Efficiency and Productivity

3/24/2021 Comparison Analysis of Islamic

and Conventional
In Pakistan (Research paper)
Contents and Figures
Contents and Figures....................................................................................................................................i
Abstract.......................................................................................................................................................ii
Introduction.................................................................................................................................................1
Literature review.........................................................................................................................................3
History of Islamic banking in Pakistan.........................................................................................................7
Current Situation.........................................................................................................................................8
Methodology...............................................................................................................................................9
Results.......................................................................................................................................................11
Trend Analysis...........................................................................................................................................12
Conclusion.................................................................................................................................................13
Bibliography.................................................................................................................................................a
Appendix.....................................................................................................................................................b
Figure 1 Trend Analysis of Balance Sheet (Islamic Bank).............................................................................b
Figure 2 Trend Analysis of Income Statements (Islamic Bank)....................................................................b
Figure 3 Trend Analysis of Income Statement (Conventional bank)............................................................c
Figure 4 Trend Analysis of Balance sheet (Private Conventional Bank).......................................................c
Figure 5 Trend Analysis of Balance Sheet (Public conventional bank).........................................................d
Figure 6 Trend Analysis of Income Statement (Public Conventional bank).................................................d
Figure 7 Financial Performance of the banks (2015-2019)..........................................................................e

i
Abstract
This paper is used to analyze the productivity and efficiency of Islamic banking in comparison to
the conventional banking in both private and public sector taking help from the existing models
of efficiencies. These models removed the disparity of banks sizes. Furthermore, trend analysis
has been used to reflect on the growth of banking system. Nine financial ratios are used to
measure efficiency and performance under 1) profits 2) liquidity risk and 3) credit risk. The
ratios applied to the Islamic and conventional banks' financial statements are for the 2015-19
financial year. The study shows that there is no significant difference in profitability in interest-
free and interest-based banking. In this paper the liquidity and credit efficiency difference is
detected; however, no great differences in profitability has been seen. The results of this study
could serve to improve the performance for the existing Islamic Banking Groups.

ii
Introduction
The free interest banking system started at an approachable level in the early 1970's. Between
last 25 years, it has displayed wonderful performance. During this era, a lot of research was done
on Islamic banking; since, globally all the studies were related to conventional banking system.
The studies concluded that Interest free banking has remarkable potential to be used as monetary
mediator. Recently, many interest-based banks, mostly international banks, have moved to
interest-free banking displaying globe’s interest in Interest-free banking.

There are two different aspects to interest-free banking arrangements. First, the entire monetary
structure is operated under the Shariah leaders; whereas, the dual banking system is still allowed
to work side by side. Therefore, it seems necessary to clear out all the pros and cons concerning
the fundamental principles related to Islamic banking. This is because these principles regulate
the economy as a whole in an Islamic way according to the Islamic banking regulations.

The fundamental difference between the capitalist and Islamic economies is the unrestrained
capacity for economic decision-making of private property. The capitalist economic system says
that the economy is in the hands of few riches. This system interrupts the natural supply/demand
process; since, these rich forces can work only in a free-competition. This system of capitalism
also creates distinguishing feature between money and real-assets. On the other hand, the Islamic
economics addresses the phenomena that is supported by assets. These financial institutions aim
at producing credit that serves the public; and, activates trade and industry. Islamic institutions
try to develop the habit of saving extra money. Such institutions do not appreciate the activities
of unproductive wealth in the form of investment opportunities and safe savings. They believe in
the flow of extra capital from the hands of rich to poor.

The models that are in link with this study are cost and profit efficiency models. They have been
used to analyze the Islamic banking efficiency in Pakistan. The conventional side of production
effectiveness studies of banks have used conventional principles most of the times to evaluate the
efficiency of banks. Islamic banking also appreciates efficiency but since it cannot be evaluated
using conventional bank models – model such as cost efficiency and profit efficiency have been
used keeping in mind the sizes banks (same sized banks).

1
One struggle that is faced using efficiencies’ models is to clearly address the variables; such as,
issues concerning input and output variables, in particular, the treatment of deposits handled by
Islamic banks. The performance comparison between private and public banks is another aspect
which must be included in the analysis. This is the only way to compare the findings of
conventional and Islamic banks in terms of production efficiency on a level.

From 2015 to 2019, three types of banks’ financial statements have been obtained. These banks
cover the private and public sectors that are purely interested in the banking system; and, the
Islamic Bank that operates interest-free banking. The performance and efficiency of interest-free
banking were measured by analyzing nine ratios. Then the trend analysis technique was used to
gain an understanding of the trends of ratios. This helped to identify where these banks are
proceeding and their key indicators. This trend analysis shows how interest-free banks can
respond effectively to the new horizon.

In order to obtain the overview of studies done in this respect, I carried out a literature review.
The profitability ratio is better than the bank of the private sector and weaker than the bank in the
public sector, while the return from the equity of the two interest-based banks is poor. The
liquidity ratio shows that both interest-based banks' net loans to assets ratios (NLARs and liquid
assets) are lower to their clients. The figures of ratio are added in appendix.

The LACDSF ratio is greater than private bank deposits and shorter term funds, but is less than
the bank of the public sector. In the case of the Net Loans on Total Deposits and Bonds ratio
(Net LTDB), the majority of Islamic banking assets are not integrated into non-cash assets. The
credit risk ratio shows that the Islamic Bank favors the equity to the total asset ratio over the
conventional banks.

The equity-to-net loan ratio is stronger of interest free banks than interest based. The gross
lending ratio of impaired loans is higher than that of private banks, and lower than that of public
sector banks. The ratio analysis shows that the credit risk ratio is of highest quality between nine
ratios compared to both interest-based banks. The trend analysis shows that the interest-free
banking balance sheet items have shown a positive trend from 2015 to 2019; but, the income
trend is fluctuating.

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Literature review
Cobb and Douglas are responsible for the concept of production efficiency (“18.1.139-165.Pdf”
n.d.). The study builds on the structural relationship between economic production inputs and
outputs. By focusing mainly on financial sector efficiency, Berger and Humphrey extended the
Cobb-Douglas model to the Banking Sector (“67.Pdf” n.d.). Efficiency in the financial sector
stresses that efficient allocation of financial resources must be provided in order to promote
productivity. This means that the economy has the chance to change what it saves to be more
productive investments from resources.

In banking performance there are two efficiency concepts: production and X-efficiency
(“67.Pdf” n.d.) (Farrell 1957). Farrell focuses on productive efficiency measurement, while
Leibenstein explores why companies cannot make maximal decisions in their productivity. Two
components of production efficiency are efficiency and technical efficiency allocation (i.e., the
components of economic efficiency). In Islam, efficiency is also widely recognized and needed
to be analyzed in the Islamic way. Efficiency costs and profit are linked to the handling of a
bank's deposit. Heffernan indicates the possibility of treating deposits as either inputs or outputs
(Héger n.d.). However, the use of deposits as an output has become more insensitive to analysis
than to input.

Every Muslim businessman should be determined to improve efficiency (cost-cutting) in favor of

consumers by implementing the Maqasid. The goal of Islam is that everything considered is
needed to preserve: enrich with faith, life, intellect, posterity and wealth. This all needs to be
incorporated into Maqasid. (“(PDF) Assessing Production Efficiency of Islamic Banks and
Conventional Bank Islamic Windows in Malaysia” n.d.)

Interest-free banking is based on the credit risk system of interest based banking. Therefore,
Basel II suggested that the minimum capital requirement calculations should be identical to those
required by conventional banks (Kahf, n.d.). This article discusses the Islamic financial activities
and then analyses Pakistan's Islamic procedure since 1985. This article revealed a moderate

3
impact of Islamization in this sector since the banks adopted a system closely similar to the
traditional system. Another reason is that they belong to the State (Cornelisse and Steffelaar
1995).

Conventional banking systems have been analyzed worldwide; and, innovations are needed to
remain on the global market. This has led to the introduction of Islamic banking by
conventionally-owned banks and the creation of some new Islamic banks worldwide. Islamic
banking is on the infant stage, so it is facing some difficulties (Ahmad and Hassan 2007).

Another study on the regulations and performance of Islamic banking was carried out in
Bangladesh. The most important findings in this research article are that the Shariah regulatory
framework is lacking the interbank monetary market. Its absence is what that affects Islamic
banking performance. Discrimination on legal reserve requirements has also been observed. The
researcher suggested that the independent banking act in Bangladesh should control, guide and
oversee Islamic banking operations and practices to provide the stakeholders with legal support
(Ahmad and Hassan 2007).

The study was also carried out in the United Kingdom regarding Islamic banking problems,
challenges and opportunities. Data from senior bank officials were collected. Heterogeneous and
potential customers in the United Kingdom face the main problem. In addition, in the United
Kingdom there has also been a lack of experts and competition from conventional banks.
Electronic banking has been concluded to be a key part of Islamic banking's success. The
challenges of the Islamic Banking system must be discussed with British officials and Islamic
banking representatives and rofessional people with the knowledge of Islamic banking must be
recruited (Karbhari, Naser, and Shahin 2004).

