1

STUDY OF SHORT-TERM PERFORMANCE OF ISLAMIC AND

CONVENTIONAL BANKS AFTER THE ANNOUNCEMENT OF
MONETARY POLICY
By

AWAIS ILAHI

(BBA07133002)

Bachelor's of Business Administration

(FINANCE)

Session (2013-2017)

Department of Management Sciences

The University of Lahore (Sargodha Campus)

2017
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APPROVAL SHEET
Supervisor
NAME Mr. Shahid Rasheed
DESIGNATION Lecturer (Department of Management Sciences)

SIGNATURE ………………………………………………..

Department of Management Sciences

Head of Department
NAME Dr. Rozia Mustafa

SIGNATURE ……………………………………………….
Thesis Committee Members
 NAME Mr. Muhammad Junaid Shahid
 DESIGNATION Lecturer (Department of Management Sciences)

 SIGNATURE ………………………………………………..

 NAME Mr. Anwar Hussain

 DESIGNATION Lecturer (Department of Management Sciences)

 SIGNATURE …………………………………………………..

 NAME Mr. Yasir Mehmood

 DESIGNATION Lecturer (Department of Management Sciences)

 SIGNATURE ………………………………………………….
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CERTIFICATION

This is to certify that AWAIS ILAHI having Reg#BBA07133002 has completed his thesis titled,
study of short-term performance of Islamic and conventional banks after the announcement of
monetary policy under my supervision. I am satisfied with the quality of student’s research work
and allow him to submit his thesis for further process as per the University of Lahore rules and
regulations.

Supervisor

-------------------------------

Mr. Shahid Rasheed.

Lecturer,

Department of Management Sciences

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DECLARATION

I AWAIS ILAHI registration number BBA 07133002 hereby declare that this submission is my
own original work towards the Bachelor of Business Administration, and to the best of my
knowledge and that it has not been submitted for a similar degree in any other university.

-------------------------

AWAIS ILAHI

(BBA07133002)
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DEDICATION:

Dedicated to

My Parents

‘Your prayers are what I need more than anything else in my life’

And

My Supervisor

‘Their immense support and encouragement towards the successful completion of

my course’
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ACKNOWLEDGEMENT
It’s the grace of ALMIGHTY ALLAH that has led this work to its completion. The gracious and

All-Compassionate. I can never dare to deny of his gifts that he has granted me, best of which is

that HE has provided me with the torch of eternal guidance in the form of his Holy Prophet

(PBUH), who is the knowledge for humanity as a whole.

I sincerely and honestly thank my supervisor, Mr. Shahid Department of Business

Administration, Lahore University, Sargodha Campus, for his unmatchable and dedicated

supervision for the completion of this study. He has really been extremely patient, helpful and

cooperative.

I also greatly thank HOD and faculty members of Business Administration Department of

Lahore University Sargodha Campus, for their cooperation and support.

I am very thankful to my family. The prayers and support of my family has helped me

throughout my work.

Thank you all!

AWAIS ILAHI

(BBA07133002)
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Table of Contents

1. Introduction..........................................................................................................................10

2. Literature review..................................................................................................................16

3. Methodology..........................................................................................................................24

3.1. Security return..............................................................................................................25

3.2. Market Return...............................................................................................................26

3.3. Market Model................................................................................................................26

3.4. Abnormal Returns........................................................................................................26

3.5. Aggregation of Abnormal Returns..............................................................................28

3.6. Cumulative abnormal return.......................................................................................28

4. Results....................................................................................................................................30

5. Conclusion.............................................................................................................................40

6. Refrences ..............................................................................................................................42
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Abstract
This study evaluates the impacts of monetary policy on banking sector of Pakistan. Banking
sector includes both Islamic and conventional banks. Total sample of 10 banks is used in the
study in which 5 are Islamic and 5 are conventional registered at Karachi stock exchange. Data
have been used which covers the time period from January 2012 to June 2017. All data is based
on daily basis which has been extracted from Karachi stock exchange website. This is an event
study to investigate the impacts on AR’s and CAR’s after the events took place. The period of
interest is of 30 days, in which 10 days are before the event and 20 days after the event. Results
shows that in Pakistan Islamic banks are not so much effected by the monetary policy shocks.
The study found that conventional banks are more effected by policy rate change and they are
more sensitive to interest rate change then Islamic banks.

Keywords: Monetary policy shocks, abnormal returns, cumulative abnormal return.

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Chapter #1

INTRODUCTION
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1. Introduction
Economic performance in any country is dependent upon its financial sector. In Pakistan banking
sector comprises of both Islamic and conventional banks. Conventional banking is based on
interest and is against Islamic principles and therefore is prohibited. Islamic banks, on the other
hand, are Shariah compliant and operate according to Islamic laws.

Studies supporting the merits of the Islamic monetary system emphasize the relative stability
accorded by the interest-free system due to its asset linked nature as opposed to the interest-
based system which is subjected to the interest rate fluctuations. A monetary system which is
relying on interest-free assets is proposed to have lesser element of uncertainty, thus is more
predictable and has reliable links to monetary policy objectives. Consequently, there is a general
belief that the financial intermediaries, in particular the banks, operating within the interest-free
system is shielded from the risks associated with interest rate fluctuations and are more stable
compared to the conventional banking system (Khan, 1985).

