Comparison between Islamic and Conventional Banks

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Siti Rochmah Ika and Norhayati Abdullah conducted a study of performance comparing Islamic banks and conventional banks in Indonesia. Their study which is titled “a Comparative Study of Financial Performance of Islamic Banks and Conventional Banks in Indonesia” was printed in the international journal of business and social studies in august 2012. The study starts by outlining various differences between Islamic banks and conventional banks. Islamic banks are guided by Islamic moral code which restricts the kind of investment that one may undertake and the methods of generating income that Muslims may be involved in. Islamic banks observe the Islamic law which prohibits acceptance or imposition of interests because according to the Sharia law, profits should be earned from goods and services only and money does not belong to any of these categories. According to Ika and Abdullah (2012), not all goods and services are consistent with the Islamic laws and income from those commodities that are not right in the Sharia law is forbidden. In addition, Islamic banks have an extra task of collecting Zakat which is a religious offering according to the Muslim laws. Therefore, the Zakat agencies have to be taken into consideration when preparing the income statement.

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Islamic banking in Indonesia begun in 1992 but the growth was slow until 1998. This is when the government implemented a policy that encouraged Islamic banking, The enactment of the Act no. 1/1992 opened opportunities for profit sharing banking thus, paving way for the 1st Indonesian Islamic bank. However, the bank remained the only Islamic bank until 1998, though the number of Islamic rural banks increased from only 1 to 78 during the same period. This slow growth was attributed to the government which was unwilling to support Islamic banking. The change of government in 1998 was a new dawn in Islamic banking because the new government was more willing to support Islamic banking. The implementation of the Act that required Indonesia central bank to provide all the necessary assistance to Islamic banks led to the increase in the number of Islamic banks. Bank Shariah Mandih was opened in 1999 and this was followed by establishment of Islamic units in various commercial banks. In addition, issuance of the blueprint for Islamic banking development of Indonesia by the Indonesia central bank in 2002 was very crucial in propelling Islamic banking forward according to Ika and Abdullah. Currently, there are several other Acts which have been enacted to support Islamic banking.

While there has been tremendous growth of Islamic banks in terms of asset base, the same has not been the case when it comes to market share. Due to this low penetration of the Islamic banks, the government enacted the Indonesia Syariah Banking Act in 2008. Nevertheless, Islamic banks are increasing their activities compared to the period prior to 1998.

The study is conducted in two phases, 2000-2007 before the release of Fatwa and the other one is after the release of Fatwa, 2005-2007. In addition, the study carries out the comparison between the banks using various financial ratios. It is important to note that the study collects data from the three existing Islamic banks and various conventional banks.

The study by Ika and Abdullah found that profitability of conventional and Islamic banks did not differ significantly. This was because Islamic banks increased their financing services given that a higher percentage of their income is from these services. At the same time, interest rates in Indonesia were on the rise during this period thus increasing income for conventional banks.

Regarding liquidity ratios, Ika and Abdullah (2012) found that Islamic banks have a higher ability of covering their current liabilities using their current assets. This is because most financial services of Islamic banks are short term for example, Murabahah receivables. On the same note, Islamic banks usually invest in low risk but short term ventures. Consequently, it is crucial that Islamic banks ensure they have enough liquid cash to cater for the short time ventures whenever opportunity arises. Conventional banks are compelled to finance their long term or medium term assets using short term liabilities that keep on streaming in, especially from deposits. This in the end limits the banks from investing in long term non liquid ventures (Ika & Abdullah, 2012). These banks face the risk of having a maturity variance therefore making the bank to have a problem of liquidity management. This due to the fact that finances which are mainly from the deposits are not guaranteed in terms of duration and clients can withdraw them whenever they feel like. On the other hand, the study found no significant difference regarding risk and solvency of Islamic and conventional banks.

The results of the study are not so different from the studies that were carried earlier on the same subject. Some studies have argued that there is no much difference between Islamic banks’ financial characteristics and that of conventional banks. This is because murabahah is not any different from the interest charged by conventional banks. In this regard, profitability and efficiency of the two banks are depicted to be similar. However, the study done in Malaysia depicted that Islamic banks are more liquid than conventional banks. The study also depicted that Islamic banks faced lesser risks compared to conventional banks. This can be attributed to the fact that Islamic banks act more as intermediaries that help in enhancing flow of money from savers to investors. Therefore, the ratio of capital to liabilities is very low to sustain any business outside the banking sector thus decreasing the risk profile of Islamic banks.

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On the contrary, the study that was done in the United Arab Emirates and Pakistan depicted that there are huge differences regarding profitability and liquidity of Islamic banks and conventional banks. It was found that Islamic banks were stronger compared to conventional banks in terms of liquidity and profitability (Ika & Abdullah, 2012). The results were similar to the study that was carried out in Bahrain. However, there was no difference in terms of credit performance between the two banks.

Ika and Abdullah’s study is limited to the period after 2000. Nonetheless, this is good because in the period before 2000 Islamic banking was not common among people. It was not until 1999 that Islamic banking started penetrating to many parts of Indonesia. However, the study is limited to the three big Islamic banks and leaves out the rural Islamic Banks as well as the Islamic units of commercial banks. It will, therefore, be crucial that future studies try to include these aspects in their research. Similarly, for some reasons the study did not include more recent years from 2007 to 2011. Further research should be done to cover these years.

Reference

Abdullah, N., & Ika, S. R. (2011). A Comparative Study of Financial Performance of Islamic Banks and Conventional Banks in Indonesia. International Journal of Business and Social Science, 2(15), 199-207.

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BusinessEssay. 2022. "Comparison between Islamic and Conventional Banks." May 3, 2022. https://business-essay.com/comparison-between-islamic-and-conventional-banks/.

1. BusinessEssay. "Comparison between Islamic and Conventional Banks." May 3, 2022. https://business-essay.com/comparison-between-islamic-and-conventional-banks/.


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