Islamic Banking and Profitability in Saudi Arabia (Research Proposal Sample)

Dissertation Proposal: Islamic Banking and Profitability in Saudi Arabia
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Dissertation Proposal: Islamic Banking and Profitability in Saudi Arabia
Islamic banking is banking activity, which is consistent with principles of Islamic Shariah, and their practical application that are meant to develop the whole scope of Islamic economics. Specifically, some banking institutions call it Shariah Compliant Finance (Nzibo 2014). Since the Shariah, principles prohibit floating or fixed payments or acceptance of any fees or interests (usury or riba) on any loanable finance, the banks participates in sharing of losses or profits with the borrower. It is important to note that although Islamic principles have been applied by various historical Islamic economies at varying degrees, it is only in the twentieth century that their usages have become widely applicable in Islamic community (Sailan Muslim 2009; Iqbal and Molyneux 2006). According to Ernst & Young report, the Islamic banking is rising rapidly continuously gaining a lot of popularity in both Muslim and non-Muslim communities. Saudi Arabia, which is one of the largest hubs of Islamic Banking, has accounted a total asset value of $ 1.6 trillion (Ghafoour 2013). Therefore, this proposal seeks to lay out the framework of the study that will investigate to establish relationship between Islamic Banking and profitability in the Kingdom of Saudi Arabia.
Research Questions
* What are the general characteristics of Islamic Banking?
* Identify contrasting elements of conventional banking and Islamic banking towards profitability
* Identify common Shariah compliant instruments in Saudi Arabia.
* What are the internal determinants of profitability in the banking sector?
* What are the macroeconomic interactions/ external determinants that affect profitability in Islamic Banking?
* How can profitability in Islamic Banking be measured?
Objectives of this Study
* To describe the general characteristics of Islamic Banking
* Identify and discuss the most contrasting elements between the conventional and Shariah compliant banks.
* To discuss the Shariah compliant instruments that banks in Saudi Arabia apply.
* To identify and discuss the internal determinants of profitability to banks in Saudi Arabia
* To realize the macroeconomic/external determinants interaction that favors/ hinders the growth of profitability in Islamic Banking in Saudi Arabia.
* To propose how profitability in the banking sector can be measured
Literature Review
Islamic banking is a banking system that is based on Islamic Shariah principles in the whole guidance of Islamic Economics. It is found on two basic principles: prohibition of Interest collection and sharing of loss and profits between the bank and the customer. Generally, Islamic banking espouses certain features that normally distinguish it from conventional banking. The first characteristic of Islamic baking is to avoid riba (interest) (Lewis 2013). Riba is perceived to be an increase in money form without an increase in the assets themselves. Therefore, this increase, which represents nothing, when charged, is forbidden according to Islamic jurisprudence. Secondly, Islamic banking ensures that the bank shares profit and loss with the borrower. This acts like partnership venture that is backed with real assets in the process of financing. By eliminating perils of uncertainties (gharar) and interest (riba), they promote the real economic activities and thus the economy may not plunge into effects of recession (IBNI 2014). Since the banks do not charge interest to avert its risks, it ensures that there is a very careful evaluation of risks on any investment demand they undertake with the customers. The banks are normally conceived to be multi-purpose but not purely commercial. They are actually crossbreeds of investment management institutions and investment trusts, investment and commercial banks and therefore offer a variety of services to its customers. Being equity oriented institutions, they cannot permit their management to borrow for short term and lend for long term (Bashir 2000). The banks operate primarily on the principles of Shariah unlike the conventional commercial banks, which do so on manmade basis (Beck, Demirguc and Merrouche 2010). The Islamic banks promote risk sharing between the customer and themselves, unlike the case in commercial banks where investor is assured of the prefixed interest. Islamic banking collects zakat, which is not applicable in conventional commercial banks. Moreover, the Islamic banks functions on partnership with the borrower unlike the conventional commercial banks which are just determined to get bank full interest and principal. Although the conventional banks may charge extra money on defaulters, Islamic banks are not mandated to do so. The Islamic banks will always participate in ensuring that equity grows, which is not the case in the conventional banks. Therefore, the Shariah compliant banks pay greater attention to appraising and evaluating any development projects. As the conventional commercial bank gives a lot of emphasis on credit worthiness of the customer, Islamic banking is much concerned with the viability of the project. Therefore, the relation of a client in an Islamic bank is that of partners, which is different from that of commercial bank that is characterized with the creditor –borrower (Beck, Demirguc and Merrouche 2010).