Monetary Policy is formulated by the Central Bank to facilitate economic growth. To control the
supply and availability of money, a government attempts to influence the overall level of
economic association with its political objectives usually these objectives are directed towards
the achievement of macroeconomic stability. Monetary policy is usually administered by the
Central Bank. The mechanism that affects stock prices is based on transmission channels
(interest rate channel, exchange channel, asset price channel and credit channels) etc. These
channels require solid insight to determine the effect of monetary policy on stock prices by
considering time and effect mechanism that can result in successful practices of policies. The
stock market is highly sensitive to unexpected fiscal and monetary policies. But this sensitivity
may vary among different economies. Monetary and fiscal policies are the means used to control
and regulate the economy.

State Bank of Pakistan has a responsibility to implement monetary policy and control economic
activities through monetary actions. Looking at background of monetary policy, we can divide it
into two regimes. First regime is prior to 1990s and second comprises the period after 1990s.
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State Bank of Pakistan has been using different direct and indirect instruments for conduct of
monetary policy in Pakistan. Direct instruments include cash reserve ratio, fixed margin
requirements, reserve ratio (CRR) and restriction of credit to different sectors and purposes etc.
while indirect instruments include the discount rate, open market operations, T-bill auction rate,
statutory reserve ratio and statutory liquidity ratio etc. Direct instruments were mostly used
before the 1990s while indirect instruments started to emerge after financial reforms in 1990s.

The monetary policy in Pakistan has evolved in response to structural developments in the
domestic economy and changing dynamics in the international market. Although SBP Act1956
assigned the dual objectives of stabilizing inflation at low level and sustaining high economic
growth to monetary policy in Pakistan, SBP did not have either any authority or the appropriate
instruments to pursue these goals before 1990’s. The importance of monetary policy in
macroeconomic management directs the intention and considerable interest of researchers and
policy makers to find out the impact of monetary policy on stock market performance in
developing and developed countries.

In early 2000s Inflation and twin deficit were low due to loose monetary policy. This boost
economic growth in year 2004 & 2005 and GDP growth was more than 7% in these years but
loose monetary policy put inflationary pressure on the economy and inflation goes to 9% in the
year 2005 which was 3% in the year 2001.Due to inflationary pressure in 2005, a tight monetary
policy was pursued by a state bank to lower the inflation in upcoming years. Inflation increased
again to 20% in 2008. This was highest in the history of Pakistan (monetary policy statement,
August 1012). After 2008, inflation decreased significantly due to steps taken by State Bank of
Pakistan and was 12%** in the year 2012 that was within the target of the government.

It is worth mentioning that because of the electronic money that has created by lending from the
banking system, the velocity of money supply dramatically increased as compared to the real
domestic product (GDP). Thus, the purchasing power of the poor gets diminished, whereas of the
rich get constantly increased thereby lending to income disparity and unjust transfer of wealth. In
fact, the issue is not the inflation by itself but the implemented monetary policy that grants the
banking system the right of creation of money and offering it to the rich minority under the
justification of creditworthiness instead of embracing the risk-sharing philosophy that reduce
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inflation and promote equitable distribution of wealth. However, the reason of mentioning these
negative attributes is to strongly emphasize the effects of the interest-based conventional system
monetary policy, which adversely affects the Islamic financial services industry.

The Islamic finance industry and the conventional system show some differences in terms of the
methods they use and the risks they take, investors they deal with, etc., both of them operate in
the same environment and desires of investors and depositors are more or less similar. Therefore,
both industries inevitably affect each other. Among these effects, monetary shocks come in the
forefront because monetary policy changes have power to have immediate effects on the whole
economy, especially for financial industries.

In Pakistan Islamic banking started in year 2002 and as of December 2015 there are 6 full-
fledged Islamic banks operating in Pakistan. Most of the conventional banks are also running
Islamic banking parallel to their conventional banking business. The global expansion of Islamic
finance in recent years has been spectacular. Prior to the financial crisis and according to the
International Financial Service London (IFSL), Sharia compliant assets Were estimated to have
grown by over 10% a year from about $150 billion in the mid-1990s to $531bn by the end of
2006, with balance sheet assets of Sharia compliant banks totaled $463bn in 2006 (Elsiefy,
2013), and in 2011 total assets in Sharia-compliant financial institutions have doubled to $900
billion (Beck etal.; 2013). Rough three different stages till 2000s. Islamic banking has grown
unabated since its inception in the mid-1970s. The industry has increasingly carved out a
significant slice of the global financial market (Mallin et al., 2014).

As one of the fastest growing sectors in the global financial services in the past three decades,
Islamic finance has become noticeably significant in many countries, and consequently has
gained enormous recognition and credibility worldwide.

Conventional banking are based on interest, while Islamic banking follows Islamic Shariah as the
basis of operation (Siraj and Pillai, 2012), that is based on three main prohibition practices, i.e.
Riba (Interest), Gharar (Uncertainty), and Maysir (Betting) (Amba and Almukharreq, 2013; Beck
et al.; 2013). That is, Islamic banking follows an equity approach than interest-based approach in
both deposit and lending.
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Hence, to be able to compete with conventional banks, Islamic banks have to offer financial
products that are comparable to the ones offered by conventional banks. This exposes Islamic
banks to similar credit, liquidity and risks driven by market instability.

