1. Ratio Analysis
The performance and the stability of banks can be quantified and measured through the analysis of their financial ratios. We can have several hundreds of ratios at our disposal. However, we will use only those that are common, and of some meaning for the analysis of the banks. Also, it is important to note that we should use only major and comparable ratios in order to fully understand the financial position of these banks as compared to all those ratios that may include some vagueness in the research.
Mainly five categories of these financial ratios are used to eliminate the vagueness created by redundant use of the financial heads and items from the financial statements. Hence, the five categories are: (CFA 2009, p498):
However, for the banking industry, which is our main concern, we will use only the first four categories, making an exception of the Valuation category. The financial stability department of the State Bank of Pakistan, which is the central bank of this major economy in the Muslim world, and actively involved in the promotion of Islamic Banking, suggests that the financial ratios fairly reflect the stability, health and the performance of the banks. Hence, these ratios can be used for our purpose.
Instead of just doing the Financial Ratios Analysis, we should also do the analysis of the banks' insolvency risk, which is measured by the z-score. This will be done for both the categories of banking systems: Islamic Banks; as well as the Commercial Banks. The statistic based on z-score is calculated with the help of the data on the bank's expected profits, the riskiness or the variation in such profits and the capital base of the bank. In other words, the following variables help to calculate the z-score and test it, we need the profit margin, its likelihood of occurrence and the shareholders equity available to compensate in case of the negative margins (losses).
A z-score represents the number of standard deviations by which the return on asset have to decrease in order to incur a loss (a negative return). Z-scores can be measured by the following formula:#p#分页标题#e#
z = (ROA+CAP)/σ (ROA) where:
ROA (Return on Assets) = Net Income / Total Assets;
CAP (Capital to Asset Ratio) = Equity / Total Assets; and
σ (ROA) = standard deviation of return on assets (proxy for the variation of return).
According to the formula, the higher z-score means that the equity base and the return added on it is much higher than the potential risk to the earnings as measured by the standard deviations. Hence, such usage of the z-score testing as the test for measuring risk is recommended by many researches in the field. By the definition of the z-score here, it can be said that it directly relates to the probability of a bank's insolvency. It is necessary to evaluate and understand the extent to which Islamic banks are risky as compared to conventional banks. Z-scores will play an integral role in helping us identify the risk profile of Islamic banks.
One of the most extensively used statistical measure of conformity is the use of regression and correlation. The extent to which two different datasets match in terms of moving together is evaluated by a regression analysis. This context will look closely at how the dataset we obtained for Islamic and conventional banks will be moving in tandem with the GDP and inflation (CPI) of their respective countries.
A pooled regression test will be used to perform the respective tests and statistics generated from the regression such as the R-squared value will be used to make judgments on the relationship between the profitability and growth of Islamic and conventional banks with respect to their national growth and inflation. This test is extremely as it is crucial to understand the synchronization of growth of these banks with their national economies. It would be difficult to make pre-assumptions about either Islamic or conventional banks however, it has generally been seen that while conventional banks were wiped of several billions of dollars, Islamic banks stood their ground and even grew in some countries. Thus, bearing this in mind, a pooled regression test will enable us to identify the polarity of growth of Islamic and conventional banks with their respective economies.
1.1 Financial Ratio Analysis:
Financial statement analysis involves comparing the firm's performance with that of other firms in the same industry. In this research, we are comparing banks with banks but having two categories within the banking industry: Islamic banks and the conventional banks. Ratio analysis also involves evaluating trends of the financial position of the firm over a time period.
The ratio analysis of the firm's financial statements helps the management of the firm to identify problems and deficiencies and then to take actions to try to improve performance. It also helps the decision makers to make operational as well as strategic decisions that would help the firm over a long period of time.#p#分页标题#e#
Financial statements mainly comprises of the balance sheet, the income statement and the cash flow statement. The balance sheet and the cash flow statement both report the firm's position at a given point of time. It gives the situation in which the company is standing at that point of time. And the income statement tells about the performance of the company's operations over a certain time period, usually a year.
