Sci.Int.(Lahore),26(5), ,2014 ISSN ; CODEN: SINTE

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1 Sci.Int.(Lahore),26(5), ,2014 ISSN ; CODEN: SINTE RELIGEOUS ASPECTS OF FINANCE PROMISES: EVIDENCE FROM PAKISTAN Syed Muhammed Hassan Bukhari 1, Huma Nawaz 2, Awais Imam 3, Mubashar Majeed Qadri 4 Virtual University of Pakistan, 1 syed.hassan@vu.edu.pk 2 humanawazfeb@gmail.com 3 awaisimam@gmail.com 4 Mubashar_qadri@hotmail.com ABSTRACT: Most of research on Islamic finance focuses on Islamic finance instruments. Little research considers understanding of the market for Islamic finance. Thus, this research investigated and explored Pakistani-based Islamic finance providers and compares performance of Pakistani Islamic and conventional banks. Th study empirically investigated differences in performance between Pakistani Islamic and conventional banks by financial ratios. The Poisson distribution modeling technique was used to analyze the data. The results provided support for the superior efficiency of Islamic banks in Pakistan. Keywords: Islamic finance; Islamic banking; performance; Islamic financial system; Pakistan Islamic banking 1. INTRODUCTION The Development of Islamic finance in the global market has been very encouraging to meet the ethical and religious principles. According to the Global Islamic Finance Report [1], the assets of 1.34 trillion are being managed according to Islamic investment principles, while 20% of banking customers now moved towards Islamic financial products. With its continued strong presence, the Islamic finance industry is expected to get a big edge in the form of increased share and demand in global financial markets at upcoming years. The evidence comes from Islamic financial system that is running with conventional system has seen a continuous development in the Gulf cooperation council (GCC) countries. While it has also gotten success to attract financial centers of world big countries like UK, USA, Italy, France, China, Singapore, Korea and Japan. As an important element of Islamic financial system,the role of the sukuk market to promote sustainable and equitable development being recognized. Various authors suggest the needs of an appropriate Sharia report to account for the Islamic based transactions [2, 3]). In this regard, Pakistan was among the three countries in the world that has been attempting to implement Islamic banking at national level. The root of Islamic finance in Pakistan can be traced back to the September 29, 1977 with the presidential order to the local Council of Islamic Ideology (CII) at national level [4]. The intensity of Islamic banking in Pakistan is estimated at 7.6 trillion rupees, While this figure seems high at first sight, it remains negligible compared to the potential for Islamic finance in Pakistan, currently, estimated it stands 10 percent of the total capital size of the banking sector in the country [5]. The disparity between the current state of Islamic finance in Pakistan and its potential raises questions about constraints to the development of this type of finance. Information about Islamic finance providers in Pakistan and on the performance of Pakistani Islamic financial institutions further prevents a good understanding of this market. Indeed, research on the detailed state and the performance of the Islamic finance market in Pakistan is rather scant. RESEARCH QUUESTIONS The aim of this paper is to fill this gap by answering three questions, (1) what does the market for Islamic Finance in Pakistan look like? - what we believe is the first comprehensive performance measures of Pakistani-based Islamic finance providers, (2) To what extent does Pakistan benefit from Islamic financial system?, (3) How do Pakistani Islamic banks perform compared to their conventional peers in a parallel fashion? 2. LITERATURE REVIEW In todays financial market,interest based financial system is dominant. Interest is a basic constituent of most of buying and lending transactions. Big Business in today s world is apparently not possible without adopting this interest based capital system. This financial system has legal support of government in large parts of the world including Muslims and non-muslims countries. In this situation, Muslim investors strongly realized need to develop innovative types of assets that comply with Islamic law (Shariah). To cater this the first product Sukuk was launched which took handsome share at initial level. The Sukuk is Shariah permissible, financial instruments, to appeal Muslim investors and to those who want to invest in an ethically obliged type of economic system as prescribed by the Islamic law. They made their debut global appearance in the year 2002 with the first Global sukuk worth US$ 600 million being issued by the Malaysian government. The trading volume of sukuk increases gradually with the passage of time. At 2012, the amount of sukuk issuance reached to US$ 177B. This figure depicted the increase demand of sukuk in the marketplace. These statistics are based on global patterns of worldwide sukuk issuance, including the countries of Kuwait, Bahrain, Qatar, Indonesia, and Saudi Arabia, UAE, Malaysia and the rest of the world [5]. Islamic s as Islamic finance providers are one of the business organizations that offer a multitude of products and service for profit. Organization as it is goal oriented, boundary-maintained and socially constructed systems of human activity [6]. Performance evaluation enables the system to assess its efficiency and effectiveness over a period of time