Economists are frequently asked to measure the effects of an economic event on the value of
firms. On the surface this seems like a difficult task, but a measure can be constructed easily
using an event study. Using financial market data, an event study measures the impact of a
specific event on the value of a firm. The usefulness of such a study comes from the fact that,
given rationality in the marketplace, the effects of an event will be reflected immediately in
security prices. Thus a measure of the event's economic impact can be constructed using security
prices observed over a relatively short time period. In contrast, direct productivity related
measures may require many months or even years of observation. The event study has many
applications. In accounting and finance re- search, event studies have been applied to a variety of
firm specific and economy wide events. Some examples include mergers and acquisitions,
earnings announcements, issues of new debt or equity, and announcements of macro- economic
variables such as the trade deficit.1 However, applications in other fields are also abundant. For
example, event studies are used in the field of law and economics to measure the impact on the
value of a firm of a change in the regulatory environment (see G. William Schwert 1981) and in
legal liability cases event studies are used to assess damages (see Mark Mitchell and Jeffry
Netter 1994). In the majority of applications, the focus is the effect of an event on the price of a
particular class of securities of the firm, most often common equity. In this paper the
methodology is discussed in terms of applications that use common equity. However, event
studies can be applied using debt securities with little modification.

This study is equally important for researchers, economists, policy makers and more specifically
for investors, who are more interested to analyze the values of their investments. A change in
monetary policy directly affects financial and real sectors of the economy of Pakistan. This study
aims to test the short-term performances of conventional and Islamic banks after the
announcement of monetary policy. The study is important, as there are many stakeholders
interested in short-term financial performances of Islamic and conventional banking industry.
Firstly, financial performance indicators help regulator to keep an eye on financial industry
outlook and its future growth and challenges. On the basis of financial indictors corrective
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measures can be taken which can be helpful for the banking industry. Secondly shareholders
need to know the performance in order to assess their investment potential and future investment
strategy. The data is taken from Pakistan from year 2011 to 2017.
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Chapter #2

LITERATURE REVIEW
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2. Literature review

Financial intermediaries such as commercial banks (both Islamic and conventional) are
inherently exposed to interest rate risk particularly due to the fact that they have little control
over the deposit structure of the banks. An increase in interest rate signals a higher cost of funds
and banks may have to pay higher interest rates to attract new deposits.

Comparative analysis is often used in literature to measure performance of similar organizations.

Financial ratio analysis is one of the tools which have been used extensively in literature to
measure and compare performance of banks. Samad (2004) carried out study while comparing
Islamic and conventional banks in Bahrain for the years 1991-2001. The result of the study
shows that credit performance of both types between profitability and liquidity. Another study
conducted by Srairi (2010) performed cost and profit efficiency analysis by using stochastic
frontier approach. The study was carried out by analyzing 71 commercial banks in GCC
countries from the year 1999 to 2007. The results reveal that conventional banks are more
efficient than Islamic banks.

Iqbal (2001) has carried out their study regarding performance of Islamic banks by using trend
and ratio analysis for the year 1990 to 1998. Kaleem and Isa (2003) have carried out their study
regarding Islamic and conventional deposit return by using econometric techniques. The results
showed that Islamic banks have significant contribution in developing economies. The result of
the study shows that performance of Islamic banks is better than conventional banks. Akhtar et
al. (2011) has made comparative analysis of Islamic and conventional banks. The results
revealed that liquidity risk and networking capital to asset has positive relationship. Also capital
adequacy of conventional banks and return on assets (ROA) of Islamic banks has positive and
significant relationship with liquidity risk.

Further study reveals that changes in interest rates by a central bank alter equity prices. Rapallo
(1998) used vector auto regressive (VAR) model to investigate the impact of monetary policy on
different European equity markets. A significant relationship has been found by using variance
 17

decomposition and impulse response analysis. Similarly, Gregoriou et al. (2009) examined the
impact of monetary policy on sectorial returns in the United Kingdom by employing panel and
time series regression model and by considering data for the period of 1999 to 2009. The study
reveals that anticipated and unanticipated both components of monetary policy reveal significant
shocks over stock return. The study concluded that market respond against expected and
unexpected components which is being already priced into the market. Gerald and Robert (1995)
examined the impact of discount rate changes on security returns in united during period of 1962
to 1991 through the event. The result reveals that there is an inverse relationship between the
discount rate and stock prices.

Stoica and Diaconasu (2012) analyzed the impact of monetary policy on stock price by using co
–integration and granger casualty test. They argued that there is long and short term relationship
between interest rate and stock prices in European countries. Monetary policy announcement
significantly influences both European and US markets.

As mentioned by Al-Abadi et al (2006) that any variations of the proposed factors may
contribute their impacts on the movement of banks‟ stock return. Theoretically, the
macroeconomics factors such as money supply, industry production index, exchange rate,
interest rate, and inflation are considered as the sources of volatility of stock market and would
be regarded as the leading indicator of banks‟ stock returns. In this case we intend to identify the
sensitivity of banks‟ stock return against the changes of interest rate and exchange rate.
Furthermore, through the revenues costs and profitability of banks also are directly influenced by
the unexpected changes in interest rates and exchange rates (Saunders and Yourougou, 1990).
Likewise the banks‟ discounted cash flows are influenced by the changes of interest rate and
foreign exchange rate. This is indicates that the changes of these variables will have impact on
bank stock returns directly.

