THE FINANCIAL PERFORMANCE OF INTEREST-FREE ISLAMIC

BANKS VS. INTEREST BASED CONVENTIONAL BANKS: AN

EVIDENCE FROM PAKISTAN

1 Introduction

The industry of Islamic financial services is taking a part in this modern period and rising
quickly. Financial institutions making experienced and competitive environment. The key
feature of success of Islamic banking is developing new strategies, which forces the market
to take interest in the new Islamic banking concepts. Attractive product and services held
fast providing competitive product offerings to meet the more various and differentiated
needs of consumers and businesses.

1.1 Background
Islamic banking has been started for 45 years, and took place in the market about since last
30 years. Now the Islamic banking has extended in whole the world, according to some
studies and research Islamic banking industry assets growing rapidly. The Islamic banking
describe the banking system which apply the Islamic law also called shariah. The main
motive of Islamic banking is supported by shariah, Shariah acquiescent is defining
characteristic of Islamic finance compared to the conventional system. The main difference
between conventional (Banking system which earn and increase wealth by charging
interest) and non-conventional (Banking system which earn or increase wealth without
Riba (interest free), Maisir (gambling), Gharar (Speculative Trading) are prohibited. The
many Islamic finance concepts which are being used are Mudharabah (profit sharing),
Ijarah (Leasing), Musharakah (Partnership) and Diminishing Musharakah (House
Financing). Many Islamic economics studies have discussed in depth about the rationale
behind the prohibition of interest (Chapra, 2000) and the importance of profit and loss
sharing in Islamic banking (Dar and Presley, 2000). Additionally, Dar (2003) classified
four types of financing acting as alternatives of interest; investment-based, sale-based, rent-
based and service-based.

1.2 Islamic Banking

Islamic banking is now growing rapidly in Pakistan due to their attractive plans, strategies
and goals, today there are about six full-fledged Islamic banks have licensed and more than
12 banks are being in process to convert in Islamic banking branches all over in the
Pakistan, the Islamic banking total assets are over Rs. 225 billion as of June 2012 and the
market share of deposits is about 4.2% (Aurangzeb Mahmood). Pakistan is Islamic country
and the Muslims would prefer Islamic banking means some of them don’t trust or believe
on interest so Islamic banking took a part in every field of banking system but Islamic point
of view and law which imposed on all these Islamic banks. So there are about thirty four
full-fledged and window within conventional banks. Islamic banks are providing services
to the people of Pakistan, there are: Meezan Bank Limited (The Premier Islamic Bank), Al
Baraka Banking Group (Your Partner Bank), Bank Islami Pakistan Limited (Serving You,
the Right Way), Dubai Islamic Bank and more.

1.3 Significance of the study

There are lot of studies dealt with several aspects of the financial performance of the bank.
These studies have many objectives that is rare it finds out the performance characteristics
of financial system. Studies on the bank performance have got more attention from the
financial policy makers, managers, researchers, workers and financial institution owners in
recent years. Bank efficiency studies helps in taking effective decision that which changes
should occur in regulatory environment that impact on performance. Regulators can also
adopt or operate the studies to explore market structure and performance issues, mostly in
examining incase the profitability of bank is consumed by market power factors. Full-
bodied banking sector can make banks active in the same industries to raise profits by
fixing prices of financial products and services at levels of unfavorable customers. This
situation is called market power hypothesis. Study of efficiency are more important for the
managers from the business strategic point of view, managers need to take some steps to
find out the reasons and elements for why and how the innovate their efficient performance
from the both the input and output side. Studies of efficiency help managers benchmark
the performance of their banks major competitor. Comprehensively, the studies of bank
efficiency show the results as the interest to financial policy-makers, managers, owners
and financial institution.

2. Objectives of the study

This study could be a primary effort to examine the financial performance of Islamic banks and
make comparison with conventional banks

So therefore, the objectives of the study are:

1. To compare the performance of Islamic vs. conventional banks using; capital adequacy,
asset quality, management quality, earnings and liquidity as performance determinants
in Pakistan.
2. To test for any significant differences in the performance between Islamic
Banking and Commercial Banking.

3. Literature Review

Islamic banking system elements that is constant with Islamic laws and its principles
(sharia). These principles comply with Islamic laws and make Islamic economies. Islamic
laws strictly prevent earning interest on lending money so Islamic banks not agree or accept
to pay interest during business but conventional banking system are total opposite to the
Islamic banking system. According to statement and comparison between conventional and
nonconventional banking system to the efficiency of Islamic banking system point of view
that how it is efficient in this period in rural areas of Pakistan. Furthermore, a review on
the previous studies undertaken to highlight the comparative performance and Islamic and
conventional banks and the determinants of their profitability and financial performance.

The measurement of efficiency is the one form of scrutinize a company’s performance.

Efficiency can be measured in three ways; maximization of output, minimization of cost
and maximization of profit, in general efficiency is divided into two components
(Kumbhakar and Lovel, 2003). A firm can be considered as technically efficient if, it is
capable to gain the maximum output from given minimized inputs used in generating or
producing outputs.

Kettel (2011) asserts that in the uttermost belief of all Muslims, Islam is the religion
revealed by Allah to his last messenger Prophet Mohammed (Peace Be Upon Him) to earth.
It is a complete religion comprising all aspects of human life in this world and hereafter
world. Islam is alleged as comprising of three broad concepts:

Aqidah: which concerns all forms of faith and belief by a Muslim in Allah and his will,
from the fundamental faith in His being to the ordinary beliefs in His commands.

Sharia'a: which concerns all forms of practical actions by Muslims manifesting their
faith and belief, including man-to-man activities (Muamalat); which comprise all mankind
activities (political, economic and social).

Akhlaq: concerns behaviour, attitude and work ethics, within which Muslims perform
their practical day-to-day activities. Sharia'a or Islamic Law , at times referred to Islamic
Jurisprudence, is the instigating foundation of Islamic Banking. As illustrated in the table
below, a significant portion of Muamalat is the conduct of economic activities which
constitute banking and financial services that form the founding principles of Islamic
Banking.

There are several key principles of Islamic Banking, with the central tenet being prohibition
of interest (Riba) as revealed in Quran (Al-Baqarah,2:275) "Allah has permitted trade and
has forbidden riba". Geelani (2005) assets that Riba refers to any predetermined payment
above the actual amount of the loan principal; this is contrary to conventional banks that
charge fixed interest rates on both deposits and loans. Uncertainty and speculation (gharar)
are also forbidden, since any transaction the bank enters should have well-known outcomes
that all contracting parties must have perfect knowledge of as cited in Kahf and Khan
(2007).

Similarly, " the depositor, the bank and the borrower all share the risks and rewards of
financing a business venture" as elaborated by Chapra and Ahmed (2012). Kettel (2011)
also declares that Islamic banks promote risk sharing between providers of funds
(investors) and users of funds (entrepreneurs), while their counterpart conventional banks
assure the investor a predetermined rate of interest and pass all the risk to the entrepreneur.

This study conducted by Moin (2008) to evaluate the effectiveness of Avant-grade

(Pioneering) bank in Islamic banking industry in Pakistan: The study checks out Meezan
Bank Limited (MBL) comparing with five traditional banks in Pakistan. The study
examined and analyzed some aspects: risk, profitability, liquidity and efficiency for (2003-
2007). The research concluded that Meezan Bank Limited was less profitable, more solvent
and less efficient as compared to five traditional banks. Though, there was no main
difference between both banking streams in liquidity.