A comparative analysis of Islamic and Conventional Banking, Summaries of Economics

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A Comparative Analysis of Islamic and Conventional Banks Introduction This literature review aims to compare the profitability and efficiency of Islamic and conventional banking, two different types of banking. Islam forbids interest; hence the Islamic banking system consists of goods compliant with Shari’ah principles and does not include riba (interest), hence the name interest-free banking (Abdul-Majid et al., 2010 ). The system evolves as time passes, and there is a rising desire for interest-free products. Financial operations that follow Shariah, or Islamic law, are known as Islamic banking, Islamic finance, or Shariah-compliant finance (Abdul-Majid et al., 2010). Two key tenets of Islamic banking are sharing profits and losses and forbidding lenders and investors from collecting and paying interest (Toumi, 2021). A growing number of clients want to conduct their banking in an Islamic manner, and many commercial banks are launching Islamic banking products in addition to traditional ones. Numerous non-Muslims also patronize Islamic banks. Some non-Muslim nations also place a high value on Islamic banking. More than 250 Islamic financial institutions are functioning in close to 80 countries, according to National Bank for Development of Egypt data (“The rise in Islamic banking”, 2015). Each social system has a unique economic structure. Islam has a matching economic system since it is a comprehensive and unique social structure. Islamic economics is quickly evolving into a unique and diverse economic framework. As a result, several Islamic financial institutions have mushroomed in Muslim and non-Muslim nations, including Africa (Thomi, 2014).). The current literature review concludes that Islamic banking institutions are more profitable, efficient, and creditworthy than other banking forms owing to the distinctive consideration of assets and liability.

Additional Islamic finance institutions in South Africa include Stanlib Shari’ah, Equity Fund, Element Islamic Equity Fund, Symmetry Islamic Fund, and Oasis Crescent Equity Fund (Toumi, 2021). The IB have become prevalent in many parts due to their profitability and stability. Modern Islamic Banking Due to the tenet of avoidance of profiteering, the main products of Islamic banks are currently based on the profit and loss sharing principle), interest-free loans (Qard-e-Hasna), sales contracts (Salam), (Mudarabah), partnerships or joint ventures (Musharakah), leasing contract (Ijarah trade with markup, and Islamic bonds (Sukuk) and hedge funds (Abdul-Majid et al., 2010). Islamic banking was initially founded with simple profit and loss sharing accounts, Islamic savings, and investment products, and these products have since grown in popularity as Islamic. Different Islamic banking products Mudarabah This item is utilized in commercial financing. The bank supplies the money, and the company supplies the work. If a loss occurs, the bank is responsible for paying it, so long as the Mudarib did not intend it to happen (Salman & Nawaz, 2018). Murabaha This IB product is an agreement to resell things for a profit over their cost. The customer gives the bank the go-ahead to buy the products from a third party. Then, the bank sells the products to the customer for a price that includes both cost and profit (Abdul-Majid et al., 2010). The firm also finances itself using this product.

Ijarah This product is typically used to buy cars, delivery vans, and other types of vehicles. The client pays monthly rentals to the bank, which buys the client’s car (Ahmad & Saif, 2010). Ownership of the vehicle is given to the client upon payment of the purchase price plus the profit. Musharakah Musharakah is a partnership agreement wherein the bank and the client commit a certain amount of funds to a project. They divide the gain or loss in such a way that the gain is divided in a predetermined proportion with mutual consent, and the loss is divided between the partners in the proportion they invested their money (Ahmad & Saif, 2010). This product is typically utilized in mortgage loans for homes, for instance, in new construction and remodeling. Financial Performance Financial performance is considered in diverse ways. Measuring financial performance entails different items, for instance, total interest expense, total interest income, deposits, loans, and advances. Operational performance is a vital issue in IB. Efficiency and profitability are relevant parameters for IBs (Abdul-Majid et al., 2010). Evaluating the performance of banks involves diverse criteria, including profitability, quality of products, innovation, liquidity, management performance, and productivity. Islamic Banking Products and Associated Financial Performance Islamic finance and the linked products form the foundation of Islamic banking, which counts among the most rapidly growing finance industry sectors in over 300 institutions within 75 countries (Thomi, 2014). IBs financial performance is improved its

Asset growth is a crucial determinant of capital structure change. Conventional banks (CBs) alter their leverage strongly in reaction to the total assets relative to Islamic Banks. This attribute is due to conventional banks’ upper-hand capacity in sourcing funds externally. Consequently, conventional banks tend to attain leverage alterations faster and inexpensively. Conversely, Islamic banks (IBs) possess more regulatory capital; however, the ability to respond to risks is lower. According to the research results by Hoque & Liu (2022), Islamic banks have a lower capacity to respond to risks; hence they are in a disadvantaged position relative to the CBs regarding capital structure management. As such, IBs have the onus to expand their financing tools as well as the funding sources for the reduction of adjustment and enhance their capacity to deal with risk. Liability Islamic banks must gather deposits and outside funds like conventional banks provide funding for the growth of the actual economy in society. IBs must then use these resources to finance readily available assets, for instance, mortgages and commercial loans. Profit-sharing investment accounts, demand deposits and savings deposits comprise an Islamic bank’s liabilities. In principle, IBs should have a different capital structure than CBs because Islamic banks obtain funding from profit-sharing investment account (Toumi, 2021). Investment account holders (IAHs) do not have any influence over or governance powers over Islamic banks, even though profit-loss sharing (PLS) investment accounts adhere to Shariah principles and can be utilized in place of conventional interest-bearing deposits. IBs typically do not opt to transfer the loss to IAHs even if the investments earn a negative return while still offering competitive returns. IAHs may deposit money into different financial institutions if the return accrued is no longer competitive. The shifted commercial risk is, therefore, probable to materialize. It illustrates how IBs could risk equity