Ioannidis and kontonikas (2008) examined the impact of monetary policy on equity prices of 13
OECD countries. The study reveals that different countries have different monetary policy
framework, prove each of them same that stock prices react differently because of their diverse
structures vary from country to country.
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Gerald and Robert (1995) examined the impact of discount rate changes on security returns in
united during period of 1962 to 1991 through the event. The result reveals that there is an inverse
relationship between the discount rate and stock prices.

In another recent study by Srairi (2009), the author compares the profitability of Islamic and
conventional banks for the Golf Cooperation Council (GCC) countries using the bank-scope
database (66 banks). He discusses the determinants of conventional and Islamic bank
profitability in the GCC region and investigates their performance using panel data analysis over
the period 1999–2006. His findings retain the bank's characteristics, macroeconomic variables
and finance industry indicators as significant determinants of profitability for Islamic banks. The
author identifies a strong link between economic growth and banking performance, again
concluding with mixed results regarding the performance superiority of Islamic banks compared
to commercial banks. In the same context, Beck et al. (2010) also investigated the efficiency
hypothesis for Islamic and conventional banking systems.

Understanding the empirical relationship between the monetary policy (exchange rates, interest
rates) and stock prices are important and useful to policy makers, professional investors and
academics. In fact, it has been debated for many years. Although the scholars and practitioners
have studied the subject extensively, the effects of monetary developments in the stock markets
are still not fully understood. It has been argued that a change in stock prices could affect
exchange rates or a change in exchange rates could affect stock prices.

However, there are studies who believe that exchange rate and stock prices have significant
relationship. Some studies of stock market volatility and exchange rates in emerging market,
provide strong evidence that the relationship between stock and foreign exchange markets is
regime dependent and that stock price volatility responds asymmetrically to events in the foreign
exchange market (Walid, Chaker and Fry 2011). This is supported by prior studies (Aggarwal,
1981) which suggest that there is a significant causal relationship from exchange rates to stock
prices. Likewise the fluctuations in the term structure of interest rates result primarily from
changes in inflationary expectations. Bashir and Hassan (1997) have explained that there is a
certain relationship existing between stock returns and changes in interest rates. Despite all these,
there is still not any conclusive causal relationship between exchange rate, interest rate and stock
 19

price. Thus, we believe that the impact of exchange rate and interest rate changes on banks‟
stock return have attracted more interest and major concern to bank managers, regulatory
authorities and academic communities due to the failure of some banks associated with the
adverse effects of fluctuations in the interest rate and exchange rates. Indeed it has also attracted
much attention of the investors in the stock market.

Kashyap and Stein (2000) investigate the cross-sectional differences in the way that banks
respond to monetary policy shocks, not only across bank size 178 International Journal of
Central Banking December 2013 and liquidity but also across bank type—i.e., conventional
versus Islamic—in Pakistan between 2002:Q2 and 2010:Q1.2 The country and sample period
provide a unique setting to analyze this differential response. Pakistan may be one of the few
countries where both well-developed conventional and Islamic banking sectors have coexisted
for a considerable period, formally since 2002 when Islamic banking was reintroduced in
Pakistan. Out of forty banks that grant business loans, six banks are licensed by the Banking
Policy and Regulation Department of the State Bank of Pakistan as sharia compliant full-fledged
Islamic banks.

Despite the fact of the vulnerability of the Islamic financial system to the interest rate as a tool of
monetary policy, Choudhry and Mirakhor (1997) argue that Islamic financial system has indirect
instruments of monetary control and proposes the equity-based government securities with rates
of return based on budgetary surplus that not only improves the efficiency of the economy but
also enhances the reforms of the banking and financial sectors under the establishment of the
Islamic central banks. Although, this is how it should be, the reality is that in the context of
Malaysia according to empirical findings of Haron and Ahmad (2000), there is a clear
relationship between the interest-free deposits, its profit rates and the interest rates of fixed
deposits in the conventional banks. Interestingly, each 1 per cent increase in the rate of profit of
the interest-free deposits is found to increase such deposits by 71 million ringgits, whereas an
increase in the interest rate of the conventional banks significantly decreases the level of interest-
free investment deposits by 65 million ringgits. A result that is consistent with earlier researches
that have been conducted in Sudan, Jordan, Malaysia and Singapore.

As a different view, the Islamic economist Abdullah (2015) argues that the monetary policies
have negative impacts not only on Islamic financial system but also on its conventional
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counterpart. He investigated the effect of monetary theory and banking practices on the
Malaysian economy through a full population analysis of money supply, GDP, interest rates and
prices.

In this study, we examine the importance of the reason why the banks ‟ stock returns can be
responsive to monetary policy shocks (interest rate and foreign exchange rate). According to
Joseph and Vezos (2006), volatility transfer hypothesis suggests that random shocks can induce
higher volatility in financial markets and also due to the contagion effect which are highest in
more volatile markets, thus investors and banks may look abroad to invest in alternative financial
assets.

