COMPARISON OF ISLAMIC AND CONVENTIONAL FINANCE

COMPARISON OF ISLAMIC AND CONVENTIONAL FINANCE 

 A. Efficiency and Profitability

The efficiency of Islamic banks tends to be comparable with that of conventional banks. Many argue that despite differences between the business models of conventional banks and Islamic institutions, at least for the period before the recent global recession, the efficiency of both banking systems was not significantly different (di Mauro et al., 2013). However, the story seems to have changed during the financial crisis. Recent studies show that the profitability of Islamic banks decreased more than for conventional banks during the crisis, mainly because of weaker risk management practices and financial crisis spillovers to the real economy (for example, Rashwan, 2012 and Hasan and Dridi, 2011). Although the international evidence suggests that both cost and profit efficiency of Islamic banks are on the rise, Islamic banks in advanced countries seem to be more efficient than those in other countries. This could be partly explained by well-established regulatory frameworks, more advanced human capital, and better risk management practices in these countries (Tahir and Haron, 2010). 

B. Risk Management

In addition to facing common risks with conventional financial institutions, Islamic banks also face their own unique risks. The Shari’ah-compliant nature of assets and liabilities distinguishes them from conventional banks while at the same time exposing them to similar market, credit, liquidity, operational, and legal risks. Notably, differences in opinion among 

religious scholars regarding the Shari’ah compliance of specific financial arrangements can expose Islamic banks to the risk of noncompliance with Shari’ah principles.28 Further, operational differences across countries result in different permissible financial products, thereby raising legal uncertainty in the area of cross-border Islamic financial activities (Jobst, 2007). Islamic financing is also subject to high judicial risk, as clients may turn to Shari’ah courts that rule on a case-by-case basis, as well as seek redress in regular courts.29 Additionally, Islamic financial institutions may confront commercial pressure to pay competitive rates of return that exceed returns on the assets that are actually being financed, with the result being that shareholders may have to forgo part, or all, of their share in profits to minimize the risk of funds withdrawal. Such exposure to rate of return risk (resulting from unexpected changes in rates of return) engenders a risk that is unique to Islamic banks known as displaced commercial risk. Finally, equity risk arises when Islamic banks enter into musharakah and mudârabah partnerships as providers of funds and they share in the business risk of the activity being financed. Mark-up risk tends to rank highly for Islamic banks.30 The 2001 Islamic Development Bank (IsDB) report contends that Islamic banks face more severe mark-up (interest rate) risk in fixed-income instruments like istisna’ and murahabah. The report argues that operational risk, liquidity risk, credit risk, and market risk are next to mark-up risk for these institutions. All in all, profit-sharing investment accounts (PSIA), diminishing musharakah, mudârabah, salam, and istisna’ tend to be considered riskier than murahabah and ijārah. To mitigate risks, Islamic banks use a variety of prudential reserves.31 PER are intended to smooth profits for investment account holders (IAH). These reserves are funded by setting aside a portion of gross income before the bank’s profit share is deducted and are not part of equity capital. The Islamic bank can also use IRR, which are funded by a portion of the income to investors after allocating the PER, to cover future investment losses of account holders. Since IRR belong to the equity of IAHs, they are also not included under the bank’s equity capital. Finally, fiduciary risk reserves (FRR), which are much less frequent and less popular than PER and IRR, are funded by a portion of the income to the bank before the payment of dividends to shareholders. 