2 2472 ISSN ; CODEN: SINTE 8 Sci.Int.(Lahore),26(5), ,2014 by comparing with its objectives or with market leader to overcome its weaknesses [7]. Our data indicate that the number of Pakistani banks offering Shariah-compliant products remains limited to 8.6% of total banking assets in the country [8]. We also discover a wide diversity in the style of Islamic financial services available in Pakistan.3 We were able to identify 19 institutions with overall 1115 branches offering financing in 8 major different Islamic financing modes: Murabaha, Ijarah, Musharaka, Mudaraba, Diminishing Musharaka (DM), Salam, Istisna, and Qarz/Qarz-e-Hasna. Table 1: Overview of Islamic banking and conventional Pakistani s Country Islamic s Conventional s Pakistan Name Branches Name Branches AL Baraka (Pakistan) 92 Standard Chartered 130 (Pakistan) Islami Pakistan 89 The of Punjab 306 Burj 75 Faysal 265 Dubai Islamic Pakistan 100 NIB 179 Meezan 310 Habib 1,540 In order to evaluate bank's performance, this study uses ratio measures. O'connor [9] and Libby [10] had used this method in the early 1970s. Since then, it has been found in many studies such as Chen and Shimerda [11], Sabi [12], [13], Samad [14]. On efficiency and liquidity, Mohamad, Hassan [15] and more recently Johnes, Izzeldin [16] used them to compare differences between the overall efficiency of conventional and Islamic banks. Samad [14] investigate differences in stability between Islamic and conventional banks using t-test to financial ratios for Islamic and conventional commercial banks in Bahrain for the period Their results suggest that there is no major difference in performance between Islamic and banks with respect to profitability and liquidity. Conversely, using a sample of 12 Islamic banks and 71 conventional banks from Indonesia and z-scores to measure bank stability, Gamaginta and Rokhim [17] found that Islamic banks were in general less stable compared to conventional banks and that small Islamic banks tend to do similarly to conventional banks. Islamic banking in Pakistan has seen substantial growth during the last decade and now comprises over 10 percent of the country s banking system with an asset base of above Rs billion and a network of more than 1,100 branches [18]. The Meezan bank limited counts the largest number of Islamic finance providers in Pakistan if one excludes this premier bank, their number remains low compared to what one would expect from an area that is home to about Rs.533, 227 million of total assets in Islamic banking.table 1 show that Meezan bank limited counts the largest number of institutions offering Islamic banking with 320 branches all over the Pakistan.Dubai Islamic bank Pakistan has the second largest number of Islamic banking network with 100 branches in all over the Pakistan according to State of Pakistan. Unlike previous studies which use either country case studies or a bank s financial statements as part of a larger sample covering some aspects, we use a sample exclusively constituted of major Islamic banks and randomly selected conventional Pakistani banks. Therefore, as a consistency check, we use the share of assets of Islamic banks in total banking assets of Islamic banks and conventional banks respectively as a dependent variable to account for the performance and comparison of Islamic banks and conventional banks. Since seem to work well even if the sample sizes are not large [19] 3. METHODOLOGY The sample contains almost all the Islamic banks from the sampling frame obtained from State of Pakistan. There are total 6 Islamic banks operating in Pakistan out of which 5 seleted. Where as 5 conventional banks are selected using simple random sampling from the total sampling frame of 26 Pakistani banks.in total we have upto 25 observations for five Islamic banks and almost 75 observations for five commercial banks over the period In evaluating Islamic and conventional banks performance,this study uses ratio measures. Our calculations are based on individual bank data drawn from the commercially widely used Scope database and SBP database.the financial ratios data is extracted from non-consolidated income statements and balance sheets of our ten selected banks. In order to empirically explore differences in the performance of Islamic and conventional Pakistani banks, we use the following likelihood function for the Poisson model: Equation 1 Where β j is the relative change in E(y x) associated with a small change in j x. However, the marginal effect differs between individuals. X is a set of factors that could explain the diffusion of Islamic banking. 3.1.DATA AND VARIABLES We collect bank-level balance sheet and income statement data from State bank database. SBP covers a large share of the banking sector in most Pakistan. Hence, it allows us to construct a sample that offers a full coverage of the banking sector in the provinces under study. Specifically, we collect from SBP data 2012 to measure banks business profitability, shareholders equity, efficiency and stability as well as variables to control for bank characteristics. These variables are described in appendix table 2. We focus on commercial banks and Islamic banks separately in a parallel manner to avoid fluctuations in results caused by differences in business