Malaysia is the first country in Islamic banking to play a crucial role. This article shows an
innovation known as alijara-wa-iqtana and hire purchases (El‐Din and Abdullah 2007). Strong
legal framework must be developed to strengthen Islamic banking transactions. The operational
regularity and substantive legislation to resolve Islamic banking issues must also be reinforced
(El‐Din and Abdullah 2007).

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Rather than restricting the Shariah it should be analyzed to make new innovations. Shariah's
potential and knowledge must be explored. There is a huge need for co-operation in order to
make a profound study of Islamic strong products possible in collaboration with Shariah
scholars, researchers and academics (El‐Din and Abdullah 2007). The government and other
agencies must also make efforts to purchase and buy new avenues of Islamic banks. The most
important thing right now for the government is to eliminate the insecurity about Islamic
recruitment (El‐Din and Abdullah 2007).

Globalization has had a political, economic and financial impact on our lives. Globalization’s
positive aspect is that there is the movement between countries of human capital and new
technology. The government cannot control the flow of capital on the other side. The price of oil
in GCC countries boosted investment and also fostered Islamic finance. There is no doubt that
there is potential for growth in Islamic financial institutions, yet certain challenges exist. These
internal and external challenges are of two types. Internal challenges include that customers still
rely on traditional banking and the numbers of the existing IFIs are insufficient to meet the
international transaction requirements. Moreover, it remains premature to attract new customers.
Secondly, the unified regulatory system for products and transactions is also lacking (“(PDF)
Internationalization of Islamic Financial Institutions: Challenges and Paths to Solution |
Abubakar Suleiman - Academia.Edu” n.d.)

Islamic banks globally grow benefiting from their unique characteristics, but their position is
growing rapidly in response to the challenges of growth. However, the institutional arrangements
are still needed to participate in the global economy. The compatibility of Shari'ah should be
assessed by skilled Shariah scholars, as the person consults the medical specialist to find the best
solution for any medical problem. This is why the Shariah problem is resolved by the qualified
Sharia scholar in order to make the exact decision.

In Malaysia and Bahrain, an additional study was conducted by analyzing seven banks' financial
record. This article was intended to analyze the viability of Islamic financial products in
contracts based on interest. It analyses that Islamic banks are paying Zakat and financing

5
Shari'ah's economic activities. However, it concludes that legal framework needs to be
implemented in order to regulate Islamic financial products in the Islamic financial market
(“(PDF) Performance of Interest Free Islamic Banks Vis-à-Vis Interest-Based Conventional
Banks of Bahrain” n.d.).

Islamic banking is a system that actually follows Shariah regulations and rules and also follows
Shariah by Islamic economic systems. In Egypt and Malaysia, a study of interest-free banking
was conducted from 1950 to 1960. However, for Islamic banking this study did not set any facial
value. Founded in Dubai in 1994 the first Islamic bank and in 1976 it has now 53 member
countries. Almost all countries around the globe have now been set up for a day by the Islamic
Bank. Some institutes have been founded in the United States even in small numbers. The goal is
for Ulama and the bankers to build a strategic alliance (Kahf, n.d.).

In this rapidly growing world, Islamic banking really needs to be reconsidered. The structure for
success in the future must also be redefined. The traditional banks have really appreciated
Islamic banking and they also have ways to become mainstream banks. In this era, the fusion of
Islamic banks is obligatory to survive. Size, capital and the ability to create assets must be
increased (Kahf, n.d.)

There is conventional banking throughout the world. However, innovation is the key to long-
term survival. By following this notion, Islamic banking has introduced. Therefore, interest-free
banking has some challenges in the initial phase. Interest Free Banking is poor regulatory
framework and there is no adequate interbank money market. Basal II suggested that Islamic
banking has the same risk as interest-based banking, so the calculation of the capital as the
interest-based banking requires it. It is necessary to rethink how the efficiency of this banking
can be improved in this increasing world. The banking growth is slow, but there is no need to
worry about it because the growth in childhood is slow.

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History of Islamic banking in Pakistan.
The procedure of converting Pakistan economy into Islamic was initiated as on 29th September,
1977. However, the plan was executed into pieces due to its massiveness. On January 1, 1981,
banks were ordered to organize deposits on the basis of the sharing on profit and loss. Then
interest free counters in all public and one in overseas bank were established. The Organisation is
always confronted with the resistance to the change. It is a difficult task to implement the
change. The broad plan and commitment to implementing the change are needed to bring
changes in traditional set-ups.

Therefore, The Financial System Transformation Commission (CTFS) was created under the
supervision of SBP. In October 2000 and May 2001, the Commission submitted two interim
reports and later submitted a report in August 2001 which contains a number of
recommendations. Firstly, that monetary systems to be on the basis of Islamic principles and
secondly a team to be made to make sure that these rules were being carried out.

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Current Situation
SBP launched a strong mechanism in December 2001 in order to establish an interest-free
banking system. Under the mechanism, interest-free financial institutions developed and are
scheduled to provide fifty percent of their total stocks to the public on the stock market. About
fifteen percent of the paid capital would be shared by the sponsor director. The free financial
institutions are bound to maintain an 8 percent at least capital adequacy ratio based on risk-
weighted assets. In January 2002, Meezan Bank Limited (MBL) was awarded the Commercial
Banking System. The MBL then set up its ten branches network and the US$130 million
balance.

In January 2003, the Central Bank of Pakistan directed that with the help of already established
banks, additional and individually Islamic banks to be set up. Already in June 2004, fifty percent
of banks initiated interest-free banks for prevalence. The non-interest banks allowed the liquidity
requirement and cash reserve deposits to be maintained. The Central Bank of Pakistan to
maintain a maximum level of forty percent of its liquidity requirement and special cash reserve
away from the non-Islamic financial system.

In September 2002, the Pakistan Security and Exchange Commission authorized the Mudarbah
organisations, based on Musharkah, to issue Term Funding Certificates. Then another decision
was made in 2003 to create small and medium-sized enterprises Mudarbah with the participation
of twenty Murabah organisations in order to start companies in minorities and far distant areas.
Murabah companies must solve small medium-sized enterprises (SMEs). These small steps of
big plan made it possible to incorporate Islamic banking into global networks.

8
Methodology
Ratio measures have been used to analyze the banks chosen for the model. This method has been
used earlier as well, it is not a new way to evaluate banks’ performance. O’Connor and Libby
has started the use of this method in 1970. Thereafter, many researchers used this method too
(O’Connor 1973) (Libby 1975).

This methodology shows various positive aspects. The key advantage is that this method
removes the disparity. Banks are not equal in size but this method brings all banks at one
benchmark. In addition, the trend analysis is used to assess the trends of the 20015-19 income
statements and balance sheets. Three types of banking companies are considered in this study; an
Islamic bank and commercial banks are taken (government and private). Each banking firm's
website contains these financial statements. Nine ratios analysis has been done using the help of
financial years 2015-2019.

Profitability
Profitability is an important factor to judge the performance of the bank. Therefore, the ratios
used to analyze the performance are:

1) Return on Assets (ROA)= Net Profit/Total Assets:

We can assess the efficiency and effectiveness of management and the bank using this
ratio. A positive ROA indicates that the financial instructions are more efficient.
2) Return on Equity (ROE)= Net Profit/Equity:
This ratio calculates the rate of return on capital and equity capital.
3) Cost income Ratio (COSR)= Total cost/Total income:
This index can be used to calculate profit and economic efficiency.

Liquidity

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Liquidity means how quickly a bank can convert its cash into assets and meet its requirement. It
means availability of cash. Higher amount of the liquid assets means that the firm has good
liquidity especially in short term. The ratios used to evaluate liquidity are:

1) Net Loans to Asset Ratio (NLAR)= Net loans/Asset Ratio:

It is used to calculate the percentage of capital is entrenched in loans. Higher ratio shows
the less liquidity firm has.
2) Liquid Assets to Customer Deposits and Short Term Funds Ratio (LaCDSF) =
Liquid Asset/Customer deposit and short term funds:
The deposit is known as the off-measure deposit. The statement clarifies the position of
deposits and short-term funds that fulfil sudden withdrawal requirements. The greater the
ratio, the less threatened is the financial institution, the more liquid commercial bank.
3) Net Loans to Deposits and Borrowing (NiTDB): Net Loans/Total Deposits and
Borrowing:
It is the measure about total deposits fixed into non-liquid assets. Higher NiTDB means
that the firm has more liquidity risk.

Credit Risk Management

It is really important to evaluate the credit risk management because of the conventional
principles being the basis of performance judgement. This is the only factor that is mostly used
in Islamic banking that is similar to conventional banks (same base for the interest rate to be used
in profit sharing ratios). The following ratios are used to evaluate credit risk management:

1) Common Equity to Total Assets (CeTA) = Common Equity/Assets:

This measure is the share capital as a percentage of total assets. It demonstrates the
potential for banks to protect themselves from investment and assets. This also shows that
the loss of potential loan assets is absorbed by shock.
2) Total Equity to Net Loans (TeNL) = Total Equity/Net Loans:
The share capital is shown as a percentage of total net loans and it removes the cushion
available that is needed for adjusting loan losses.
3) Impaired Loans to Gross Loans (ImGL) = Impaired Loans/Gross Loans:

10
 The quality of the bank's assets and loans can be checked more reliably. The gross loans
ratio that are bad debt in the commercial bank portfolio is calculated.

11
Results
The benefit of using these ratios is that these ratios eliminate the disparities created because of
the sizes of bank especially with regards to loans, deposits and assets. The measures of
profitability indicate that return on assets of Islamic banking is higher than private but lower than
national bank. This further tells us that assets of national bank have been sequenced in a
competent way to get good return on assets. Moreover, in ROE again performance of Islamic
bank is not great. National bank again is standing at a good position. Last, COSR of private bank
takes a good leap from Islamic bank and national bank.

Measures of liquidity indicated that Islamic bank is doing good only in net loans to deposits
borrowing. In net loans to assets again National bank has outstanding performance. NB is more
efficient that can be understood using LDADSF. This is because national bank is in a position to
meet the sudden withdrawals. Net loan deposit and borrowing indicates that liquidity efficiency
of Islamic bank is better than conventional banks.

In credit performance, the study finds that equity to asset ratio of Islamic bank is better than
conventional banks. This explains that Islamic banks have greater capacity of being resistant or
shock absorbent against losses of loans assets. Moreover, in equity to net loan Islamic bank again
showed outstanding performance with contrast to conventional banks. However, total impaired
loans to Gross Loan Ratio of Islamic bank is not lower from conventional banks, this tells that
Islamic bank is not in superior quality than conventional banks.

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Trend Analysis
There has been an increasing trend in Assets, Liabilities, Share Capital and Reserves of Islamic
banking. This shows that Islamic banking (interest free banking) will increase in future.
However, there is a fluctuating trend in income statement of Islamic banking since they are in the
growing phase.

Conventional banks showed not great growth in first years due to trickledown effect of 2008
recession and political reasons. However, its growth started in later years but again started
decreasing in 2019 onwards (covid-19 effect). This shows that it required serious management’s
attention.

Public sector showed better trends except Reserves in balance sheet. It showed a bit decreasing
trend in 2015. On the other side of a dramatic decrease in income statement as well in 2018
(covid-19 struck).

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Conclusion
Pakistan is among the pioneers of the IBS, and over the years, the concept is expanding at a good
pace. In recent years, the Islamic Banking sector has seen an annual growth rate of over thirty
percent supporting government initiatives and preferences.

This research paper helps in evaluating the efficiencies of banks in Pakistan. To conclude are
evaluations, I have used ratio analysis and trend analysis keeping in mind the profit efficiency,
liquidity efficiency; and, credit risk management to make comparison. The trend analysis showed
that in deposits and asset side Islamic banking showed a growing trend; whereas, in income
statement side fluctuations has been observed because of dealing with loans without interest.

In ratio measures the profitability performance of Islamic banks compared to conventional banks
is poor and needs attention. In liquidity performance the performance of Islamic banks for Net
loans to total asset ratio needs dire attention from the management to show positive results. The
Net loans to deposit and borrowing ratio, equity to asset ratio and equity to net loan ratio are in
favor of the Islamic bank. However, the Total impaired loans to Gross Loan Ratio are weakest of
Islamic bank. However, on Balance sheet side Islamic bank showed tremendous results.

13
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a
Appendix

Figure 1 Trend Analysis of Balance Sheet (Islamic Bank)

Figure 2 Trend Analysis of Income Statements (Islamic Bank)

b
 Figure 3 Trend Analysis of Income Statement (Conventional bank)

Figure 4 Trend Analysis of Balance sheet (Private Conventional Bank)

c
 Figure 5 Trend Analysis of Balance Sheet (Public conventional bank)

Figure 6 Trend Analysis of Income Statement (Public Conventional bank)

d
 Figure 7 Financial Performance of the banks (2015-2019)