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Does the banking system affect banks’ performance?

Islamic vs. conventional banking

Written by Anonymous

Paper category

Master Thesis

Subject

Business Administration>Finance

Year

2017

Abstract

Master Thesis: The overall mission and purpose of the bank According to Wright (2012), global technological and economic progress is attributed to financial intermediaries. In the financial system, entrepreneurs who need financing come into contact with financial intermediaries and individuals that provide loans. Both entrepreneurs and loan providers benefit from this business relationship. Loans are also good for the economy, because money is usually borrowed for major investments, such as real estate or cars. Generally speaking, there are different types of financial intermediaries, such as venture capitalists, insurance companies, hedge funds, or banks (Hillier, Grinblatt, and Titman, 2011). They are connected with other financial institutions and different markets in the financial system. Such a financial system plays a role in sharing risks, facilitating transactions, and allocating funds (Wright, 2012). As a financial intermediary, banks interact in the national and international banking systems. Usually, the central bank responsible for national monetary policy and price stability is responsible for overseeing the national bank (Deutsche Bundesbank, 2015). The central bank can also be a multinational institution, just like the European Central Bank's bank in the European Union Eurozone. Today, almost all countries’ banking systems have central banks, including the countries studied here, but central banks are not part of this research. Banks usually further differentiate based on the types of assets they operate. For example, commercial banks and savings banks receive short-term deposits but invest in long-term assets, such as businesses (in the case of commercial banks) or provide mortgages to private individuals (savings banks) (Wright, 2012). Investment banks would rather engage in the capital market to issue public debt and equity to clients, or they would advise clients (Karim, 2001; Wright, 2012). The main risk of commercial banks is credit risk (customers cannot pay loans), while investment banks mainly face risks related to securities transactions (Karim, 2001; Wright, 2012). Although the non-tradable assets of commercial banks are “usually held until maturity on the balance sheet,” securities involve more risks (Karim, 2001, p. 176). In the case of the securities tank, depositors are likely to suffer huge losses because the bank’s assets are more valuable in the going-forward state than in the liquidation state (Karim, 2001). Banks can also conduct commercial and investment banking services. This is known as the universal banking model and is applied in Germany, for example (Wright, 2012). The general business model of a bank can be described as follows: The bank makes a profit by charging interest from customers to obtain credit. 2.1.1 Banking in the countries studied The practice of commercial banks is common in the Gulf Cooperation Council countries and Jordan, but the increase in Islamic bank assets is significant (Maghyereh, 2004; Turk-Ariss, 2009). Nevertheless, these countries are still regarded as emerging economies, and their capital markets and finance mainly come from banks (Turk-Ariss, 2009). Their banking system is monopolisticly competitive (Turk-Ariss, 2009). Therefore, despite the high degree of concentration in the banking industry (for example, in Qatar, the three major banks account for about 70% of total assets), there is still competition (Al-Hassan, Khamis, & Oulidi, 2010). In the past few decades, many of these countries have been intervened by financial liberalization, with the aim of promoting (international) competition in terms of deregulation and privatization of banks (Turk-Ariss, 2010). According to Turk-Ariss (2010), most countries with developing markets are promoting financial liberalization, which has facilitated the global transition to a universal banking system. Similarly, before the first attempt to denationalize in the 1980s, Bangladesh had five state-owned banks operating (Samad, 2008). Today, private banks and foreign banks are also operating. Bangladesh, Jordan, and the Gulf Cooperation Council are considered bank-based systems, while Malaysia is considered a market-based system (Al Karasn​​​eh and Bolbol, 2006; Demirgüç-Kunt and Levine, 1999). In the former, banks are responsible for providing financing and connecting investors with companies/individuals that need funds, while in the latter, financial markets take on these tasks (Hillier et al., 2011). It corresponds to the argument of Turk-Ariss (2009) that the capital markets of the Gulf Cooperation Council countries and Jordan are “weak or almost non-existent” (p. 694). In some of these countries, a small number of citizens have bank accounts (see Appendix A). Islamic banking can promote financial inclusion, especially in countries with large “relatively unbanked Muslim populations” (Kammer et al., 2015, p. 8). In addition to individuals, Islamic banking institutions also promote financing channels to promote financial inclusion for small and medium-sized enterprises (SMEs) that can promote economic development (Kammer et al., 2015). 2.1.2 Differences in Islamic banks The business of Islamic banks differs from traditional banks in some respects. Islamic Bank is mainly engaged in commercial and investment banking. Nevertheless, they adopted a model different from the general banking model. Islamic banks will mix funds obtained from investment accounts and shareholders and invest them in the same investment portfolio. Read Less