3 Sci.Int.(Lahore),26(5), ,2014 ISSN ; CODEN: SINTE models, legal structures and mandates. We relate bank-level data to different financial variables (Equity, ROA, ROE, Market share, EPS, Capital adequacy ratio) controlling for the level. Our sample comprises 10 Pakistani banks of which 5 conventional and 5 Islamic banks operating in Pakistan. 3.2.RESULTS AND DISCUSSION We used econometric estimation techniques to model how Islamic banking is diffused in the Pakistani financial system. We use a Poisson distribution method, which is more appropirate for discrete variables. Table 2: Performance Measures in Terms of Volume (Rupees in Million) Islamic s Variables Mean SD Min Max Total Assets Equity ROA ROE Market Share EPS Capital dequacy Ratio Total Assets Equity ROA ROE Market Share EPS Capital dequacy Ratio Table 2 shows descriptive statistics for the variables of the study. It reflects minimum value, maximum value, mean and standard deviation of each variable i.e. Totals assets and financial ratios of bank performance regarding selected Islamic and conventional banks. The average ROA and ROE of Islamic banks, are respectively,.0062 and.082, compared to.074 and.142 of the conventional banks. The average Capital Adequacy Ratio of Islamic banks is.164 compared to.122 of conventional banks. But, In respect of Total Assets, Market Share, EPS and Equity conventional banks have a much larger volume of Rupee business as compared to those of Islamic banks. The coefficient of skewness reflects the direction as (+) sign indicates that data is positively skewed and ( ) sign for ROA (Islamic banks) and capital adequacy ratio (commercial banks) reveals the negative side. Values of total assets, equity of Islamic banks and total asset, ROA, market share of commercial banks shows platykurtic pattern. While remaining values of Islamic banks and commercial banks are leptokurtic. Higher kurtosis means more of the variability is due to a few extreme differences from the mean, rather than a lot of modest differences from the mean, Values of our all variables have only a minor difference with normal kurtosis i.e. 3 due to minor difference from the means (Table 3). Table 3: Skewness and Kurtosis Variables Skewness Kurtosis Islamic s Total Assets Equity ROA ROE Market Share EPS Capital adequacy ratio Total Assets Equity ROA ROE Market Share EPS Capital adequacy ratio As a dependent variable the assets of Islamic banks as a part of total major Islamic banking assets to account for relative size, and test whether the factors determining Islamic bank diffusion shape financial sector assets toward more Islamic finance. Similarly, As a dependent variable the assets of commercial banks as a share of total under review commercial banking assets to account for relative size, and test whether the factors determining commercial banks diffusion shape financial sector assets toward more commercial finance. Table 1 Appendix shows correlation results among different variables used in the subject field. There is convincing evidence of a close correlation between financial sector development and operation. These are the indicators that commitment towards values and ethics can bring significant strategic success for the newly adopted financial system (Islamic) with traditional Islamic system (commercial banks) through managerial performance and welfare and protection of all stakeholders of the constitution. Table 4 sets out the results related to determinants of Islamic and commercial banks respectively. Overall, the pseudo R- squared, which measures the goodness of fit, is relatively high between and suggesting that much of the variation in the dependent variable data is driven by explanatory variables, and that the model is relatively well specified. Equity is in all specifications strongly significant and has the correct sign. As with conventional banking, rising equity tends to raise the assets of Islamic banks and commercial banks as well, in a country. Similarly, assets in the Islamic financing rise, the profitability of Islamic banks also rises. The coefficient is positive and significant at the 1 percent level, regardless of the specification. The positive coefficient we report for equity, ROE and market share suggest that Islamic banks in Pakistan have a more conservative approach and stable while negative coefficient of commercial banks ROE and market share suggest variability in the performance of commercial banks. Overall, our model is significant for Islamic banks and commercial banks at P< z = We find that Islamic banks have a higher z - score of equity, return on average equity and market share. These results suggest that Islamic

4 2474 ISSN ; CODEN: SINTE 8 Sci.Int.(Lahore),26(5), ,2014 Table 4: Comparison of Islamic ing and commercial banking Performance: Share of Islamic Assets in Total ing Assets, Poisson distribution model Coefficient Z P 95% C I Islamic s ROE , Market Share , EPS , Constant , Equity , ROE , Market Share , EPS , Constant , banks are more efficient and stable than conventional banks. The higher z-score of the equity ratio of Islamic banks indicates that Islamic banks are cautious about its credit advancement. In addition, the Islamic banks management is aware that they cannot afford a bank failure due to bad credit. As newcomers in the market, Islamic banks must establish good reputation otherwise it would not be able to attract new customers. Any Islamic bank s failure due to imprudent decision would undermine the reputation of Islamic banking in general. Our findings support Schaeck, Cihak [20] and Cihak and Hesse [21] conclusion of the superior performance of Islamic banks. Empirical results of this research could reflect observable characterisitics of Islamic banking system in Pakistan.While result reported in Table 4 provide quantitative assessment of Islamic banks growth parallel with conventional banks that benefited Pakistan. 