Using financial market data, an event study measures the impact of a specific event on the value
of a firm. The usefulness of such a study comes from the fact that, given rationality in the
marketplace, the effects of an event will be reflected immediately in security prices. Thus a
measure of the event's economic impact can be constructed using security prices observed over a
relatively short time period.

Event studies have a long history. Perhaps the first published study is James Dolley (1933). In
this work, he examines the price effects of stock splits, studying nominal price changes at the
time of the split. Using a sample of 95 splits from 1921 to 1931, he finds that the price increased
in 57 of the cases and the price declined in only 26 instances. Over the decades from the early
1930s until the late 1960s the level of sophistication of event studies increased. Myers and Bakay
(1948), Barker (1956, 1957, 1958), and Ashley (1962) are examples of studies during this time
period. The improvements included removing general stock market price movements and
separating out confounding events. In the late 1960s seminal studies by Ball and Brown (1968)
and Fama et al. (1969) introduced the methodology that is essentially the same as that which is in
use today.
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Chapter #3

METHODOLOGY
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3. Methodology
3.1 Data

I have to evaluate the “Impact of monetary policy shocks on banking sector of Pakistan”. To examine this
impact I have selected monetary policy variables. Monetary policy is issued by state bank of Pakistan in
Pakistan. State bank of Pakistan is the sole authority of issuing monetary policy. Different types of tools
are used in monetary policy, such as “interest rate” which is also considered as ONR (overnight policy
rate), money supply etc. I have used interest rate as the main variable of monetary policy. Interest rate is
which is also popular as the name of overnight policy rate ONR. To measure an event's economic impact I
am using security prices observed over a relatively short time period. To attain the objectives this study
uses a sample of 10 banks, of which 5 are conventional and 5 are Islamic banks, listed in the Karachi
stock exchange. This study covers the period from January 2012 to June 2017 on a daily basis. The
historical prices of all the securities are collected from KSE official website for period mentioned above.

Rational investors derive their decision based on what maximizes their utility therefore their
main concern when investing is to maximize the future cash flow of their investments. Anything
that affects the future cash flow is included in the decision of whether to invest or not. In order to
address the research objective through gathering evidence from Pakistan, this study analyzes the
impact of the monetary policy shocks on the stock prices of Islamic and conventional banks.
Using financial market data, an event study measures the impact of a specific event on the value
of a firm. The usefulness of such a study comes from the fact that, given rationality in the
marketplace, the effects of an event will be reflected immediately in security prices. In contrast,
direct productivity related measures may require many months or even years of observation. The
objective is to investigate the information content of these announcements. In other words, the
goal is to see if the release of accounting information provides information to the marketplace. If
so there should be a correlation between the observed change of the market value of the company
and the information.

At the outset it is useful to briefly discuss the structure of an event study. This will provide a
basis for the discussion of details later. While there is no unique structure, there is a general flow
of analysis. This flow is discussed in this section. The initial task of conducting an event study is
to define the event of interest and identify the period over which the security prices of the firms
involved in this event will be examined-the event window. It is customary to define the event
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window to be larger than the specific period of interest. This permits examination of periods
surrounding the event. In practice, the period of interest is often expanded to multiple days,
including at least the day of the announcement and the day after the announcement. This captures
the price effects of announcements which occur after the stock market closes on the
announcement day.

The total number of observations in my study are 120 days, hundred days before the event and
twenty days after the event. The period of interest is of 30 days, 10 days before the
announcement of event and 20 days after the announcement of event. The periods prior to the
event are included because the market may acquire information about the performance prior to
the actual announcement and one can investigate this possibility by examining pre-event returns.

List of conventional banks used in this study;

Allied banks limited, Bank-al-Habib limited, Habib bank limited, Bank Alfalah limited, United
bank limited.

List of Islamic banks used in this study;

Meezan Bank limited, Bank Islami limited, First Dawood investment Bank limited, The Bank of
Khyber, Askari Bank limited.

List of monetary policy dates used in this study;

1. 8 June 2012
2. 14 December 2012
3. 13 November 2013
4. 15 March 2014
5. 15 November 2014
6. 12 September 2015
7. 21 November 2015
8. 30 January 2016
9. 26 November 2016
10. 20 May 2017

Monetary policy announcements or events will have different impacts on the performance of
Islamic and conventional banks because in some announcements the policy rate will be
increasing and decreasing in some other and in some policy statements policy the rate will
 25

remain the same as in the previous. Therefore, I categorized the events in three categories
1.increasing 2.decreasing 3.maintained or unchanged, and then investigated their impacts on the
performance of Islamic and conventional banks through the functions discussed below.

3.2 Security return

After identifying timeline of the study I first calculated the individual security returns. The
Security return is the return of single security. A return is the gain or loss of a security in a
particular period. Formula for return (RI):

Ri=ln ( pp 12 )
RI is the return of the individual security, where P1 and P2 are the present and previous day
values of the stock price respectively.
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3.3 Market Return

In other words market return is also called market performance or. A number of approaches are
available to calculate the normal return of a given security. The approaches can be loosely
grouped into two categories-statistical and economic

Rm=ln ( P1
P2 )

Rm is the market return on stocks, here P1 and P2 are the present and previous day closing
values of market as a whole.

