Introduction
Islamic banking and finance is one of the banking sectors that are on an upward trajectory in the world banking industry. The growth of this sector has been precipitated by the unique features that define it. The roots of Islamic finance go back to 1963 in Egypt. However, it gained prominence after the world economic crisis in 2008. As a result, studies have been conducted to determine the performance of Islamic banks and financial stability in order to establish the effects of the global financial crisis on this system of banking. In addition to this, the studies have been done comparatively with the conventional banking systems (Beck, Asli and Merrouche, 433).
Conventional banks faced severe difficulties during the 2008 global financial crisis. On the other hand, the Islamic banks showed remarkable growth largely attributed to their heavily controlled operational environment that is based on shariah law. The sharia law limits investments in the instruments that affected the conventional banks and set off the crisis. For this reason, the considerable stability of the Islamic banks during the global financial crisis attracted has changed the focus of policy makers and fiscal analysts throughout the world. The focus is based on the fact that despite the global financial crisis that has afflicted both developed and developing economies, the Islamic finance industries has thrived. It enjoyed a 29 percent growth in assets during this period (Chapra).
Financial experts posit that the perseverance of the Islamic banks in the harsh financial environment is as a result of participatory banking practiced where all the financial transactions must be based on trade or linked to assets. Financial solidity is a vital tool for the growth of economies since most transactions in the actual economy are made through the financial system. Consequently, the banking industry plays a crucial role in the financial service sector that affects economic development. For this reason, the solidity and growth of an economy are largely reliant on the stability conferred by its banking sector (Chapra).
The banking sector plays the role of the intermediary link between surplus and deficit units as well as assisting funds for productive functions resulting in economic development. The current study on Islamic banking is aimed at establishing the importance of stability of the Islamic banking before, during and after the global fiscal crisis. (Hassan and Jemma, 3).
Research Problem, Objectives, and Importance
Although there are various empirical studies that have been conducted to determine the association between the banking sector and financial stability, studies of Islamic banking and the global financial crisis are few. As a result, the purpose of the research is to investigate the association that exists between Islamic banking and financial stability during the world economic crisis. The research questions were;
- To calculate and analyze the financial performance ratios of Islamic banks with specific reference to liquidity and capital adequacy ratios from the year 2005 to 2010.
- To comprehend the effect of the global financial crisis on the financial performance of Islamic banks.
The relevance of this research is based on the fact that it focuses on a vital sector of the global economy that is the Islamic finance industry. It is relevant to every individual in the society and has a big impact on the economy either positively or negatively. Muslims constitute about a quarter of the global population. For this reason, there has been an enhanced recognition of and demand for financial products that are based on the Islamic religion for Muslim and non-Muslim consumers (Cihak and Heiko, 2).
Literature review
Due the strong bond between stability and endurance of the banking sector and economic safety, studies have been carried out to determine the healthier banking sector. The comparison pits the Islamic banking sector on one hand the conventional banking on the other hand. Research has shown that Islamic banks fared well compared to the conventional banks between 2005 and 2010 (Lewis and Latifa). This performance is dependent on the fact that Islamic banks are more equity financed than the conventional banks. The performance pointers of profitability, liquidity, and the adequacy of capital were minimally affected by the global fiscal crisis in Islamic banks based on the trends observed from 2007.
A comparative study on the impact of the 2007-2008 economic recessions on Islamic and conventional banks in Malaysia showed that Islamic banks held more liquid assets than the conventional banks. For this reason, they were less vulnerable to liquidity dangers as a result of the financial crisis (Beck, Asli and Merrouche 436). This study was conducted over a duration of five years from 2006 to 2010. The sample period was demarcated into before, during and after the financial crisis. The performance indicators that were used included profitability, liquidity, and the credit risk of the banking institutions that were studied.
In a study to determine whether participating banking is more stable compared to the conventional banking system in Turkey, there was a positive outcome. The study results showed that the Islamic banking system was more solid than conventional banking based on profitability, adequacy of capital and liquidity during the global financial crisis period. The research study employed the trend analysis method spanning 2006 to 2011 on an annual basis. The performance pointers that were analyzed included profitability, liquidity, credit risk and the asset quality ratios (Chapra).
Another study was conducted in Pakistan to compare the financial performance of the Islamic banking and conventional banking. The duration of this study was between 2007 and 2011 with the help of up to six financial ratios. From the results obtained, they revealed that Islamic banks have a reduced risk in dealing with loans. On the contrary, the conventional banks are better equipped in managing expenses compared to the participating banks (Hasan and Jemma, 5).
The global financial crisis prompted the developed nations to come up with a new financial system that would take on the challenges of the crisis. Some of the mitigation measures that were used included the reduction of bank rates and interest-free financial system that borrowed from the Islamic principles. The capitalist financial system among other failures highlighted the failure of risk cushioning at different levels as the main reasons of the global economic recession. For this reason, Islamic finance needs to take valuable lessons from the collapse of the conventional banks to avert future crises similar to the conventional banking system (Cihak and Heiko, 4).
Some of the factors that precipitated the financial crisis were the speculative transition and the careless lending transactions. Due to the global financial crisis, the capital markets crashed in addition to the fiscal crisis. Before the crisis, Islamic banks had higher non-performing loan ratios since they had reduced capacity to evergreen loans. The explanation can be provided by the fact that Islamic banks do not have the capacity to offer lending services. This also shows that they were less exposed to the risk-free government sector and more exposed to the consumer sector that has a high rate of default. For this reason, the conventional banks did not enjoy a level playing field when compared to the Islamic banks. For this reason, the risk concentration was skewed in favor of the Islamic banks. However, this assertion needs careful interpretation since the definition of sectors is different across the different countries. For instance, in some countries, the classification is based on the type of borrower rather than the use of loans (Lewis and Latifa).
Research Methodology and Data
Majority of data analysis techniques were employed. The majority of the data is obtained from the balance sheet, income statements and the statements of cash flow that are published by all Islamic banks that are defined. In addition to this, some relevant financial ratios are computed based on the mean for the period of 2005 to 2010. This ratio analysis is used extensively by numerous institutions to investigate the performance of banks. One of the positive aspects of using ratio analysis is in the fact that it eliminates all the disparities that come up as a result of the differing sizes of the banks. The six-year period that defines the study is broken down into three phases. The phases include the periods before, during and after the crisis (Cihak and Heiko, 7).
It is not easy to establish the time of the onset of the crisis since it was varied across nations. However, the average estimate was 2005-2006 for the period before the crisis, 2007 to 2008 for the period of the crisis and 2009 to 2010 for the period after the crisis. Financial ratios computing was done with the help of Microsoft Excel while SPSS software was used to focus on hypothesis testing and the assessment of the impact of the financial crisis on the performance ratios of Islamic banks. In addition to this, One Way Analysis of Variance was used to test the related samples of data. Consequently, the ratios of finance are placed into two broad classifications; liquidity and capital adequacy ratios (Beck, Asli and Merrouche, 438).
Liquidity refers to how expeditiously a bank can change its assets into cash at a face value to meet the cash needs of the depositors and borrowers. The vital ratios in this category are the investments assets ratio and the liquid assets ratio. The investments assets ratio shows the percentage of the bank assets that are tied up in loans. A high investment asset ratio means that the bank has reduced liquidity. On the other hand, the liquid assets ratio is a deposit runoff ratio that focuses on what proportion of consumer and short term funds could be met in the event of sudden withdrawal. A higher percentage of this ratio makes the bank more liquid leading to stability in the event of a classic run on the bank (Chapra).
On the other hand, the capital adequacy ratio evaluates the bank’s ability to service time liabilities and other risks that include credit risk and operational risk. The use of this ratio is to determine the robustness and solidity of the financial systems across the world. It also has to ratios that are employed, and they include the equity total assets ratio and the equity/ liabilities. The equity total assets ratio is a cushion against asset malfunction. A high figure for this ratio shows better protection for the bank. The equity liabilities leverage ratios measures how the assets are financed with debt or equity (Lewis and Latifa).
Results and Discussion
Investment Asset Ratios
Results from the studies show that the liquidity of the Islamic banks is improved during the period spanning from 2005. Compared to the conventional banks, Islamic banks attained a reduced investment assets ratio in 2009 with 46.11 percent. In 2007 to 2008, it was observed that the investment asset ratio increased as a result of the unstable financial markets at that particular time. It then stabilizes from 2008 to 2009. Using the One way ANOVA, the P value was greater than the level of significance. For this reason, the null hypothesis that stated that there is no significant difference in IAR before, during and after the economic recession was accepted. Consequently, it is clear that the Islamic banks remained stable during the global financial crisis (Cihak and Heiko, 12).
In terms of the liquidity assets ratio, the Islamic banks attained a high ration of 33.96 percent in the year 2007. Consequently, it is evident that the liquidity of the Islamic banks increased from 2006 to 2007. However, in 2008, this ratio was affected due to the unpredictability of the financial markets but the effect is small in comparison to the conventional markets. From 2008 to 2009, the results reveal an improvement in the ratio. Consequently, it is clear that Islamic banks have a high runoff ratio from the incidence of the global financial crisis in 2008. As a result, it can be said that Islamic banks had a higher percentage of deposits and short-term funds to cushion against sudden withdrawals compared to conventional banks. With the use of ANOVA, it was established that there was no significant difference in the Liquidity Asset Ratio before, during and after the global financial crisis. Consequently, Islamic banks were not affected by the global financial crisis. Furthermore, it is clear that Islamic banks held more liquid assets than the conventional banks resulting in reduced vulnerability to the liquidity risk (Hasan and Jemma, 15).
Capital Adequacy Ratios
From the results obtained, it is evident that the Equity Total Assets Ratio of the Islamic banks maintains a similar range during the period of research that incorporates the 2008 global financial crisis. Islamic banks attained a high ratio of 26.34 percent in the year 2010. From these results, it is clear that Islamic banks had an adequate capacity of absorbing the losses resulting from loans. From ANOVA, it was determined that there was no significant relationship and disparity in this ratio during the global economic recession. As a result, Islamic banks were cushioned against the crisis bringing to the fore the ability to remain stable during harsh economic times. It also shows that Islamic banks rely heavily on equity capital meaning that equity financing works as a cushion against asset malfunction (Hasan and Jemma, 17).
In assessing the Equity Liabilities Ratio, the average results reveal that Islamic banks remained stable during the years of 2007 and 2008. The highest value is recorded in 2009 at 40.12. Usually, a bank that boasts of a high Equity Liabilities Ratio is viewed as better performing in comparison to a bank with a reduced Equity Liabilities Ratio. Consequently, it is evident that Islamic banks have adequate capacity to deal with financial shocks compared to the conventional banks. One way ANOVA of the results obtained shows that Islamic banks remained stable during the global economic recession. In addition, the results reveal that Islamic banks are capable of coping with financial losses and dealing with impaired loans compared to the conventional banks. For this reason, Islamic banks are less risky than the conventional banks across the world (Chapra).
Conclusion
The research studies entail the performance and stability of the Islamic banks during the global economic crisis. Aspects such as the liquidity and the capital adequacy of these banks during this period were analyzed. The research study spanned the duration from 2005 to 2010. This period was relevant since it coincided with the period before, during and after the global economic recession. The performance pointers that were used in the research study included the use of liquidity ratios and the capital adequacy ratios. From the results, the clear indication is that Islamic banks held more liquid assets and were less vulnerable to undergoing liquidity. The high liquidity ratio that is present between the Islamic banks and the conventional banks could be as a result of the reduced scope of Islamic banking investment.
The results of the one-way Analysis of Variance showed that there was no significant disparity before, during and after the global financial recession on the liquidity ratios of Islamic banks. The conclusion from this observation is that Islamic banks held a higher percentage of deposits and short-term funds that would provide a cushion for sudden withdrawals.
Through the study period, it is also evident that the capital adequacy ratios are solid throughout the period that was considered in the research. The total equity ratios showed an increased proportion of the total assets belonging to the Islamic banks. For this reason, it is also clear that Islamic banks were better placed in dealing with losses resulting from loans. Consequently, the view that Islamic banks have better equity financing and rely on profit and loss sharing association rather than the debt credit relationship common in conventional banks is given weight. In addition to this, the results obtained and analyzed from the equity liabilities ratio reveal that Islamic banking enjoyed a high ratio during the period of the research study. As a result, it is safe to conclude that Islamic banks are better placed in dealing with financial shocks in comparison to the conventional banks. Further analysis of these results using the one-way ANOVA technique showed that there was no significant disparity before, during and after the global financial recession on the capital adequacy ratios of the Islamic banks.
The implication from the research study reveals that the Islamic banking sector performed in a much better way during the global economic crisis compared to the conventional banks. The reason for this better performance can be attributed to the Sharia principles that the Islamic banking system is based. These principles, together with the asset-backed financing have laid down the platform on which the Islamic banking system thrives on.
Works Cited
Beck, Thorsten, Asli Demirgüç-Kunt, and Ouarda Merrouche. “Islamic vs. Conventional banking: Business model, efficiency, and stability.” Journal of Banking & Finance 37.2 (2013): 433-447.
Chapra, Muhammad Umer. “The Global Financial Crisis: Can Islamic Finance Help Minimise the Severity and Frequency of Such a Crisis in the Future?.” Islam and Civilisational Renewal (ICR) 1.2 (2009).
Cihak, Martin, and Heiko Hesse. “Islamic banks and financial stability: An empirical analysis.” IMF Working Papers (2008): 1-29.
Hasan, Maher Mohamad, and Jemma Dridi. “The effects of the global crisis on Islamic and conventional banks: A comparative study.” IMF Working Papers (2010): 1-46.
Lewis, Mervyn K., and Latifa M. Algaoud. Islamic banking. Cheltenham: Edward Elgar, 2001.
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