4. CONCLUSION The objective of this paper is to improve understanding of the Islamic finance market in Pakistan. Essentially, the shift towards Islamic financial market system has forced developers to pay attention towards investors. Providing product with a big profitable return is no longer sufficient, satisfying the customer s affective needs has become increasingly important in the current Islamic economic system. In terms of volume (average Rupee business), the performance of Islamic banks is far below the conventional banks in Pakistan. This is expected since firstly, conventional banks in Pakistan have the advantage of an age old extensive network of branches and more staff compared to Islamic banks who are newcomers to the marketplace. Secondly, the management of Islamic banks, although in the hands of staff who are well-educated and experienced in running conventional banks, have not acquired adequate experience to run Islamic banks which are substantially different in their way of operation. The results of this research suggest that developments of Islamic financial system are not solely dependent on effective evaluation but also in service quality. The comparison of financial measures expressed in terms of various financial ratios indicates that there is no major difference in profitability and liquidity between Islamic banks and conventional banks. Our findings also argue that Islamic banks as newcomers to the financial market are doing well as conventional banks. In addition, Islamic banks are exposed to less credit risk compared to conventional banks. Their credit performance is superior to that of conventional banks. 5. LIMITATIONS AND FUTURE DIRECTIONS This research study was restricted to a few banks of Pakistan. Secondly, Elements to measure bank's performance was held acceptable. A larger sample covering all financial ratios of Pakistan would have allowed us a more powerful analysis. In addition, we failed to determine individual novelty. A more diverse approach may be adopted in the future to judge the performance of Islamic banks. REFERENCES 1. Global Islamic Finance Report. ( Ismail, H. and A. Latiff, Reporting Islamic Based Transactions: Question of Substance. The Malaysian Accountant, Hamat, M., Accounting Issues in the Operation of Islamic ing, in International Integrated Course on Islamic ing and Finance Wisham, I., A. Muneeza, and R. Hassan, Special legal features of the Islamic wa'd or pledge: Comparison with the conventional law on promise within the sphere of Islamic finance. International Journal of Law and Management, (3): p Amanah, H. Frequently Asked Questions Sept 2012]; Available from: qs# Aldrich, H., Organizations evolving. 1999: Sage.

5 Sci.Int.(Lahore),26(5), ,2014 ISSN ; CODEN: SINTE Dess, G.G. and R.B. Robinson, Measuring Journal of Economics and Management, (1): p. organizational performance in the absence of objective measures: the case of the privately held firm and conglomerate business unit. Strategic management journal, (3): p Mohamad, S., T. Hassan, and M.K.I. Bader, Efficiency of conventional versus Islamic banks: international evidence using the Stochastic Frontier Approach 8. Dar, H. Pakistan as a global leader in Islamic banking and finance [cited 2013, March 24; Available from: (SFA). Journal of Islamic Economics, ing and Finance, (2): p Johnes, J., M. Izzeldin, and V. Pappas, A comparison of performance of Islamic and conventional banks 9. O'connor, M.C., On the usefulness of financial ratios to Journal of Economic Behavior & investors in common stock. Accounting Review, 1973: Organization, p Gamaginta, D. and R. Rokhim. The stability 10. Libby, R., Accounting ratios and the prediction of comparison between Islamic banks and conventional failure: Some behavioral evidence. Journal of banks: evidence in Indonesia. in proceedings of the 8th Accounting Research, 1975: p Chen, K.H. and T.A. Shimerda, An empirical analysis of useful financial ratios. Financial Management, 1981: p Sabi, M., Comparative analysis of foreign and domestic bank operations in Hungary. Journal of Comparative Economics, (2): p Hempel, G.H., D.G. Simonson, and A.B. Coleman, management: text and cases Samad, A., Comparative efficiency of the Islamic bank vis-à-vis conventional banks in Malaysia. IIUM international conference on Islamic economics and finance Anwar, Y., Stress upon Islamic financial industry Press Release, S.B.o. Pakistan, Editor 2013, State of Pakistan: Pakistan. 19. Seber, G.A.F., The estimation of animal abundance Schaeck, K., M. Cihak, and S. Wolfe, Are competitive banking systems more stable? Journal of Money, Credit and ing, (4): p Cihak, M. and H. Hesse, Islamic banks and financial stability: an empirical analysis. 2008: International Monetary Fund. APPENDICES Albaraka Islami Appendix Table 1: Correlations (Summary Statistics) Burj DIB* Meezan Scb Bop Faysal Nib Hbl Albaraka islami Burj bank DIB* Meezan bank scb Bop Faysal Nib Hbl *Dubai Islamic Appendix Table 2: Variables Definition Total banking assets Financial Ratio Equity Total assets of the banking system. A financial ratio is a comparison between one bit of financial information and another. A stock or any other security representing an ownership interest. ROA ROE Return on Equity = Net Income/Shareholder's Equity Market share The percentage of an industry or market's total sales that is earned by a particular company over a specified time period. EPS Earning per share = Net income available to shareholders Number of shares outstanding Capital adequacy ratio A measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures.