A Research Proposal on the Reasons Why Islamic Banks (IBs) Are Resilient To Crisis

According to Gobat, Yanase and Maloney (2014), the tremendous development of IBs in middle incomecountries is linked to their strong resistance of the effects associated with financial predicaments as opposed to the CBs. Nevertheless, diminishing study findings can be traced to support such assertions. This study will utilize figures from countries where IBs and CBsoperate cohesively such as Pakistan to provide an opportunity for the comparison of the two banking system in a financial crisis. It is expected that the IBs will be suffer from diminishing issues associated with financial crisis such as withdrawals during and after the predicament.

However, comparative studies show that Islamic banks with both conventional and Islamic operations have a higher probability of attracting deposits during financial crisis rather than losing (Salem (2013); Hassan, Kayed & Oseni (2013). This observation proposes a typical responsibility for the religious labelling in the banking industry. Additionally, empirical evidences have shown that IBs provide increased number of loans during financial crisis, a decision which is often less responsive to changes in deposits. It is, therefore, meaningful to ascertain that increased financial involvement of the faith-based groups such as the Islamic banks may augment the stability of the national as well as global banking system.

Literature Review

Asutay (2015) argue that both IBs and CBs have similar roles. The two types of banks are actively involved in the effective management of all types of risks including operational and liquidity risks. However, the main point of contrast between these two systems is that the former functions in accordance to the Islamic teachings, and the Islamic guidelinesreferred to as Sharia. Islamic banks have a variety of roles in the banking industry. First, their aim is to ensure that there is effective creation of maximum returns on capital invested (Bigas, 2012: Mirakhor, Iqbal, Krichenne&Askari (2013).

Secondly, these banks play a critical role in ensuring that there is adequate attainment of socio-economic goals as outlined in the Islamic teachings. Such goals include ensuring that the country in question achieves high economic growth rate, promotes attainment of full employment, and ensures that there is socioeconomic justice coupled with equitable distribution of wealth and income (Ahmed, Asutay& Wilson, 2013). However, this system has a firm adherence to the teachings, principles and the guidelines outlined in the Islamic religion, which prohibits the use of interest or usury (Riba). As a result, all forms of business arrangements and their contrasts come from four major bases of Islamic teachings. These sources include the Holy Quran, the Qiyas, the Ijmaa and the Sunna.

According to Bigas (2012), both banking and finance in Islam operate on the principle of justice and fair treatment of everyone, which is often attained through risk sharing. Therefore, sharing of profits and loses remains the main binding principle in the Islamic as opposed to the conventional banking system which relies on the interest earned. Studies show that this principle of sharing profits can play a critical role in helping Islamic Banks to be more stable and resilient as opposed to the Interest Depended System. This system can result in increased inflation, excessive fluctuations of return rates and the deterioration of more economic fundamentals (Gobat, Yanase & Maloney, 2014).

Salem (2013) adds that different Islamic organizations recommended that the PLS system operates on economic justifications which can help different financial systems to attain their stability and continuity for a variety of reasons. Primarily, this system assists Islamic banking in the effective enhancement of the capital allocation efficiency since the allocation funds is basically founded on the reliability of the developments and the return on capital which fundamentally relies on the firms output (Asutay, 2015; Bigas (2012).

Secondly, empirical studies have demonstrated that the PLS system can help in the reduction of unjust distribution of wealth brought about by the interest-depended credit systems (Mirakhor, Iqbal, Krichenne & Askari, 2013; Ahmed, Asutay & Wilson (2013). Thirdly, the PLS system can accept all projects without segregation since the systems predictable outcomes are always below the amount of the firms debt. This practice can account for the rapid increase in the banks investment volumes, which can eventually create more jobs in the country. Fourthly, Islamic finance has the ability to help more robust and liquid financial market by ensuring that there is efficient reduction of speculations that may affect the firms publicity by inspiring trading pillories and investment certificates founded the profit sharing principles (Hassan, Kayed & Oseni, 2013).

Lastly, the PLS system can help in the reduction of economic pressures associated with high inflation rates experienced in the market. This practice remains successful because the supply of goods can never be exceeded by that of money. It is, consequently, imperative to ascertain that the PLS systems connection with the real economy and Islamic Banking systems interest prohibition could prevent financial crisis (Mirakhor, Iqbal, Krichenne&Askari, 2013). Muslim scholars highlighted imprudent and excessive lending and risk taking as the main causes of the eruption of the 2007-2008 financial crises. The three practices were, however, agitated by three different variables: the inadequate fiscal market discipline caused by the lack of the PLS system; the continuous need for the increase in the amount of derivatives such as the Credit Default Swap (Ahmed, Asutay & Wilson, 2013).

