save it and secure the welfare, happiness and prosperity of

mankind”

Islamic banking in Pakistan started in 1977-78, which included the elimination of

interest from the operation of specialized institution and commercial banks. On June

26, 1980, amendments were made in the corporate and financial system to allow the

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issuance of new interest-free instrument of corporate financing named, Participation

Term Certificate (PTC). In the same time, with the aim of rising risk based capital,

Ordinance was introduced to permit the establishment of Mudaraba companies and

floatation of Mudaraba Certificates. July 1, 1985, all commercial banks in Pak Rupee

were made interest free which was mark-up technique with or without buy-back

agreement. However, in November 1991, Federal Shariat Court (FSC) declared it un-

Islamic (Source: IIFM).

In January 2000, in the State Bank of Pakistan, a Commission for Transformation of

Financial System (CTFS) was constituted to introduce Shari'ah compliant modes of

financing. CTFS was held responsible primarily for creating legal infrastructure

conducive for working of Islamic financial system, launching a massive education and

training programs for bankers and their clients, to create awareness for the general

public about the Islamic financial system and also to deal with major products of

banks and financial institutions, both for assets and liabilities side (Source: IIFM).

In September 2001, Government of Pakistan decided to make shift to interest free

economy in a gradual and phased manner without causing any disruptions. It was also

agreed that State Bank Pakistan would consider for establishing subsidiaries by the

commercial banks for the purpose of carrying out Shari'ah compliant transactions,

specifying branches by the commercial banks exclusively dealing in Islamic products

and, creating new full-fledged commercial banks to carry out utterly banking business

based on proposed Islamic financial products (Source: IIFM).

In January 2002, Meezan Bank Limited was granted first Islamic Banking License by

State Bank of Pakistan. On 15 September 2003, The State Bank of Pakistan (SBP)

established the Islamic Banking Department with the mission to promote and regulate

Islamic Banking Industry in line with best international practices ensuring Shari'ah

Compliance and transparency and the with the vision of making Islamic banking the

banking of first choice for theproviders and users of financial Services. The foremost

task of the department is to promote and develop the Shari'ah Compliant Islamic

Banking as a parallel and compatible banking system in the country. Department is

comprised of three divisions: Policy Division, Shari'ah Compliance Division, and

Business Support Division. A Shari'ah Board comprised of experts to guide the

Islamic banking industry is also in place at SBP.

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3.2 ISLAMIC BANKS IN PAKISTAN:

Presently, there are six full-fledged Islamic banks operating in Pakistan. These banks

with their year of incorporation are:

AlBaraka Islamic Bank Pakistan (1991)

Meezan Bank Limited (2002 – restructured as Islamic bank)

BankIslami Pakistan Limited (2003)

Dubai Islamic Bank Pakistan Limited (2005)

Emirates Global Islamic Bank Limited (2007)

Dawood Islamic Bank Limited (2007)

Among the banks listed above, Albaraka Islamic Bank (AIB) is the only foreign

Islamic bank operating in Pakistan as branches of AlBaraka Islamic Bank Bahrain

since 1991, and Meezan Bank Limited (MBL) has the honor of being the first

domestic commercial bank offered full-fledged Islamic banking license by SBP in

January 2002.

There is massive demand for Islamic financial services and the growth of Islamic

Banking in Pakistan has been commendable during the last two years. However, the

lackof infrastructure support & lack of professional Islamic Bankers has constrained

the growth.

Banks of Pakistan have been involved basically in catering to the needs of the

government organizations, subsidizing the fiscal deficit, engaging in trade financing,

and serving a few large corporations. Small and medium enterprises, housing sector

and the agricultural sectors which create most of the growth and employment in

Pakistan were deprived of lending. Moreover, financial system of Pakistan was also

under political influence in that there was utmost political intervention in lending

decisions and in the appointment of managers.

3.3. ISLAMIC BANKING SECTOR:

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Islamic banking industry has sustained the high growth rates of assets, deposits and

financing & investment during the quarter ended-March 2010. The YoY growth in

assets, deposits and financing & investment was 33, 40 and 25 percent, respectively in

March 2010. The share of Islamic banking has further improved as assets and deposits

of Islamic banking Institutions (IBIs) stood at around 6 percent each of the banking

sector in Pakistan (Table 1). During Q1-2010, the assets and deposit showed positive

growth compared with a negative growth in both asset and deposit of the banking

industry. This primarily reflects the depositors’ confidence and keen interest in

Islamic banking offerings.

3.3.1. OPERATING PERFORMANCE:

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As shown in Table 2, the earning and profitability ratios shows mixed picture. The

ROE and ROA of IBIs remained lower than the industry at 7 percent and 0.8 percent

respectively. The intermediation cost of IBIs is on the higher side as compared to the

industry. The operating expense also remained high compared to the industry; the

operating expense to gross income ratio of IBIs was 70 percent compared to 52

percent for the industry.

The higher operating/intermediation cost is largely attributable to the expansion phase

of the IBIs; the branch network of IBIs more than doubled during last two years,

which would take some time to achieve break-even and start making profits. Further,

the limited investment avenues to place the growing deposit base and low ADR at

52% also contributed in relatively lower income and thus higher operating expenses to

gross income ratio of IBIs

3.3.2 Outreach Expansion:

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The branch network of IBIs has increased to 654 branches in March 2010. The

geographical coverage of Islamic banking extends across the four provinces and Azad

Kashmir, Northern areas and Federal capital covering 81 cities. In terms of bank and

unbanked areas, the Islamic banking coverage is highly skewed towards banked areas

as unbanked area only account for 2.2 percent of the Islamic banks’ branches.