3.4 Market Model

The market model is a statistical model which relates the return of any given security to the
return of the market portfolio. The model's linear specification follows from the assumed joint
normality of asset return. In applications a broad based stock index is used for the market
portfolio, with the 100 Index. The benefit from using the market model will depend upon the R2
of the market model regression. The higher the R2 the greater is the variance reduction of the
abnormal return, and the larger is the gain.

Rit=αi+ βiRmt + ↋it

3.5 Abnormal Returns

In this section the problem of measuring and analyzing abnormal returns is considered. The
framework is developed using the market model as the normal performance return model.

Some notation is first defined to facilitate the measurement and analysis of abnormal returns.
Returns will be indexed in event time using t. Defining t = 0 as the event date, t = T1 to t = T2
represents the event window, and t = To to t= T1 constitutes the estimation window. Let L1 = T1
- To and L2= T2- T1 be the length of the estimation window and the event window respectively.
 27

This facilitates the use of abnormal returns around the event day in the analysis. When
applicable, the post- event window will be from t = T2 to t = T3.

Figure: 1. Time line for an event study

It is typical for the estimation window and the event window not to overlap. This design provides
estimators for the parameters of the normal return model which are not influenced by the returns
around the event. Including the event window in the estimation of the normal model parameters
could lead to the event returns having a large influence on the normal return measure. In this
situation both the normal returns and the abnormal returns would capture the event impact. This
would be problematic because the methodology is built around the assumption that the event
impact is captured by the abnormal returns. On occasion, the post event window data is included
with the estimation window data to estimate the normal return model. The goal of this approach
is to increase the robustness of the normal market return measure to gradual changes in its
parameters.

Given the market model parameter estimates, one can measure and analyze the abnormal returns.
Using the market model to measure the normal return, the sample abnormal return is

AR=Ri−Rm

AR is the abnormal return of the portfolio, where Ri and Rm are security and the market return
of the on stocks respectively.

3.6 Aggregation of Abnormal Returns

 28

The abnormal return observations is aggregated in order to draw overall inferences for the event

of interest. The individual securities abnormal returns can be aggregated using ARit for each

event period, Given N events, the sample aggregated abnormal returns for period t is

I
AVG . AR= ∑ ARit
N

Avg.AR is the avg. of all abnormal returns of the individual securities, N is the number of events.

3.7 Cumulative abnormal return

The concept of a cumulative abnormal return is necessary to accommodate for a multiple period
event window. CAR is the sum of abnormal returns. CAR will help us to measure the effect of
the event

CAR=∑ AR

CAR is the cumulative abnormal returns, it is the sum of all the abnormal returns of the
individual securities.
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Chapter #4

RESULTS AND DISCUSSION

 30

4. Results

This part presents the findings of the study which aims to compare performance of both Islamic
and conventional banks after the announcement of monetary policy.

Table No.1 Abnormal Returns (AR)

ABNORMAL RETURNS (AR)

NO CHANGE IN POLICY DECREASE IN POLICY
RATE RATE INCREASE IN POLICY RATE
Conventional Islamic Conventional Islamic Conventional Islamic
0 0 0 0 0 0
0.000651448 0.007144 -0.004712806 -0.001227 0.013639801 -0.002559
-0.000857072 0.008637 0.003755256 0.0055494 -0.007465951 0.0034235
-0.000497573 -0.00348 0.003547413 0.000126 0.012406244 -0.018028
0.001164002 0.010503 -0.000608001 0.0083298 0.002189253 -0.015385
-0.001529209 -0.00914 -0.001853443 0.0086427 -0.004890763 0.0271737
-0.004615411 0.004588 -0.001098705 -0.001957 -0.002151389 -0.000533
-6.51522E-05 -0.00172 -0.004592026 0.0007698 0.012311178 0.0203265
-0.003165131 5.1E-05 -0.001697815 -0.017503 0.004312699 0.0192759
-0.009087904 -0.00413 0.002032835 0.0022644 0.009541313 -0.008674
0.006951865 0.002255 -0.005598567 -0.017773 -0.01389756 -0.006591
0.002134849 -0.00647 -0.003021417 -0.000388 -0.00322136 0.0014847
0.003981987 0.002266 -0.002852111 -0.000633 -0.00532897 -0.00961
-0.00793945 0.007343 -0.001699338 -0.002072 -0.003694643 -0.004658
-0.001519913 -0.00973 -5.70304E-05 -0.004094 -0.001937647 -0.029975
-0.001030556 0.006547 -0.00132652 -0.003486 0.001367653 -0.002393
0.00180877 0.001139 -0.006570247 -0.004858 0.004521964 0.0127143
-0.001110072 -0.00475 0.000502177 0.0032282 -0.008757829 0.0231126
0.00429445 -0.00095 -0.000902298 0.011894 0.001366119 -0.020772
-0.000197477 0.00451 -0.002801941 -0.009241 0.000589396 0.0411771
0.002842351 -0.0074 -0.001533689 -0.003421 0.013810921 -0.04956
-0.000116766 0.009187 -0.004399101 -0.011403 -0.002934992 -0.001047
0.001396643 -0.00891 -0.00182003 0.0047976 -0.008958001 0.0204415
0.002012278 0.002382 0.007349618 0.0087761 -0.002249305 0.0034693
-0.001608139 -0.00581 0.0022151 -0.008256 -0.000909333 0.0097309
0.005111995 0.006803 0.002017648 -0.004214 -0.003692188 -0.001559
0.001938927 -0.0064 -0.003307604 -0.006407 -0.004298751 0.0108345
0.002950696 -0.00243 0.001371282 -0.001378 -0.001814025 0.009988
-0.001089339 0.003121 -0.002737218 -0.00144 0.00270369 -0.016555
0.001436957 0.007502 0.002636966 -0.006122 -0.096638984 0.0359093
 31