Any study seeking to understand different implications of the global financial doldrums on IBs and their counterparts, a researcher must begin with the effective comparison of their transaction models (Chapra, 2008; Hassan, Kayed & Oseni, 2013). First, all Islamic Banks are founded on Sharia rules and regulations making their products and services to be uniquely different from those of their conventional counterparts. A substantial amount of studies sought to compare different factors that enable Islamic Banks to be more flexible to global economic predicaments. Sharia principles outline prohibition of selling debt by these banks as the main reason for their resilience.

Furthermore, Islamic banks do not channel their investments in dangerous assets as well securities that are mortgage plan supported. Hassan, Kayed and Oseni (2013) highlighted derivatives and selling of debts as the major causes of economic crisis in the world. Secondly, IBs and CBs differ in the way they handle various issues associated with risk taking. The conventional Banking System transfers risks to themselves through their depositors who obtain a certain predetermined revenues on their investment capital. Contrary, the Islamic Banks encourage sharing of both profits and losses; the returns for their stockholders are not also certain and exclusively rely on the banks financial performance.

Chapra (2008) adds that another critical point of contrast between the IBs and the CBs lies in the manner in which they handle risk transfers. Borrowers in the conventional banking system pay interests independently of the return of their investment hence transferring their risks through securitization or with the credit default swaps making the financing process to be debt-based. However, Islamic banking has two primary different applications of sources: the use of Musharakaor Equity membership and the Mudharaba referred to as Trustee finance. Musharakaor Equity membership allows investors and the banking organization to contribute equally when sourcing the projects capital.

Similarly, the two participants are required to have an equal share of the profits and loses gathered by the firm in a given financial period concerning their shareholding capital (Dridi & Hasan, 2010). However, the Mudharaba system allows sharing of roles between participants. First, the Islamic banks provide the capital required for the sustainability of a project, the investor comes as the main contributor of all the expertise knowledge, skills, labor and the entire management of the firm. However, the difference comes in the way profits and losses are handled. Here the bank and the investors share all profits while the bank caters for the accrued alone (Dridi&Hasan (2010).

Study Justification

There are diminishing studies being conducted on the existence and functioning of both the IBs and the CBs actions through and after a financial disaster. Boukhris and Nabi (2013) examined the effect of worldwide economic crisis on a number of factors associated with the banking industry such as growth in the banks credit, profitability, growth in assets and the external ranking, on a model of 120 Conventional and Islamic financial institutions. The results of their study supported the stronger resilience, sustenance and stability of the Islamic Banks throughout the 2007-2008 worldwide financial catastrophes.

However, Islamic banks profitability declined sharply compared with the conventional banking systems by 2009 when the financial catastrophe was transferred into real economy. The two researchers contended that the existence of the IBs added to the financial strength witnessed for the duration of the crisis. Another study conducted by Olson and Zoubi (2008) on the resistance of IBs compared to CBs during worldwide economic disasters had a number of findings. First, the IBs appeared to be more profitable than the CBs before the economic crisis, after which they became less profitable. However, the CBs remained resilient to the calamity than IBs. These contradicting findings between different researchers call for a new study to be conducted to ascertain why the IBs are believed to be highly resistant to Crisis.

Research Methodology

This study will use financial ratios to investigate the effect of financial disaster on the operation and position of the IBs, which has direct association with their resilience. The researchers will begin by performing an effective comparison of the banks performance for the period between 2007 and 2010 depending on the mean test of equality. The main objective of this process will be evaluating the performance of CBs and IBs throughout the two financial disaster that occurred in (2007-2008) and after the crisis (2009-2010). The ratios to be examined in this case will include the banks liquidity, profitability, capital adequacy, leverage and efficiency.

The Profitability ratios are employed when determining the potential of a given financial organization to yield financial revenues in comparison to its costs and associated expenses over a given financial period. Hiking profitability ratios are indicators of good performance. The study will apply different types of profitability ratios in order to determine whether the performance of each bank outsmarts the other.

Boukhris and Nabi (2013) study established that the IBs are highly profitable when compared to the CBs basing on the above ratio. The Capital adequacy ratio will be used as an indicator of the banks potential to face shock while withstanding losses. However, this study will consider the capital gathered by a given bank as a cushion that can provide adequate solutions for the already existing banking issues. The study will use capital Asset Ratio as a capital adequacy ratio.

Siddiqui (2008) maintains that the resilience of the bank during financial crisis depends on the level of it capital adequacy ratio. Liquidity ratio exists as a...