Islamic banks use conventional risk management measures, but there is a need for additional risk mitigating tools to address their unique risk exposures. Conventional tools in use by Islamic banks that do not conflict with Shari’ah include internal rating systems, risk reports, internal control systems, external audits, maturity matching, and GAP analysis. However, the unique nature of Islamic financing, with a diverse set of instruments used as sources and uses of funds, calls for the development of new techniques, processes, institutional setup, and procedures to further enhance risk management practices and tackle Islamic finance–specific risks. Corporate governance concerns are associated with these prudential reserves. While IFSB standards set rules on disclosure requirements on displaced commercial risks and smoothing practices, investment account holders generally have no control over the PER and IRR usage and, in some cases, are not informed of the Islamic bank’s practices of maintaining these reserves. Also, an investment account holder with a short-term horizon may be negatively affected by the constitution of reserves that will most likely benefit someone else in the future. In addition, IRR may give rise to moral hazard akin to that arising from deposit insurance, as bank management may be encouraged to engage in excessive risk taking. Further standardization for Shari’ah compliance would benefit Islamic financial institutions. Unlike conventional banking where a unified set of international standards help agents to identify risks associated with the bank’s activities, Islamic financial institutions often face difficulties presenting internationally accepted Islamic instruments to their customers. While it seems challenging to standardize different interpretations of certain religious matters across jurisdictions and Shari’ah scholars, harmonizing differences in the Shari’ah compliance of different instruments would reduce uncertainty and foster industry growth. In this vein, the AAOIFI and IFSB have provided some Shari’ah standards and governance guidelines.

C. Sukuk and Conventional Bonds 

Sukuk are usually asset-based financial securities. According to the AAOIFI, sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, property right, and services. Another definition is provided by the International Islamic Financial Market (IIFM), which defines sukuk as a ‘commercial paper that provides an investor with ownership in an underlying asset.’ Sukuk are not debt certificates with a financial claim to cash flow, and they may not be issued on a pool of receivables. Rather, they are similar to a trust or ownership certificate with proportional or undivided interest in a project or an asset, and carrying the right to a proportionate share of cash flows. The underlying asset or project is a distinctive feature of sukuk compared with a pure debt    

bligation for the issuer created by conventional bonds, with monetized assets being Shari’ah-compliant in their nature and use.33 As a result, sukuk prices should vary not just with the creditworthiness of the issuer, but also with the market value of the asset or project being financed. Further, unlike bondholders, sukuk investors may be held responsible for asset-related expenses. Moreover, whereas a bond-holder has to use a court of law to get ownership of assets in case of borrower’s default, sukuk contracts envisage such transfer of ownership automatic in case of default on payments. Sukuk represent a distinct class of securities with both bond- and stock-like features. Conventional financial instruments for raising funds in capital markets are debt (bonds) and equity (shares of stock). Sukuk are Shari’ahcompliant investment certificates issued by sovereign and corporate entities to finance their activities. Similar to bonds, sukuk have a maturity date with often a regular stream of income over the life of the certificate, along with a final bullet payment at maturity. Sukuk and shares of stock are also similar for two reasons: they both represent ownership claims and are not guaranteed a return. However, sukuk must be related to a specific asset, service, and/or project for a period of time, whereas equity shares represent ownership claims on the whole company, with no maturity date. Using a sample of more than 11,000 conventional bonds and sukuk, the average issue amount and maturity are larger for sukuk than for conventional bonds. However, some argue that sukuk financing instruments are not different from conventional bonds.34 One view is that, being structured along the lines of conventional securitization, sukuk do not constitute financial innovation. Rather, they generally provide a return that is equivalent to interest payments on conventional bonds, with the difference being that sukuk returns are generated from an underlying asset rather than from the obligation to pay interest.

Krasicka and Nowak (2012) observe that, although sukuk and conventional bonds are fundamentally different instruments, their returns are driven by common economic factors and their price behavior exhibits a similar pattern, implying that sukuk may not provide significant diversification benefits for investors. However, the opposing view is that sukuk are different from conventional bonds because the latter do not include the risk sharing element (Iqbal and others, 2014). Çakir and Raei (2007) show that sukuk provide diversification benefits when combined with conventional securities by the same sovereign issuer. Godlewski, Turk, and Weil (2013) show that sukuk are different from conventional bonds, at least in the eyes of investors, because the stock market reaction to the issuance of each type of corporate security is different.