Shariah Compliant Instruments and Generation of Profits
For equity structure instruments, the Islamic banking system has instituted Musharaka to refer to partnership. In this case, the borrower agrees with the lender bank to start and run the business venture but return to him the agreed share of profit/loss and the principle (Faizulayev 2011). On the debt structure, Murabaha is a markup/ cost plus, which involves purchasing of a tangible asset from a third party and selling it to the client at an agreed price on installments where profit margins are added (Islamic Development Bank 2014) . This is not the case in commercial bank, the markup should not be so high, and it is mandatory that the buyer is aware. On Ijara, the Islamic bank will acquire assets on behalf of customers leasing them to willing clients over a specific period and although getting profit, it avoids charging interest rate. In Istisna, an Islamic bank will finance the construction of an engine, ship or other assets so that payment can be made later to it. Qard Hassan is an interest free loan that is only acceptable in Islam. In Wadia, a customer will deposit money in the bank, earning nothing as the bank use the money as it desires. However, his funds must be secured (Faizulayev 2011).
Internal Determinants of Profitability in Islamic Banking
For internal sources that determine profitability, analysts list fund use management, fund source management, and liquidity and capital ratios that determine the internal profitability of the Islamic banks. In this case, it is noted that profitable banks are normally well capitalized or enjoy cheaper sources of capital for any subsequent improvement of its structures. Profitability was also seen to be very much dependent on the ratio between bank loans to the total assets. Since the Islamic banks normally do not depend on interests on loans to earn profits, during difficult times of businesses, their profitability can be under stress. The reverse, however, may be true. The type of ownership are also likely to affect the profitability of the firm indicating that depending on domestic ownership, banks may benefit from tax breaks among other preferential treatments. Other important determinants are asset quality, capital size, and managerial operations size (Wasiuzzaman and Tarmizi 2010).
External Determinants of Profitability in Islamic Banking
External determinants on an Islamic Bank’s profitability are those that cannot be controlled by its management. Among the widely known and discussed external determinants are the market share, competition variables, concentration, regulation, inflation, and money supply, scarcity of capital and size of the industry. On Competition, there is no resolved opinion whether competition affects profitability or not. Most researchers would like however to incorporate it in market structure in the scope of regulations. Concentration, which is defined as the size and number of firms in the market, has had positive impact on profitability (Haron and Azmi 2004). When the firm has a bigger market share, it is evident that it will increase in efficiency and hence profitability. The scarcity of capital as determined by high interest rate on it may hinder the profitability of firms in the market. Most researchers nevertheless agree that expansion in money supply would increase profitability in banking sectors. On inflation, it was also found that it had positive relationship with profitability of the banks (Wasiuzzaman and Tarmizi 2010).
Measuring Profitability in Islamic Banking by Derivations from Internal Determinants
To measure the return on the above instruments of Shariah compliant banks, banking firms are employing measures such as Return on Assets (ROA), Rate of return on investment deposits (ROD), Return on assets (ROA) and Return on investment Deposits (ROD) (Haron and Azmi 2004).. Others are Net Interest margin, but in the case of Islamic banking, it will be used to refer to profit on costless assets to match with conventional banking. The other measure consists of liquidity ratio, which will be shown by Loans to Asset ratio. It should be understood that when things are constant, deposits are transformed into loans, which may result in the bank having higher profits. However if the banks have to fund the high loan portfolios i...