Table No.2 Cumulative Abnormal Returns (CAR)

CUMULATIVE ABNORMAL RETURNS (CAR)
NO CHANGE IN POLICY DECREASE IN THE INCREASE IN THE POLICY
RATE POLICY RATE RATE
Conventional Islamic Conventional Islamic Conventional Islamic
0 0 0 0 0 0
0.019543441 0.214333 -0.070692088 -0.01841 0.068199003 -0.01279
-0.00616871 0.473434 -0.014363244 0.064829 0.03086925 0.004323
-0.021095915 0.369142 0.038847951 0.066719 0.092900468 -0.08582
0.013824143 0.684242 0.029727929 0.191666 0.103846735 -0.16274
-0.032052133 0.410148 0.001926289 0.321306 0.07939292 -0.02687
-0.170514476 0.547801 -0.014554293 0.291946 0.068635973 -0.02954
-0.172469043 0.496086 -0.083434676 0.303493 0.130191865 0.072094
-0.267422968 0.497617 -0.108901897 0.04095 0.151755359 0.168474
-0.540060084 0.373691 -0.078409367 0.074916 0.199461926 0.125105
-0.331504119 0.44135 -0.162387878 -0.19167 0.129974128 0.092151
-0.267458637 0.247158 -0.207709128 -0.19749 0.11386733 0.099575
-0.147999037 0.315137 -0.250490792 -0.20698 0.087222482 0.051527
-0.386182525 0.535412 -0.275980861 -0.23806 0.068749267 0.028236
-0.431779904 0.243646 -0.276836317 -0.29947 0.059061031 -0.12164
-0.462696597 0.440068 -0.296734121 -0.35175 0.065899295 -0.1336
-0.408433505 0.474249 -0.395287827 -0.42462 0.088509117 -0.07003
-0.441735655 0.331669 -0.387755173 -0.3762 0.044719969 0.045534
-0.312902141 0.303151 -0.40128965 -0.19779 0.051550564 -0.05832
-0.318826465 0.438442 -0.443318769 -0.3364 0.054497544 0.147562
-0.233555933 0.2164 -0.466324106 -0.38771 0.123552149 -0.10024
-0.237058906 0.492009 -0.532310619 -0.55875 0.108877188 -0.10547
-0.195159603 0.224772 -0.559611064 -0.48679 0.064087182 -0.00326
-0.13479126 0.296226 -0.4493668 -0.35515 0.052840659 0.014083
-0.183035424 0.122066 -0.416140305 -0.479 0.048293993 0.062737
-0.02967556 0.326143 -0.385875592 -0.5422 0.029833056 0.054943
0.028492258 0.13419 -0.435489659 -0.63831 0.008339302 0.109115
0.117013152 0.061143 -0.414920432 -0.65898 -0.000730824 0.159055
0.084332979 0.154776 -0.455978709 -0.68058 0.012787624 0.076282
0.127441698 0.37983 -0.416424216 -0.77242 -0.470407295 0.255828
 32

Table.1 shows the comparison of Islamic and conventional banks AR’s and how they react when
there is decrease, increase or no change in the policy rate.

When there is no change in the policy rate, there is a positive change in the values of
conventional and Islamic Banks’s AR. On the other hand if the policy rate decreases there is
negative change in the values of Islamic banks AR, but relatively no change in the conventional
banks AR. If the policy rate increases it has the negative effect on the values of the AR of both
Islamic and conventional banks.

Table.2 shows the comparison of Islamic and conventional banks CAR’s and how they react
when there is decrease, increase or no change in the policy rate.

When there is no change in the policy rate, there is a slight but positive change in the values of
conventional and Islamic Banks’s CAR’s. On the other hand if the policy rate decreases there is
negative change in the values of Islamic banks CAR’s but relatively no change in the
conventional banks CAR’s. If the policy rate increases it has the negative effect on the values of
the CAR’s of both Islamic and conventional banks.
 33

Graph.1 shows the results of how the abnormal returns of Islamic and conventional banks are
effected by the change in policy rate. We can see there were little fluctuations in the returns of
Islamic banks but they were in positive numbers most of the times before the event took place,
but right after the event values goes in negative numbers remain their till the very end. On the
other hand the returns of the conventional banks were already in the downward direction before
the event day, but after the decrease in the policy rate the returns of the conventional banks
started to grow with very little fluctuations and we can see the direction of the line is upward till
the last day of the observation.