3.3.3 Asset Quality:

The asset quality of IBIs continued exhibiting signs of weakness during the quarter

with non-performing financing (NPF) increasing to Rs 11.87 billion, which is almost

double the level in March 2009. The NPFs to financing ratio increased to 7.3% during

the quarter from 6.3% in December 2009 and 4.5% in March 2009. The rising trend in

NPFs, is attributable to the overall slowdown and weakness in the economy which has

been under stress since last couple of years due to some adverse developments both

on domestic and international front. When compared with the non-performing

portfolio of the overall banking industry, the position of IBIs is however relatively

better, the level of infected portfolio of the industry has reached to 13.1% of total

financing as compared to 7.3% for IBIs.

The relatively better asset quality of the IBI viz-a-viz the industry could be attributed

largely to cautious approach adopted by IBIs in assets acquisition (financing). The

IBIs have been selective in their financing decisions to book a better risk even at the

cost of significantly lowering their profit margins; the declining ADR of IBIs also

highlights their cautious approach in asset acquisition. This conservatism though

sounds good in regulatory perspective, however, may not be good for long term

sustainability and growth of IBIs. The low profitability ratios of IBIs viza- viz the

overall banking industry among others are also attributable to this over conservatism.

The improvement in profit margins of IBIs will thus require some diversification in

asset mix, improvement in risk appetite, product innovation, and expansion of

outreach to new areas/sectors like SMEs, Agribusiness which are so far largely un-

tapped.

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3.3.4 FINANCING PRODUCTS:

The financing mix remained concentrated in Murabaha, Ijarah and Diminishing

Musharakah—all fixed income modes. Some financing activity has been initiated

through Salam and Istisna, which together constituted about 10% of IBIs financing

mix as of March 31, 2010. However, negligible activity was observed in participatory

modes like Musharakah and Mudarbah. IBIs, despite having excess liquidity have

shown reluctance to venture into non-traditional areas like agriculture and SMEs and

diversify their product mix from totally fixed returns to a mix of fixed and variable

returns. While there has been relatively lower demand for participatory products, the

IBIs' cautious approach in assets acquisition also partly explains the absence of

Musharaka/Mudarbah in IBIs financing mix.

3.4 TYPES OF BUSINESS THE ISLAMIC BANKS PERFORMS:

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Islamic banks have different modes of financing under which they operate. In

Pakistan Islamic banks works under seven modes of financing which are Murabaha,

Musawama, Ijarah, Salam, Istisna, Musharka and Modarbah (Usmani, 2002).

Memon (2007) state that in Murabah asset is purchased by Islamic banks at

the request of their customer and then sell it to its customer with a markup

reflecting it profit earning.

Musawama is similar to Murabah but in this case sell is not obliged to reveal

his cost,

Ijarah financing mainly used for Car Finance products in Ijarah according

Parvez (1991) Islamic bank purchase an asset and lease it to its customers,

Lease can be based on simply rental which customers pay to Islamic bank.

Salam financing based on agricultural based financing. In Salam, the seller

undertakes to supply some goods at give date in exchange of advance payment

they receive at spot (Usmani, 2002).

According to Ahmed (2006) Istisna is used for long term financing facility

involving for example construction of new power plant. Islamic banks either

own their plant, charge a fee based on profit or sale the plant to deferred bases

with charging markup as a profit similar to Murabaha Transaction.

Musharka is the agreement between two or more parties enters in to a contract

by providing their capital in different or similar amount for running a business

with the condition that they will share profit or loss as agreed in the contract

before.

Usmani (2002) states in his famous Islamic banking book that Modarbah is

that kind of partnership where one partners gives money to another in order to

invest it in a commercial enterprise. The investment amount comes from the

first partner and the management who is responsible for managing that firm

are working partners and the profit generally share between the two as

determined ratio agreed before the contract. Investor called the “Rab-ul-Maal”

and the management called the “Mudarib”.

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Figure 2 describes the breakup of mode of financing for Islamic banking in the

quarter ended September 2010. It is shown clearly in the figure that all major

components of Islamic financing declined over the quarter apart from Istisna and

Musharka.

3.5 PERFORMANCE OF ISLAMIC BANKING IN PAKISTAN:

Islamic banks in the turmoil time of economic setbacks with floods/rains affecting

many areas of Pakistan and increasing effect of credit risk still Islamic banks showed

tremendous amount of growth although there are some decline in performance

indicators (see Table 6). Islamic banking market share increase with 30 bps also there

was also increase of 3.2% growth in assets as compared to the declining asset base of

conventional banks in Pakistan. The branch network as discussed above was also

increase by 5.4% and most of the increase was dedicated solely to Islamic banking

division as compared to conventional banks who are operating Islamic bank branches.

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Islamic banks performance is indicated in below mentioned Table 7 the profitability

of Islamic banking in Pakistan which is mainly based on Return on Assets; Return on

equity is lower than the industry average. This declining profitability can be predicted

and we can see that there are many factors attributed to difficult economic condition

prevail in the country as many other commercial banks also suffer from that of

limping economy. The number of expansion of new branches in local as well as

Islamic banks we can assume that that’s the main reason as number of branches still

haven’t achieve its break even resulting in the declining of the profit for Islamic bank

in the quarter ended September 2010.

Performance can also be measure in terms of its enhancement of deposits (Farrukh,

2005). Figure 3 indicated that structure of funding growth during the last quarter in

September 2010 shown growth as deposits was increase by 2.5. However as compare

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with year to year basis deposits showed impressive growth by 38% approximately

(see Figure 3).

Islamicity means Islamic status of an issue which means whether or not it is legal in

Islam or not (Usmani, 2002). For operating of Islamic banks the Shariah under the

guidance of renowned Islamic scholars Mr. Taqi Usmani working on the principle of

Islamic Shariah. Meezan banks have developed a board which approves or

disapproves the products or services that are currently being launched in Islamic

banks. Other banks and branches of conventional banks also work on the similar

principle of Islamicity. All the products that are currently being involved are work on

the basis of Islamic rules and regulations.

3.6 FUTURE PROSPECTS OF ISLAMIC BANKING IN PAKISTAN:

Islamic banking established itself globally as do in Pakistan growing at a rapid pace.

The size of Islamic banking is expected to reach an estimated USD 1,300 billion in

near future ahead1. In Pakistan State Bank of Pakistan launched Islamic bank in 2001

with full fledge commencement of Islamic operations was first initiated to Meezan

Bank of Pakistan. Islamic bank since its inception shown a good sign of growth as

total assets word Rs. 411 billion in June 2010 showing an increase of 31% growth

compared to last one (State Bank of Pakistan, 2010). Islamic banks in future has a

great role to play for banking industry of Pakistan, as it mentioned below the key

future prospects for Islamic banking in the country are:

1 Islamic Finance in the Global Economy Second edition by Ibrahim Warde 2010.

24

Pakistan being the Muslim country and 97% of the people being Muslim has a

fairly large number of market share offer to Islamic banks. Majority of people

still don’t have bank account and since majority of people lives in rural areas

and general disliking among the nation of this country is Interest (Riba).

Therefore Islamic banks should be more advertsized and publically one has to

introduce the concept of Islamic banking which is still lacking in this country

(Imran, 2005).

Large Un-served agricultural sector is also look upon by Islamic sectors.

Pakistan being agrarian economy therefore micro finance institution should be

developed in order to develop the needs of this class. Currently Islamic banks

are largely developed in urban areas and offering the customer’s needs in big

cities therefore they should target the agricultural sector in this country and

expand their branch network to smaller towns and rural areas (Ariff, 2007).

SME is also potential area for Islamic banks. Presently only 0.2 million SMEs

have been access to financing out of 3.1 million SMEs across the country

(SBP Data). Conventional banks place their funds in government securities

which is risk free, meanwhile Islamic banks doesn’t have this type of

opportunity yet.

Housing finance is also one area which Islamic banks have started but still

there are many opportunities surrounding which they can cater and eventually

fulfill vast market of Pakistan in housing finance.

Therefore as mention above Islamic banks would indeed have a good future ahead

and eventually there is good market for Islamic banks and Islamic banks should lead

to economic growth in the country and development of banking industry.

25

5. LITERATURE REVIEW:

The volume of literature on Islamic banking profitability is rapidly expanding and a

handsome research work has been done by Muslim researchers during last two

decades. As Islamic banking is a new industry and as such sometimes researchers face

problem of the scarcity of relevant data. In this section, we have intended to review

some of the leading research studies on Islamic and conventional banking. Let us see

what previous studies say about the profitability of Islamic banking.

5.1 RESEARCH ON ISLAMIC BANKS IN PAKISTAN:

Abdul Ghafoor Awan has analyzed the vertical growth of Islamic banking and

compared it with its counterpart conventional banking. Six newly formed Islamic

banks in Pakistan and six conventional banks of the same size were selected for the

purpose of comparison. Data relating to their performance and profitability were

collected from primary and secondary sources from 2006 to 2008. The ratio analysis

technique was applied to measure the performance of key indicators of both Islamic

and conventional banks. The results of the study are very encouraging because the

26

performance and profitability of Islamic banks are far better than selected

conventional banks. Islamic banks outperform conventional banks in assets, deposits,

financing, investments, efficiency, and quality of services and recovery of loans. It

predicts the bright future of Islamic banking in Pakistan.

The performance evaluation of Islamic Banks and Conventional Banks in Pakistan

has examined by Muhammad Shahzad Moin in 2008. The aim of this study is to

examine and to evaluate the performance of the first Islamic bank in Pakistan, i.e.

Meezan Bank Limited (MBL) in comparison with that of a group of 5 Pakistani

conventional banks. The study evaluates performance of the Islamic bank (MBL) in

profitability, liquidity, risk, and efficiency for the period of 2003-2007. Financial

ratios (12 in total) such as Return on Asset (ROA), Return on Equity (ROE), Loan to

Deposit ratio (LDR), Loan to Assets ratio (LAR), Debt to Equity ratio (DER), Asset

Utilization (AU), and Income to Expense ratio (IER) are used to assess banking

performances. T-test and F-test are used in determining the significance of the

differential performance of the two groups of banks. The study found that MBL is less

profitable, more solvent (less risky), and also less efficient comparing to the average

of the 5 conventional banks. However, there was no significant difference in liquidity

between the two sets of banks. The reasons are due to the facts that conventional

banks in Pakistan have longer history and experience in doing banking business and

hold dominating position in the financial sector with its large share in the overall

financial assets of Pakistan, as compared to Islamic banks, which in true sense, started

only a few years back with all letter and spirit. The study found that MBL is less

profitable, more solvent (less risky), and less efficient during 2003-2007, however, it

is improving considerably over time indicating convergence with the performance of

the conventional banks.

Ashfaq Ahmed, Kashif-ur-Rehman and Muhammad Iqbal Siaf have done study on

comparison between Islamic and Conventional Banks from customer prospective in

2010. This study examines the relationship between service quality and customer

satisfaction regarding Islamic banks as well as conventional banks in Pakistan. It also

investigated how service quality affects customer satisfaction by assessing the

magnitude of the relationship between selected variables. This study is important due

to an emerging trend of Islamic banking practices in Pakistan in the existence of

27

conventional banking system. Data were collected from 720 bank customers by using

stratified random sampling. SPSS 15.0 version is applied for data analysis. The results

indicate that there is significant difference in perception of service quality among

customers of Islamic banks on the basis of gender but there is no significant

difference in service quality perception of male and female customers of conventional

banks. The study has a number of implications for bankers, policy makers and

academicians. It provides a guideline to Islamic banks for provision of marketable

products to meet expectations of male and female customers according to their

specific requirements. This study enables policy makers and bankers to make

effective and quality oriented arrangements to have satisfied and delighted customers

for long term benefits.

Agha Zohaib Khan has measure the growth of Islamic Banks in Pakistan since

relaunching by methodology of Financial ratios, questionnaire, interview. The study

proves that the strategy for introduction of Islamic banking in Pakistan has worked

well. The growth has been impressive by any standards. Achieving a market share of

4.5% in about 5 years in a rapidly growing banking sector is a remarkable

accomplishment compared to the best in class countries. The re-launch experience has

been invaluable and serves as a strong base on which the strategy has been put in

place.

5.2 RESEARCH DONE ON ISLAMIC BANKS IN DIFFERENT COUNTRIES:

Jill Jhones, Marwan Izzeldinn and Vasileios Pappas examined efficiency in Islamic

and conventional banks in the GCC region (2004-2007) using financial ratio analysis

(FRA) and data envelopment analysis (DEA). They found that From the FRA, Islamic

banks are less cost efficient but more revenue and profit efficient than conventional

banks. Bootstrapping confirms these small sample results. From the DEA, average

efficiency is significantly lower in Islamic than conventional banks. A decomposition

method new to the banking context shows that the efficiency difference is more a

consequence operating under Islamic rules than of managerial in-adequacies.

Productivity growth has been slight, and is caused mainly by positive technology

change.

28

Badrul-Hisham, Muhammad Samaun and Rohani Muhammad (2008) have evaluate

the performance of Islamic banking operations in Malaysia, by investigating for the

first time, both cost and profit efficiency of full-fledged Islamic banks and Islamic

window operations of domestic and foreign banks. The application of Data

Envelopment Analysis (DEA) technique has provided several efficiency measures

such as allocative, pure technical and scale efficiency that explain cost and profit

efficiency differentials among banks. The findings of the study show that Islamic

banking operators are relatively more efficient at controlling costs than at generating

profits.

IMF working paper 2008, prepared by Martin Cihak and Heiko Hesse. They have

done an empirical study on Islamic Banks and Financial Stability. The relative

financial strength of Islamic banks is assessed empirically based on evidence covering

individual Islamic and commercial banks in 18 banking systems with a substantial

presence of Islamic banking. They find that (i) small Islamic banks tend to be

financially stronger than small commercial banks; (ii) large commercial banks tend to

be financially stronger than large Islamic banks; and (iii) small Islamic banks tend to

be financially stronger than large Islamic banks, which may reflect challenges of

credit risk management in large Islamic banks. They also find that the market share of

Islamic banks does not have a significant impact on the financial strength of other

banks.

Islamic Banking in Bangladesh; A case study of Islami Bank Bangladesh Ltd. (IBBL)

is done by Muhammad Nurul Alam. The aim of the study was to see how Islamic

banking activities differ from a conventional bank and also to see how Islamic banks

may contribute to render financial services towards small and rural sector. The author

found that IBBL’s shows an overall success in both deposits and investment positions

since it started its banking activities. As regards to the deposits side it may be

observed that the total deposits increased over past ten years even though, the average

deposit growth rate from 1988 to 1994 is only 23%. It is also observed that, the bank

did not succeed much in accumulating deposits under various term deposits. This

ultimately results in a reduction of the long-term investment of the bank, especially

29

investment towards industrial sectors. It is always assigned that the growth rate of

bank branches should increase the savings position of the bank, which was not the

case with the Islami Bank. This occurred, despite the fact that, one of the important

advantages of opening a PLS Savings Account with the Islami Bank is that one can

open a Savings Account with only Taka 100.00 (2.5 US $) where as the initial deposit

figure in any other commercial banks in Bangladesh is not less than Taka 4000 (US $

100). Moreover the formalities for opening a Savings Account with the Islami Bank

are very easy and simple.

Hadeel Abu Loghod has done research on Do Islamic banks perform better than

conventional Banks? It is a case study of Gulf Cooperation Council Countries. The

author found that during his researches that The Gulf Cooperation Council Countries

(GCC), have dual banking system where Islamic and conventional banks are

operating side by side. The purpose of this paper is to compare the financial

performance (profitability, liquidity and structure) of the two banking styles over the

2000-2005 time period. Among other findings the empirical results show no

significant differences in terms of profitability. However, Islamic banks are less

exposed to liquidity risk. On the other hand, conventional banks depend more on

external liabilities than Islamic banks. Naturally, GCC markets showed that customers

were more attracted to use financial instruments offered by Islamic banks. Finally, no

statistical significant differences were found on internal growth rate for both types of

banking, which implies that this largely depends on the management style and the

general performance of the specific bank.

30

4. DATA AND METHODOLOGY

The study is aimed at comparative financial performance of Islamic banking vis-à-vis

conventional banking in Pakistan. Specifically, study makes comparison of two

Islamic banks with a group of three conventional banks performances each year in

2007-2009. Data for each year have been compiled from the income statements and

balance sheets of these two sets of banks. In the bank performance study, this type of

inter-bank analysis is pretty common. In today’s competitive financial market, one

can better understand the performance of a bank by an analysis of inter-bank

comparison.

Various indexes have been provided by financial management theories for measuring

bank’s performance. Using accounting ratios is one of them. To measure

performance, financial ratios have been used quite commonly and extensively in the

literature.

In order to see how Islamic bank has performed in comparison with the conventional

banks over 3 years, the study uses 12 financial ratios for the bank’s performance.

These ratios are broadly categorized into four groups: (a) profitability ratios; (b)

liquidity ratios; (c) risk and solvency ratios; and (d) efficiency ratios. Since there are

five conventional banks in a group to compare with one conventional bank, so we first

calculated ratio of each bank in that group and then calculated average of those five

ratios to compare that average ratio with one ratio of Islamic bank in each year. Ratios

simply means one number expressed in terms of another. A ratio is a statistical

yardstick by means of which relationship between two or various figures can be

compared or measured.

4.1 RESEARCH DESIGN:

31

This research study has been designed in such a way that it helps compare the

performance and profitability of Islamic banks with the conventional banks. The area

of the study is the whole Pakistan where Islamic and selected Conventional banks are

operating under the same legal, political, social and economic framework

4.2 SAMPLE OF RESEARCH:

At present six full-fledged Islamic Commercial Banks and 23 Conventional

Commercial Banks are operating in Pakistan. Total five Commercial banks, two

Islamic Commercial Banks and three Conventional Banks have been included into the

sample of this research study. Two Islamic Banks that included into this study are:

Meezan Bank Ltd

Bank Islami Pakistan

Three Conventional Commercial Banks that have been included into the sample are:

Habib Bank Ltd.

Muslim Commercial Bank

Bank Al-Falah Ltd.

4.3 SOURCE OF DATA:

4.3.1 SECONDARY DATA:

The author also collected data from secondary source because the primary data was

not sufficient to meet the requirement of this study. This data was collected from the

following sources

1. Annual and quarterly financial statements of six Islamic Commercial Banks and

selected Conventional Commercial Banks

2. Database of the State Bank of Pakistan.

3. Quarterly Brochures of the State Bank of Pakistan on Islamic Banking.

4. Leading Pakistani Newspapers.

32

5. Different Research Journals

6. Books on Islamic Banking and Finance

4.4 RESEARCH TECHNIQUES:

Ratio analysis technique was used to measure the asset quality, profitability and

earning potential of Islamic and conventional banks comparing them from three

financial years. Following below ratios used for analysis:

(a) Profitability Ratios: 1. Return on Total Assets (ROA) = net profit after taxes / total assets. 2. Return on Equity (ROE) = net profit after tax / shareholder’s equity. 3. Yield on Earning Assets = funded income / average gross earning

assets. Funded income is total income earned during the period by way of interest on securities. Investments and interest received on advances. The denominator is average gross earning assets represented by opening plus closing balances of advances plus investments divided by two.

4. Cost of funds = interest paid / average deposits + borrowings. 5. Net profit margin = net profit after tax / net sales. 6. Spread = Yield on earning asset – cost of fund.

(b) Liquidity Ratios: 1. Cash to deposits.2. Advances to deposits.

(c) Business development Ratios: 1. Deposits growth ratio.2. Advances growth ratio.3. Earning growth ratio.

(d) Efficiency Ratios: 1. Asset Utilization = Total Revenue / Total Assets.2. Operating efficiency = Total operating expense / Total operating

revenue.

(e) Risk and Solvency Ratios: 1. Debt to total assets = debts / total assets. 2. Equity Multiplier = Total assets / shareholder capital.

33

6. FINDINGS OF DATA ANALYSIS:

Financial analysis have been done on five selected banks categorize in conventional

and Islamic banks. The first parts deal with the basic introduction and history of

selected five banks and the second parts deals with the financial analysis with the help

of ratio and its interpretation have been done in order to find out which banks

performance is better as comparison with each other based on 2007 to 2009 financial

performance.

6.1 Bank’s Introduction:

Following are the backgrounds or history of selected banks;

6.1.1 Habib Bank Limited:

HBL established operations in Pakistan in 1947 and moved its head office to Karachi.

With a domestic market share of over 40%, HBL was nationalized in 1974 and it

continued to dominate the commercial banking sector with a major market share in

inward foreign remittances (55%) and loans to small industries, traders and farmers.

International operations were expanded to include the USA, Singapore, Oman,

Belgium, Seychelles and Maldives and the Netherlands. On December 29, 2003

Pakistan's Privatization Commission announced that the Government of Pakistan had

formally granted the Aga Khan Fund for Economic Development (AKFED) rights to

51% of the shareholding in HBL, against an investment of PKR 22.409 billion (USD

389 million). On February 26, 2004, management control was handed over to

AKFED. The Board of Directors was reconstituted to have four AKFED nominees,

including the Chairman and the President/CEO and three Government of Pakistan

nominees.

6.1.2 MCB Bank Limited:

MCB is one of the leading banks of Pakistan with a deposit base of Rs. 431 Billion

and total assets over Rs. 550 Billion. Incorporated in 1947, MCB soon earned the

reputation of a solid and conservative financial institution managed by expatriate

34

executives. In 1974, MCB was nationalized along with all other private sector banks.

The Bank has a customer base of approximately 4 million, a nationwide distribution

network of over 1,000 branches and over 550 ATMs in the market. During the last

fifteen years, the Bank has concentrated on growth through improving service quality,

investment in technology and people, utilizing its extensive branch network,

developing a large and stable deposit base.

6.1.3 Bank Alfalah Limited:

Bank Alfalah Limited started its operation in November 1997 as a public limited

company under the Companies Ordinance 1984. Since its inception being driven by

the Abu Dhabi Group has invested with innovative and revolutionary technology

based product and services. Bank Alfalah limited being the fifth largest bank of

Pakistan in terms of assets (According to Pakistan Credit Rating Agency Limited).

Bank Alfalah business portfolio comprises in all sectors of conventional banking.

Innovative and high value products that they offer include, Car financing, home

financing, Credit Cards, Debit Cards, Online Banking, ATM Cards, Term Deposit

Certificates and consumer durables products. Bank Alfalah also started Islamic

banking division in order to cater the needs of Islamic ideological customers. Islamic

banking division is completely independent of the business of conventional one. They

have separate branches that offer Islamic products and service with Shariah

compliant.

6.1.4 Meezan Bank Limited:

Meezan Bank Limited is a publicly listed company first incorporated on January 27,

1997. In January, 2002 in an historic initiative, Meezan Bank was granted the nation's

first full-fledged commercial banking license dedicated to Islamic Banking, by the

State Bank of Pakistan. The banking sector is showing a significant paradigm shift

away from traditional means of business and is catering to an increasingly wise and

demanding financial consumer who is also becoming keenly aware of Islamic

Banking. Meezan Bank strives to find commonalties with the conventional banking

system with absolutely no compromise on Shariah rulings. The bank has developed an

extraordinary research and development capability by combining investment bankers,

35

commercial bankers, Shariah scholars and legal experts to develop innovative, viable,

and competitive value propositions that not only meet the requirements of today's

complex financial world, but do so with the world-class service excellence that our

customers demand, all within the bounds of Shariah. 

 

6.1.5 Bank Islami:

Bank Islami Pakistan Limited was the first Bank to receive the Islamic Banking

license under the Islamic Banking policy of 2003 on March 31, 2005. The Bank

envisioned to focus primarily on Wealth Management as the core area of business in

addition to Shariah compliant Retail Banking products, Proprietary and Third party

products, and Integrated financial planning services. The State Bank of Pakistan

declared Bank Islami Pakistan Limited as a Scheduled Bank with effect from March

17, 2006. Bank Islami started its Banking operations on 7th April 2006 with its first

branch in SITE, Karachi. By the end of 2006, the Bank had 10 branches, nine in

Karachi and one in Quetta. The Bank further concentrated in building a nationwide

network and by the end of year 2007; its branch network grew to 36 branches in 23

cities. In 2008, the Bank opened 66 new branches nationwide which expanded its

network to 102 branches in 49 cites. This gives Bank Islami the distinction of having

the fastest expanding network in Pakistan as well as offering the widest network by

any Islamic Bank in Pakistan.

6.2 Interpretation of Ratio Analysis:

The findings of ratio analysis are derived from annual reports of five selected banks.

Ratios have been derived from Balance Sheet and Income statement for the year 2007

to 2009. The five banks that are selected from conventional banks are Habib Bank

Limited, Bank Alfalah Limited and MCB Bank Ltd meanwhile from Islamic banks

Meezan Bank and Bank Islami are selected. The averaged of both conventional and

Islamic and banks are compared in order to find out the financial analysis of these

banks that which banks performance are better in terms of financial analysis.

6.2.1 Profitability Ratios:

36

The return on assets ratio of conventional banks is higher than that of Islamic banks

mean average ratios comparing with three years. As we can see in Table 6.1 Return

on Assets of Conventional banks are 2.04% in 2007 and then we see a downward

trend with 1.72% in 2009. This shows that Conventional banks return on assets are

decreasing compared to previous years. Meanwhile Islamic banks ratio also seen a

deeper downward trends which shows 2.32% in 2007 which is also higher than that of

Conventional banks with 2.04%, but Islamic banks ROA saw a downward trend with

eventually decreasing to -0.22%. The minus sign shows that as the cumulative

averages of Islamic banks are found out from averages of Meezan Bank and Bank

Islami. Bank Islami in 2009 saw a -562,909 (000) net loss which decreasing the

profitability of Islamic banks as compare to assets.

Figure 6.1

The Return on Equity of Islamic banks is lower than that of conventional banks (See

Table 6.2 & Figure 6.2). The trend of ROE is exactly same as ROA, while comparing

return on equity it is shown clearly that Islamic banks in 2007 have better Return on

Equity as compare to conventional banks cumulative averages. This performance

should be seen as a positive sign. But in recent years with great set back of economy

Table 6.1: Return on Assets

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 2.04% 2.32%2008 1.83% 0.56%2009 1.72% -0.22%Mean 1.86% 0.88%

37

in Pakistan both conventional banks and Islamic banks saw a downward curve.

Islamic banks ratio decreases from 22.48% in 2007, 7.37% in 2008 to 3.96% in 2009.

Meanwhile conventional banks also saw a similar trend with mean average comparing

to three years is 18.04% and for Islamic banks 11.27%.

Figure 6.2

Yield on earning assets calculated by funded income divided by the sum of

investment and advances. Yield on earning asset while comparing the selected three

years it can be seen that Islamic banks mean average YOEA is 2.36% which is better

than 0.65% mean average ratio of conventional banks from 2007-2009. This shows a

better sign for Islamic banks but while comparing with last year both Islamic and

conventional banks ratio decreases. Islamic banks saws a great downward trend that is

it drops down from 4.11% to 1.83%. It is concluded that in recent times earning have

affected banks performance very heavily.

Table 6.2: Return on Equity

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 21.24% 22.48%2008 17.36% 7.37%2009 15.51% 3.96%Mean 18.04% 11.27%

Table 6.3: Yield on Earning Assets

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 0.85% 4.11%2008 0.62% 1.15%2009 0.47% 1.83%Mean 0.65% 2.36%

38

Figure 6.3

Cost of funds calculated by dividing Interest paid to the customers with the sum of

borrowing taken from other institution and other sources and total average deposits.

The lesser the cost of funds the better it’s for banks. From Table 6.4 & Figure 6.4 it

shows that Conventional banks cost of funds are increasing as compared to last year,

in 2007 the cost of funds of conventional banks is 3.75% with 4.87% in 2008 and

eventually increases to 5.41% cost of fund. This shows that conventional banks have

invested its deposit in to high cost deposit which increases interest paid to customer.