holders' interests to guarantee that IAHs can receive a reasonable return. IBs may move gains due to equity holders to designated reserve accounts, for instance, investment risk reserves and profit equal reserves (Abdul-Majid et al., 2010). IBs can pay IAHs to hedge the future low-income distribution by holding back a portion of the current profit in the special reserves. Despite the challenge of risk handling, IBs have a moral appeal and the magnanimity that can lower economic equality due to their tendency to consider social justice, equity, and fairness. Owing to this connection, many conventional banks have distinct Islamic Banking branches, for instance, Bank Alfalah and Askari Bank. Because Islamic and conventional banking is practiced side by side, the whole banking system can be described as a dual banking system. Notably, interest-based economies are to blame for the current global financial crisis. Because Islamic banking is not reliant on interest rate systems, many nations are now showing a strong interest in it (Abdul-Majid et al., 2010). As opposed to traditional banking, which is money-based, asset-based banking is more prevalent. Performance and Efficiency The average DEA-generated efficiency of conventional (Islamic) banks is roughly 38.8% (42.45%), determined using a sample of 14 conventional and 11 Islamic banks from 4 countries between 2011 and 2019. According to baseline Tobit regressions, ESG generally benefits banks’ efficiency (Alam et al., 2021). These results show that despite the prohibition of interest, Islamic banking is significantly efficient relative to conventional banking. Similar to conventional banking, Islamic banking has embraced the technological revolution. This aspect is relatable to the efficiency of Islamic banking, which is achievable through technology-powered optimization of its diverse financial products (Toumi, 2021). As such, many Islamic Banks have embraced the most recent technology, including database systems and data software.

discovered that conventional banks make more money than conventional ones, with a Return on Asset ratio nearly three times as high. However, the comparison between the chosen bank’s profitability throughout 2000–2007 showed significant growth, indicating a promising future for Islamic banks (Ahmad & Saif, 2010). The authors propose that to increase public acceptance of the Islamic financial system, Islamic banks should create new markets and accounting procedures (Hanif, 2014). The researcher asserts that a bank’s primary source of funding is the deposits made by its clients. Ahmad & Saif (2010) made another attempt to compare the profitability of Islamic and conventional banks and finance companies in Malaysia using empirical methods. In order to investigate the gap, the author produces six profitability ratios, including return on assets and return on deposits ratios. They discovered that compared to traditional interest-based banks, the ratio outcomes for Islamic banks are much greater. However, the author argues that this is since Islamic banks’ overhead costs are discounted, which lowers their operating costs, and that Riba still needs to be eliminated from the Islamic banking system (Abdul-Majid et al., 2010). To fully create the system per the criteria of religion, they should improve risk sharing in their roles. Additionally, this improvement will guarantee business success. The author goes on to say that by utilizing the ideas of economies of scale and economies of scope, Islamic banks can increase their profitability. By focusing on moral concerns, this objective can be accomplished. Given that the Islamic banking system is still in its infancy, the abovementioned higher results for Islamic banks in Pakistan could be explained by the empirical findings of two authors Ahmad & Saif (2010), who investigated how underdeveloped financial systems exhibit higher profitability but lower levels of efficiency. These results were obtained by choosing banks from both industrialized and developing nations as samples. The authors calculated various profitability and efficiency ratios for the purposes mentioned earlier. The

regression results demonstrated that higher bank development lowers bank profits while increasing bank efficiency as bank rivalry increases. Similar results were found in a study undertaken by Faizulayev (2011), which sought to understand how Islamic banks control their profitability. Their conclusions were based on comparing the ROE and ROA ratios analysis. The findings imply that Islamic banks are more profitable than traditional banks. Additionally, it has been discovered that Islamic banks are more creditworthy and less susceptible to the Return on Assets’ cyclical character. Conclusion The Islamic economic system, based on justice and morality, includes Islamic banking and finance and has the favor of modern financial revolution due to capacity to foster economic equality and sustain profitability Because it is interest-free, Islamic banking differs from regular banking. Islamic banking has distinct risk profiles and operates according to distinct principles. The government and central bank, which also regulate conventional banks, are the first regulation that applies to Islamic banks. The second type of regulation is provided by the Shariah Supervisory Board, which also approves the output of Islamic banks and monitors compliance with the board’s rules. The central bank sets down some regulations unique to Islamic banking. For instance, establishing an Islamic bank requires greater minimum capital than opening a conventional bank. Because Islamic banking is asset-based and requires the bank to own the products it later sells, which ultimately are paid for by the client, it raises the cost. As a result, Islamic banks must pay higher taxes and registration fees. Even though it is a relatively new idea in modern times, international finance is one of its fastest-growing sectors. By offering a variety of credit contracts, it helps its clients raise their economic standards. Importantly, Islamic banks do not provide any interest-bearing goods or services, and they have a Shari’ah board overseeing their organizational structure and

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