POLICY RATE DECREASE

0.02

0.01

0.01

0
AR -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
-0.01

-0.01

-0.02

-0.02

DAYS

Conventional Islamic

Graph No.1: Abnormal Returns (Islamic Vs. Conventional)

 34

Graph.2 shows the cumulative abnormal returns of the conventional and Islamic banks and how
they react to change in policy rate which is decreasing in this case. CAR’s of the Islamic banks
were growing in the positive numbers till the event day, but after the event day they went in
negative numbers and remain their till the end. On the other hand the CAR’s of the conventional
banks were lower as compared to the Islamic bank before the event took place, the direction of
the line is in the downward direction as we can see and remain there for few days and then
started to grow as we can see in the end of the observation. So we can say decrease in the policy
rate have little and positive effects on the CAR’s of the conventional banks.

POLICY RATE DECREASE

0.4

0.2

0
-9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
-0.2
CAR
-0.4

-0.6

-0.8

-1

DAYS

Conventional Islamic

Graph No.2: Cumulative Abnormal Returns (Conventional Vs. Islamic)

 35

Graph.3 shows the abnormal returns of the Islamic and conventional banks and how the react
when there is no change in the policy rate of the period. We can see there are many and more
pronounce fluctuations in the CAR’s of the Islamic banks before the event day and the
fluctuations remain the same after the event day. And conventional banks have also fluctuations
but they were little as compared to the Islamic bank, this trend also remain the same before and
after the event day.

NO CHANGE IN POLICY RATE

0.02

0.01

0.01

AR 0
-9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

-0.01

-0.01

-0.02

DAYS

Conventional Islamic

Graph No.3: Abnormal Returns (Conventional Vs. Islamic)

 36

Graph.4 shows the cumulative abnormal returns of the Islamic and conventional banks when
there is no change in the policy rate. We can see the CAR’s of the Islamic banks are high then
there counterparts, and it seems that there is no effect of the maintained policy rate on CAR’s of
the Islamic bank because they remain in the same trend before and after the event day. On the
other hand conventional banks CAR’s were in negative numbers before the event took place but
after the event the CAR’s of the conventional banks started to rise and rose to positive values as
we can.

So we can definitely assume that no change in the policy rate have positive effects on the
conventional banks performances and relatively no effects on the Islamic banks.

NO CHANGE IN POLICY RATE

0.8
0.6
0.4
0.2
CAR 0
-9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
-0.2
-0.4
-0.6
-0.8

DAYS

Conventional Islamic

Figure No.4: Cumulative Abnormal Returns (Conventional Vs. Islamic)

 37

Graph.5 shows how increase in the policy rate effects the abnormal returns of the Islamic and
conventional banks. In the graph we can see there are little fluctuations in the AR’s of the both
Islamic and conventional banks before the event day but the event took place the fluctuations in
AR’s of Islamic banks are bigger and they starting to rise as we can see in the end. And the AR’s
of the conventional banks after the event day are on exactly opposite direction as they reached to
-0.1.

So we can assume that Islamic banks have positive effects on the AR’s of Islamic bank and
negative effects on the AR’s of the conventional banks.

POLICY RATE INCREASE

0.06
0.04
0.02
0
-9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 101112 131415 1617 181920
-0.02
AR
-0.04
-0.06
-0.08
-0.1
-0.12

DAYS

Conventional Islamic

Graph No.5: Abnormal Returns (Conventional Vs. Islamic)

 38

Graph.6 shows the cumulative abnormal returns of the Islamic and conventional banks after the
increase in the policy rate. CAR’s of the Islamic banks have little fluctuations before the event
but they seems to be growing after announcement of the policy rate. On the other hand
conventional banks CAR’s were growing before the event took place, but right after the
announcement the CAR’s of the conventional banks started to fall, and they are exactly on
opposite direction to their counterparts.

POLICY RATE INCREASE

0.3
0.2
0.1
0
-9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
-0.1
CAR
-0.2
-0.3
-0.4
-0.5
-0.6
DAYS

Conventional Islamic

Graph No.6 Cumulative Abnormal Returns (Conventional Vs. Islamic)

 39

5.Conclusion

This paper is aimed at investigating the effect of monetary policy shocks on the Islamic and
conventional banks in Pakistan. Monetary policy announcements are categorized as increasing
policy rate, decreasing and no change in policy rate.

The results suggest the following; if the monetary policy rate increases it will negatively affect
the returns of conventional banks, and will have positive effects on the Islamic banks stock
returns. And if the policy rate decreases it will affect the stock returns of conventional banks
positively and no effect on the returns of Islamic banks. If there is no change in the policy rate it
will again effect the returns of conventional banks positively and relatively less and positive
effects on Islamic banks returns.

There are several limitations to our study but two are worth of note. First, there is relatively less
prior theoretical or empirical literature that compares the impact of monetary policy shocks on
the stocks returns of Islamic and conventional banks of Pakistan. Second my study have little
amount of banks samples because there not many full-fledged Islamic banks running in Pakistan.

The results show that over the five years of study, there are statistical significant differences in
CAR which indicate higher liquidity for Islamic banks and this is an expected result for Islamic
banks, as Islamic banks have limited investment opportunities resulted from the prohibition of
interest. In addition, Islamic banks cannot rely on borrowing money from central bank when
money is needed because of interest prohibition. Islamic banks are found to be more liquid than
conventional bank, which is consistent with the general literature view that Islamic banks suffer
liquidity excess.
 40

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