For Islamic banks they shows a downward trend which is a good sign but still as

compare to conventional banks its cost of funds is at higher side with 7.68% as

compare to 4.68% mean average.

Figure 6.4

Table 6.4: Cost of Funds

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 3.75% 8.89%2008 4.87% 7.41%2009 5.41% 6.74%Mean 4.68% 7.68%

39

Spread is the difference between Yield on earning assets and Cost of funds. As we can

see in Figure 6.5 conventional banks curve are on downward trend meanwhile for

Islamic banks in 2007 the spread was -4.78%, -6.26% in 2008 and -4.91% in 2009.

Spread measures the actual difference between what banks earning on its assets and

how much interest they are giving to the customers. Therefore it is concluded that

both Islamic and conventional banks ratio is not up to the mark.

Figure 6.5

Net Profit Margin ratios of conational banks are seen a downward trend (See Table

6.6). Islamic banks net profit margin saw -5.84% in 2009 that is due to Bank Islami

net loss, Islamic banks shows a negative sign in net profit margin in the year 2009. It

is concluded that conventional banks have better net profit margin than that of Islamic

banks.

Table 6.5: Spread

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 -2.90% -4.78%2008 -4.26% -6.26%2009 -4.94% -4.91%Mean -4.03% -5.32%

40

Figure 6.6

6.2.2 Business development Ratios:

The growth ratios are calculated horizontally from year to year. In this we have taken

2002 as a base year to compare the growth of Islamic banks and conventional banks

in terms of total deposits, advances and earnings.

Deposits growth ratio of both Islamic banks and conventional banks are increasing in

last four years, which shows positive trend that more customers are depositing their

money heavily as compared to last year in their respective banks. Table 6.7 shows that

as 2007 is the base year for comparison. Deposits grow 111.84% in 2008 and

124.41% since 2007 in 2009 for conventional banks. Islamic banks as compared to

conventional banks deposits increasing much greater than conventional banks. From

Table 6.7 the deposit growth ratio of Islamic banks is 261% in 2008 and 328.44% in

2009 as compared to

the base year 2007.

Table 6.6: Net Profit Margin

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 26.71% 7.46%2008 19.91% 2.76%2009 16.72% -5.84%Mean 21.12% 1.46%

Table 6.7: Deposit Growth Ratio

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 Base Year Base Year2008 111.84% 261.00%2009 124.41% 328.44%Mean 118.12% 1.46%

41

Figure 6.7

Advances growth ratio shows that increase of financing of both Islamic banks and

Conventional banks are increasing in relative to base year 2007. Both Islamic and

conventional banks advances are increasing as compared to 2007. Islamic banks

advances grow heavily as compare to conventional banks (See Figure 6.8).

Figure 6.8

Table 6.8: Advances Growth Ratio

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 Base Year Base Year2008 117.05% 222.46%2009 114.82% 328.72%Mean 115.94% 275.59%

42

Earning or net profit of both Conventional banks are slightly increasing as compared

to its base year. Islamic banks show a negative trend as Bank Islami suffering from

net loss since 2007. As compared to 2007 Bank Islami suffers major losses which

eventually showing in Islamic banks cumulative earning growth ratio. Therefore it can

be concluded that conventional banks earnings are growing better than Islamic banks

which shows downward trend and in losses due to Bank Islami.

Figure 6.9

6.2.3 Liquidity Ratios:

Table 6.9: Earning Growth Ratio

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 Base Year Base Year2008 83.34% -39.25%2009 87.68% -593.60%Mean 85.51% -316.42%

43

Comparing liquidity ratio of the Islamic banking and conventional banking reveals

that, Advances to deposits ratio of both Islamic banks and conventional banks are

decreasing in 2008 with respect to 2007. There is a Statutory Reserve Requirement

SRR for every bank to keep a reserve amount of deposits as per requirement of State

Bank policy. Conventional and Islamic banks has different SRR requirement for its

bank to keep it. From Table 6.10 Cash to deposits ratio of Islamic banks are

decreasing from 16.74% in 2007 to 11.64% in 2009 and for conventional banks its

decreases to 10.78% in 2008 from 11.60% in 2007 and eventually increases to

11.01% in 2009.

Figure 6.10

Advances to deposits ratio measure the ratio between the customers deposited its

money to the financing given to customers in order to earn profits. This ratio shows

that in 2009 compared to last two years both Islamic and conventional banks

Advances to deposits ratio are decreasing with average mean of conventional banks

show 69.17% and 58.21% of Islamic banks.

Table 6.10: Cash to Deposits Ratio

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 11.60% 16.74%2008 10.78% 13.89%2009 11.01% 11.64%Mean 11.13% 14.09%

44

Figure 6.11

6.2.4 Efficiency Ratios:

Assets utilization ratios indicates that both Islamic and Conventional banks ratio are

increasing, which shows that both banks are effectively and efficiently using its assets

to generate sales more productively and efficiently. Although from Table 6.12 it can

be seen that Islamic banks ratio decreases in 2008 to 8.91% from 13.69% in 2007. But

they recover well and in 2009 their assets utilization ratio increases to 9.12%.

Conventional banks are effectively and efficiently utilizing its assets very affectively

as its ratio increasing as compared to last year.

Figure 6.12

Table 6.11: Advances to Deposits Ratio

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 69.85% 64.75%2008 73.20% 57.83%2009 64.46% 52.04%Mean 69.17% 58.21%

Table 6.12: Assets Utilization

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 7.64% 13.69%2008 8.78% 8.91%2009 9.36% 9.12%Mean 8.59% 10.58%

45

Operating Efficiency ratio of Islamic banks as shown in Table 6.13 indicates that

there is an increase in the ratio from 247.45% in 2002 to 455.19% in 2006. This trend

shows that Islamic banks expenses are high and earnings are low, especially in 2008.