In other words, the financial statement analysis is useful to help anticipate the future conditions and as a starting point for planning actions that will improve the firm's future performance. But with these lengthy and complicated financial statements, it is really time consuming for the decision makers and other stake holders to confer something. Hence, the financial ratios are used to help evaluate the financial statements. These ratios are taken from the break down elements of the financial statements. These ratios are easy to read and understand rather than the whole financial statements.
Profitability is what every firm is seeking. The higher the profitability, the better is the performance of a bank. The profitability ratios show the combined effects of the liquidity, the asset management, and debt on the operations of the company as the profit is what comes out in the end of the income statement and this profit is what is mainly desired by the ownership and the management of a firm.
One of the most important and most often looked at category of the ratios is the profitability ratios. These ratios are integral in that they help us estimate the degree to which revenues are converted into profits. A bank may be earning extremely high revenues in comparison to its competitors however, its profitability may be low signifying a lower efficiency. On the other extreme, a low earning bank may have a higher profitability signifying a greater efficiency. Thus, it is important to compare the relative profitability of the two bank streams and analyse them over several years' data.
Return on Assets:
The performance of the firm is often and most commonly looked at through the ratio of net income (return) to total assets. In simple words, return on assets shows that what the company is getting out as net profits from its investment in the assets of the business. The assets in a company's statements are valued on the basis of original cost.
Furthermore, the total return is usually the sum of the net income and the interest paid if any on the borrowings, as it is assumed that the assets may be financed by the borrowings. Banks also do have assets employed in their business, including the loans they have offered to the customers. The return is usually the spread between the rate of borrowings and deposits, which is net of all expenses incurred.
In case of Islamic banks, the net income is the net profit earned from the investments through different financial instruments such as mudarbah, murabaha, musharakah, ijarah, etc. and the assets of the Islamic banks also comprise of the investments in different schemes through Islamic modes of financing.
It can be seen from the graph that the conventional banks experienced a rise in the ROAA (Return on Average Assets) during the booming period from 2002 till 2007. However, in 2007, it started to decline and has been declining since. But, during this same period, ROA for the Islamic Banks have been rising on average. Although, the financial crisis in 2007 hit both banking systems, Islamic banks experienced a relatively lesser impact. It has fallen from 2.6 in 2007 to around 2.1 in 2009.
The conventional banks on average were at their peak in 2006 at almost 2.5 and since then, it's been falling and has reached 1.6 in 2009. The overall decline of the conventional banks is far greater than the decline in ROAA of the Islamic Banks.
Return on Equity:
Shareholders, the real owners of the company, are mainly concerned about the return on the equity they have invested in the business. They need to know the profitability of their investment in the company. Hence, the net profit of the company is measured as a ratio of the equity the shareholders have invested in this ratio.
The main difference in the return on assets and the return on equity is that usually, the assets are financed by both the investors (such as shareholders) and the lenders (such as the banks); and the equity reflects only the investment by the shareholders. Hence, this measure shows the rate at which the company is returning the investment to its shareholder (in absolute terms and not in cash terms, as cash is paid out in form of dividends).
In terms of the banks, the equity will be the shareholders' money that they have invested in the bank to make it running. This will not include any loans that the bank's management has obtained for its operations or assets. If this measure is giving out high results, it means that investing in a bank as a shareholder is a profitable venture.
It can be seen from the graph that from our sample of banks, the conventional banks are slightly returning a better amount than the Islamic banks especially after the crisis of 2007. In this regard, we can say that the Islamic banks have taken a bigger impact as their average Return on Average Equity (ROAE) have fallen from 25 in 2006 to around 11 in 2009 as compared to conventional banks having 26 in 2006 and falling to around 16 in 2009.
There can be several possible reasons for such results. It could be that after the crisis, the investments in equity for the Islamic banks have risen, or fallen for the conventional banks. It may be possible that the investors have seen Islamic banks as a safe haven and have taken out their money from conventional banks and put it into the Islamic banks as its equity.#p#分页标题#e#
However, it could also be possible that with so many closures in the conventional banking, the competition is thinned out and the remaining banks are making higher profits than they would have been when there was more competition. There may be one or more explanations for such results however, the most popular of these is that the very basis that caused the credit crunch crisis was not influential in the operations of an Islamic bank and thus left them unscathed to a great extent.