Conventional banks on the other hand also have operating efficiency on the higher

side which again shows that their expenses are increasing day by day and earning is

not effectively increasing. This shows in all conventional banks that are Bank Alfalah,

Habib Bank and MCB Bank.

Figure 6.13

6.2.5 Risk and Solvency Ratios:

Table 6.13: Operating Efficiency

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 136.80% 247.45%2008 182.13% 455.19%2009 205.16% 366.31%Mean 174.70% 356.32%

46

Debt to total assets ratio of conventional banks are neither increasing too much and

nor decreasing. Their debts to total assets ratio are on average mean moving towards

90.76% of all the three years. This shows that liability as compared to total assets is

on normality side and for Islamic banks their ratio increasing from 81.37% in 2007 to

89.58% in 2009.

Figure 6.14

Equity Multiplier ratio of cumulative average of Islamic banks are decreasing from

18.63% to 10.42% in 2009 which shows that Islamic banks are more riskier as

compared to conventional banks. Conventional banks on other hand their average

moving on average. Their equity ratio decreases slightly in 2008 with 8.97% and

increases to 9.72% in 2009.

Table 6.14: Debt to Total Assets Ratio

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 90.97% 81.37%2008 91.03% 82.15%2009 90.28% 89.58%Mean 90.76% 84.37%

Table 6.15: Equity Ratio

Year Cumulative Avg. Conventional

Banks

Cumulative Avg. Islamic Banks

2007 9.03% 18.63%2008 8.97% 17.85%2009 9.72% 10.42%Mean 9.24% 15.63%

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Figure 6.15

7. Conclusion & Recommendations:

48

7.1 Conclusion:

This comparison shows that the financial performance of conventional banks is better

than that of Islamic banks. Although Islamic banks performance is slightly better than

as compared to last year but still major improvement has to be done in order to move

well with conventional banks. Islamic banks businesses are developing well as it is

indicated that deposits, earnings and financing are increasing day by day. As a whole

Islamic banks earnings is not suitable as Bank Islami one of the major banks of

Islamic banks industry still suffering from net losses and suffering higher losses as

compared to last years.

The major drawback of Islamic banks that is their deposits is increasing but they are

not taking full advantage of it and just holding their funds or not utilizing their funds

effectively in order to earn money on them. Ideally its deposits are holding and not

effectively are in order to earn good margin in it. In addition Islamic banks are not

using its assets more effectively and efficiently as conventional banks. On the other

hand conventional banks in recent times like Islamic suffers sever set backs from

earning section. As return on assets, return on equity all go downward in the year

2009 which shows that due to economic crises prevailing in the country it’s also

affecting heavily in banking Industry. Therefore it is concluded that although with

severe economic crises still conventional banks performance are better than that of

Islamic banks and Islamic banks have to take the full advantage of these drawbacks in

order to capture the market and run effectively with conventional banks.

7.2 Recommendations:

Islamic banks must focus more on their main earning assets to utilize them more

efficiently along with any non-operating income they have been generating. It is

because non-operating income inflates total profitability of Islamic banks. Thus,

Islamic banks in aggregate need to improve their yield on the earning assets to reach

to the level of conventional banks.

They need to pay special concern to the level of their liquidity because it is very

important as far as banks are considered. They must minimize their all type of

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expenditures especially reduction in all non-operating expenses is much more needed.

This would help Islamic banks to improve their net profit margin and to some extent

their cash-to-deposits would also be improved ultimately improving the liquidity

position. Finally, the banks must focus to generate more and more advances out of

given deposits so that their earning on advances would also improve yield on earning

assets.

Islamic banks need to penetrate more and capture more market than they have done so

far. This would help them increase deposits and other liabilities. They should

continually create more and more innovative products to attract more prospective

customers and investors. This way Islamic bank would increase their solvency by

increasing debt compared to equity.

8. References:

50

Annual Reports of 6 Islamic banks from State Bank of Pakistan and

banks websites.(Quarterely Data Sept 2010)

Ahmed, K (2006), “Islamic Banking in Pakistan”, Pakistan & Gulf

Economist, Vol. 25, no. 35, pp. 35-36, Karachi.

Farrukh, Z (2005), “Case Study on Comparative Performance of two

Islamic and two Commercial Banks”, Market Force, Vol. 1, no.3, pp.

48-53, PAF-KIET, Karachi.

Hussain, Dr. I (2006), “Evolution of Islamic banking”, Journal of Islamic

Banking & Finance, Vol. 23, no. 3, pp. 73-79, Karachi.

Mehmood, Z (2005), “Islamic Banking: A performance comparision of

Islamic bank versus conventional bank in Pakistan”, Bradford School of

Management, USA.

Memon, Dr. NA (2007), “Overview of Islamic Banking in Pakistan”,

Journal of Islamic Banking & Finance, Vol. 24, no. 2, pp. 106-112,

Karachi.

Nasir, M (2008), “Performance of Islamic Banks”, Pakistan & Gulf

Economist, Vol. 27, no.7, p.57, Karachi.

Parvez, IA (1991), “Islamic Banking”, Journal of Islamic Banking &

Finance, Vol. 8, no. 1, pp. 17-41, Karachi.

State Bank of Pakistan (2009), “Fionancial Stability Review 2008-09”.

State Bank of Pakistan (2010), “Islamic Banking Bulletin For Quarterely

Ended Period September 2010”.

State Bank of Pakistan (2010), “Banking Industry Review”.

51

Usmani, Dr. MIA (2002), Meezan Bank’s Guide to Islamic banking,

Darul Ishaat, Karachi.

9. Appendix:

52

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