Efficiency of a company can be measured in many different ways. One of the basic indicator of efficiency is that how much of the earnings are used up as expenses. The ratio of expenses to earnings shows how much is the company efficient. If the ratio is low, then it is considered to be very efficient. If it's high, then there must be some problem with the company. If it is high for the whole industry, then it can be seen that the industry is not very profitable. If the ratio is near to one, it signifies serious problems for a company, be it a bank or not. This is because if the earnings and expenses are closer to each other, then there is little room for the profits and denotes that the bank is not able to manage its operations efficiently leading to a very small net profit margin. This would definitely put off investors and is highly undesirable. Hence, the lower the ratio, the better it is.
It can be seen that this ratio is quite low for the conventional banks as compared to the Islamic banks, especially after 2004. The conventional banks efficiency is being steadied even during the financial crisis. The expenses are hovering to around 40 percent of the earnings, which is reasonably lower than for the Islamic banks. When looking at the Islamic banks, the expenses rose from 40 percent in 2004 to 80 percent in 2005 and slowly falling back to 60 percent during the financial crisis but staying there during 2009 as well. Hence it is also possible to see that the Islamic banks' efficiency have improved during this period as this ratio has fallen significantly. However, in this regard, the Islamic banks are not as efficient as the conventional banks. But we will also not ignore the fact that our sample does not represent the whole Islamic banking industry or the conventional banking industry and the results may be completely different for different samples.
Assets Turnover (a type of Activity Ratio):
The asset turnover ratio indicates how hard and efficiently the firm's assets are being put to use. It is also known as the sales-to-assets ratio. It shows that what each dollar of assets has produced in terms of total revenue (or sales).
“Sales” in the banking industry has different names. For conventional banks, the net interest income is used instead of sales. This is the interest earned from lending minus the interest given out on deposits. However, for Islamic banks, the interest-free system, the net profit on investments of different modes of Islamic finance is used as revenue. This is the major differing element of the income statements of the two systems.#p#分页标题#e#
From the results of this ratio, it can be seen that the Islamic banks and the conventional banks have a very close and similar trend before the financial crisis as the asset turnover keep on rising till 2006. However, this is worth noting that the ratio for Islamic banks remained a bit higher than that of conventional banks. After the 2007 crisis, the conventional banks' asset turnover fell sharply from around 0.08 in 2006 to around 0.055 in 2009. Whereas for Islamic banks; this ratio fell from around 0.089 in 2006 to 0.08 in 2009. Hence, the turnover for Islamic banks was not much affected by the crisis. This result may prove worthwhile to note that Islamic banks were having less risk during the financial crisis than the conventional banks. Though insignificant at the moment, this can be an important dimension in future studies involving Islamic banks and conventional as it provides insight into the risk profile of Islamic banks viz-a-viz conventional banking.
Solvency ratio shows the financial leverage of a firm. When a firm requires money more than the equity it has risen from its shareholders and from within the business, it needs to borrow. This borrowing can be from anyone including the bank. However, usually it is required to give out fixed rate as interest payment regardless of whether that money is properly utilized and gained from or not. Whether the company is in profit or loss, the interest payments on the debt has to be given out. If the profit is high, the shareholders gain as the leftover profit after interest payments goes to them. However, in case of loss, the shareholders bear the burden as well because the interest payment still has to be paid. Because of this debt increasing the profit rate to shareholders in good times and reducing it in bad times, this debt is said to create financial leverage.
Debt to Equity Ratio:
The debt to equity ratio is a clear measure of the percentage that a company is indebted to the external sources. It gives out the rate at which the debt is as a multiple of the equity. If the debt is less than the shareholders' equity, than this ratio would be less than 1. But if there is more external debt than internal equity, than this ratio will exceed 1. And this could be really problematic for a company. However, in today's world, high debt to equity ratio is considered normal. For a bank, whether a conventional bank or an Islamic bank, this ratio just indicates the ratio of the actual owners to the external lenders. However, in case of crisis, it is usually seen that the banks to go out of the business first had a high debt to equity ratio.
Islamic banks usually tend to have lower debt indebted to them. As their core principle of interest free banking may not be fulfilled if they take on debt on interest. So all the debt they have is interest free and such type of debt is difficult to obtain. However, according to the result of this ratio here shows that Islamic banks debt to equity ratio rose significantly during 2004-2005 and was nearly equal to conventional banks' ratio, but then it steadied around 1.6 during the financial crisis and after it. On the other hand, during this time period this ratio for conventional banks rose to 2.6 in 2007. And then the effect of the crisis took over and it fell to around 2.1 in 2009.#p#分页标题#e#
It can be realized from this result that the shock of the crisis made the conventional banks realized that they have stretched too far from how they should be financing themselves. Hence, either they started to pay off their debts to reduce the risk of bankruptcy or the lenders started to get strict control over them. On the other hand, the Islamic banks were more relaxed as they did not have high debts to fear from and continued keeping a similar debt to equity ratio.
Liquidity ratios are the indication for the company to know how much current assets there are to deal with the liabilities. In case of the banks, it shows how much loans are there to give out from the deposits available.
Total Loans / Total Deposits:
Banks give out loans to the customers (borrowers) are assets as they are receivables. Whereas, the deposits taken from the customers (depositors) are liabilities as they are payables to the depositors upon their request. Deposit is the property of the depositors; hence it's the liability on the bank to pay the depositors back their money.
This ratio for banks is similar to the current ratio used for other firms. It is similar to the ratio of current assets to the current liabilities. Hence, we can see that for Islamic banks, this ratio is lower than that of the conventional banks.
This may be because many different financial instruments are used to finance those who want the funding. So many Islamic banks may not show all the investments as current assets or loans in this case. Also, it may be possible that perhaps a higher profit rate is charged by the Islamic banks as compared to the interest rate charged by the conventional banks and people are reluctant to fulfil their financing needs from Islamic banks in order to avoid higher rates to pay back. As the Islamic banks are growing and gaining consumer confidence, it may also be possible that the people are depositing their savings in Islamic banks much more than they are using its money for their financing needs, for a time being. Here, it is worth noting that the financial crisis did not affect this rate significantly for both the banking systems.
Total Loans / Total Assets:
As discussed above, total loans can be termed as current assets as they are the receivables. Hence, this ratio is about how much part of the total assets is this receivable loan. For the sample on hand, it is worth noting that the loan to total assets ratio for the conventional banks have slowly declined during the years and not affected significantly by the crisis. However, in the same time period, this ratio for Islamic banks has risen slowly. This may show that other assets for Islamic banks have reduced as compared to main current receivable assets.
Growth analysis is the analysis used to measure and compare the growth rate of a company for different heads of accounts. It could be growth in sales, growth in assets, growth in liabilities, etc.
First of all, we will look at the growth of the deposits. Although the deposits for banks are the liabilities, it shows the demand for the bank by the customers. If more and more customers start depositing in a bank, the bank is said to be growing in terms of customer base. In other words, the demand for the bank is rising.
From the graph taken from the sample, it can clearly be seen that the growth rate of deposits have risen sharply for the Islamic banks. However, there is a major dip after the financial crisis from 35% to 25% in 2008. But after that, it has risen back to around 34% in 2009.
In case of the conventional banks, there has been a growth in the deposits, but much slower than the Islamic banks. Also, there is a major dip in growth rate from around 24% in 2006 to around 11% in 2007. And moreover, the recovery that Islamic banks have shown after the crisis was nowhere to be found in our sample of conventional banks. The deposit growth rate rose from around 11% in 2007 to just around 14% in 2009 as compared to 34% for Islamic banks.
The equity growth directly shows the investors' (shareholders) confidence as the deposit growth showed the customer confidence in the bank. Hence, it can be said that this ratio directly measures the success of a bank because if the bank is getting success, the shareholders (investors) will be putting in more money as equity to get higher returns in terms of profits.
For our sample of the banks from the two systems, we can see that there are ups and downs during the sample time period. Initially, both the conventional banks and the Islamic banks' equity growth have risen till 2005. But much before the crisis happened in 2007, there was a fall in investors' confidence since 2005 for the conventional banks. This has been shown by the sharp decline in the equity growth from around 49% in 2005 to a mere 12% in 2007 for the conventional banks. But after that there was a sharp increase next year and then it again fell in 2009. But when we see at the Islamic banks, their equity growth was at its highest during 2006 and 2007 at around 55% when this rate was having a free fall for the conventional banks. However, the equity growth rate for Islamic banks also had a major drop in the aftermath of the crisis in 2008 when it dropped to around 22% but then bounced back in 2009.
It is worth noting that the growth rate for the last year have increased for the Islamic banks and decreased for the conventional banks, thus setting out a trend for investors' confidence in favour of the Islamic banks. From this financial ratio analysis, it can be observed that the Islamic banks were affected lesser than the conventional banks.#p#分页标题#e#
The table above shows the summary of z-scores for both the banking systems and the overall z-score as an average of both. There are some surprising results here. The z-score for Islamic banks is a little less than that of the conventional banks even though the results of the financial ratio analysis showed that the Islamic banks were exposed to less risk as compared to the conventional banks during this period, especially the period of financial crisis. In other words, the conventional banks are a little more financially stable than the Islamic banks.
Looking at the trend of the z-scores during our sample time period, the graph shows that on overall, conventional banks z-score was higher thus showing that they were more insolvent as compared to the Islamic banks. However, it can be seen that there was a fall in z-score before and during the crisis in 2006 and 2007 for conventional banks and only during this period, the Islamic banks were less risky. However, the dip in the aftermath of the crisis for the Islamic banks showed that they became riskier especially after the crisis in 2008 and 2009. It is worth noting here that in 2009, the z-score for the conventional banks has a downward trend and for Islamic banks, it is rising. Hence, in the future, it may be predicted when the things get stabled that the Islamic banks would become less risky and more financially stable.
In the table above, the average results are shown. There is a higher return on assets for the Islamic bank during the period on average, and also a higher share of equity in assets as compared to the conventional banks. However, the z-score on average is lower for Islamic banks as compared to the conventional banks thus telling that even though there is less ROA and equity share in the assets for the conventional banks, they are more stable financially and have lesser risk for solvency. However, as mentioned earlier, there is a rising trend for the Islamic banks at the moment. Hence, once the dust settles down, we can have a clearer picture of the future of the two systems. However, the slight variations in the z-score do not differentiate the financial stability of the two banking systems by very much. Hence, it would be unwise to conclude something here at this point of time.
This is the overall regression of all variables including conventional and Islamic banks ROAs on the Average Z-score of all the banks in our sample.
The two tail t-critical value for 7 degrees of freedom at a 5 percent significance level is 2.365. Hence, from the results in the table above, none of the variables is significant enough on its own to affect the financial stability (z-score) of a bank. Now we try for the 10 percent level. At this level the t-critical value is 1.895 which is still higher than the t-statistic of any of the variables. At the 20 percent level however, the t-critical value is 1.415 thus making the ROA for the Islamic Banks significant enough. But, this would not mean anything important for our results. Hence, we do the regressions separately for both the systems.
This is the regression of Conventional ROA, GDP Growth and Inflation on z-scores of the Conventional Banks.
Here, we can see that the conventional banks' ROA is significant even at the 5 percent level having t-statistic of 2.60 which is more than the t-critical value at 7 degrees of freedom (2.365). Hence, the coefficient of the conventional ROA of 7.12 is significant enough. This means that there is a direct and strong relationship between the financial stability and the return on assets ratio of the conventional banks.
Islamic Banks Regression Analysis:
This is the regression of Islamic ROA, GDP Growth and Inflation on z-scores of the Islamic Banks.
Here, we can see that the Islamic banks' ROA is significant even at the 5 percent level having t-statistic of 2.98 which is more than the t-critical value at 7 degrees of freedom (2.365). Hence, the coefficient of the Islamic ROA of 5.14 is significant enough. This means that there is a direct and strong relationship between the financial stability and the return on assets ratio of the Islamic banks. In all the regressions above, it was noted that the effects of inflation rate and the GDP growth rate are not significant enough to influence the financial stability of both systems.#p#分页标题#e#
Limitations and Recommendations:
Just like any market research carried out in any stratum is tied to certain constraints, this research also has certain limitations tied in to it. Time is perhaps one of the most important and limiting constraints. Imagine a scenario where the cure for an unknown disease is being researched. There is only 1 person in the world who is affected by it and a doctor has diagnosed that person will only be able to live for 30 days. The research to discover a cure for that disease is underway. There is ample trust and evidence available that the cure will need at least 25 days to successfully cure the disease so that the time available to the researchers to find a cure is reduced to only 5 days. This is the kind of a dilemma faced by researchers trying to gather data for so many different variables across different banks for a handful of years.
The Internet proved to be one valuable resource in helping to find out the required data for so many different banks spread across different countries. However, this challenge was further made complex by the numerous formats in which different banks had their annual reports and chose to report facts and figures. The major problem was research limitations in terms of the secondary sources that were accessible; however it was reduced to the minimum by proper structuring of the work and adherence to the guidelines. The limitations of this study are inherently based on the design of the study, since the proposed research uses a quantitative method to evaluate the relative degree of similarity (or difference) between Islamic and conventional banking streams. One of the most significant limitations in the study was the analysis of data on one page. Being presented in different currencies and corresponding to different countries, it was immensely difficult to convert all data into a single comparative scale and carry out an analysis. The aforementioned are some of the limitations that were faced during the research process.
A significant limitation that perhaps hindered the data gathering process the most after non-availability of data was the fact that there are several banks in Pakistan, the UAE and the Kingdom of Saudi Arabia who offer both Islamic and conventional banking services. This makes them invalid to be chosen as a sample in either the Islamic or conventional streams. Since financial data is not presented separately, it is necessary to find banks who are purely Islamic or purely conventional to carry out an effective research. This limitation rendered several chosen banks invalid in the sample and added to the researcher's woes on timely data gathering.
An important recommendation to further researchers carrying out research on similar topics would be to refer to international journal articles and previously published datasets to gather data. At this point in time, these are difficult to procure and rare in occurrence, however, as time passes by researches like mine will be conducted and published. Future research should make use of the efforts gone behind in penning down these dissertations and re-use existing statistics given approval from their proctors.#p#分页标题#e#
Another recommendation to this study would be to maintain the number of variables covered in this study as the minimum number for analysis. It would be difficult to perform a wholesome analysis with only a few variables. Anything less than what is covered will fail to do justice to the topic and hence in future, only an increase in the number of variables should be made when analysing the two banking streams.
The research and testing processes were tiresome, cumbersome and required a mammoth effort, however, were very interested and were self-motivating. The payoff from the research was the additional knowledge about the relationship between Islamic and conventional banks that kept the research going on.
The data gathered was not sufficient enough to test the actual effects of the crisis on the financial stability of the two banking systems. Islamic banks are in the process of growing ahead and are churning out newer products and cannot be actively compared with conventional banks in the same stature. The sample size was small and caused several data gathering difficulties. Without a proper structure and format of data availability it is difficult to embark on such a research and perform subtle conclusions. It can also be inferred from the ratio analysis, z-scores and the regression analysis that Islamic banks have a relatively less risky profile as compared to conventional banks and will be expected to outperform the latter in difficult times.
Though the profitability and efficiency of Islamic banks is not as high as that of conventional banks, there is a great deal of room for improvement – that has been observed in the past five years – and Islamic banks present an important case for independent analysis that can be the subject of future dissertations and researches.