Chapter 1: Introduction
This chapter discusses the aims and objectives of the project. A detailed background of the study, research rationale and theoretical framework has also been discussed in this chapter. At the end of this chapter, the report structure of this thesis is mentioned.
Islamic Bank of Britain vs. Dubai Islamic Bank (A Comparative Study)
1.2- Background of Study
Islamic banking is very different as opposed to conventional banking, as it works on the principles of Islam and Sharia which entails avoiding interest and gives more preference to invest in a business and in sharing of profit and loss.
There are several Islamic banks all over the world and all of them operate on the Sharia principles, however some progress to profit and some decline to loss and a prime example of this is the Islamic Bank of Britain.
The Islamic bank of Britain was founded in 2004 by a group of Middle East investors. This was the first Islamic Bank in the United Kingdom. The formation of this bank was based on the simple foundation of Sharia conduct with typical products and services, however the bank underperformed, more so than anticipated. Losses were evident from the initiation of its business in the United Kingdom. Moreover, according to Financial times and its 2008 income statement, a loss of <£5,910,700 > was highlighting, displaying major cause for concern.
On the other hand, the Dubai Islamic Bank which was founded in UAE by Arabic investors and also adheres to Sharia principles has reported quarterly profit of US$ 122.5 million. This then raises the questions as to why Islamic Bank of Britain has been unable to attract the customers and what are the main factors causing losses for the bank every year.
1.3- Research Aim
The aim of conducting this research is to discover the factors and causes’ troubling Islamic banking in United Kingdom as one of the major Islamic bank has accumulated losses for a considerable period of time, although its entrepreneurs are from the Gulf where Islamic banking has been growing and prospering. Moreover the rules of Sharia apply whether the Islamic Bank is in the UK or in UAE.
After uncovering the underlying causes of the Islamic bankings’ plight in the United Kingdom recommendations will be drawn up to rectify the situation and highlight how improvements can be made. Circumstances will further be examined in form of comparisons between the United Kingdom and the UAE Islamic banks.
1.4- Research Objectives
The objectives of this research are as follows:
- To investigate the performance of Islamic banks in UK and UAE
- To explore the reasons that affect the performance of Islamic Banks
- To study the investment portfolio of Islamic Banks in UK and UAE
- To analyse the impact of risks on the performance of Islamic Banks in UK and UAE
1.5- Research Rationale
Islamic banking is a relatively new topic in the financial sector and especially in UK where the first Islamic bank started its business only in 2004. Though Islamic banks are quite successful across the globe, the first Islamic bank established in UK has not been able to gain significant success in the past 5 years. There is currently insufficient research conducted in regards to the performance of Islamic banks in the UK. This fact compels one to investigate this issue in order to gain some strong knowledge about the topic.
1.6- Theoretical Framework
This research was designed in a structured format. Initially, a detailed study of literature was conducted. The purpose of this literature review was to gain an insight in regards to Islamic banking functioning across the globe. After reviewing the relevant literature, assessments were made as to how different Islamic banks improve their performance by designing their investment policies and how different type of risks can affect the performance of Islamic banks. This assisted in the analysis of both Dubai Islamic Bank and Islamic Bank of Britain, which further assisted in arriving at a conclusion to determine the reasons of poor performance of Islamic Bank of Britain.
1.7- Structure of Thesis
Chapter 2 provides a review from literature which has been distributed into three sections. The first section describes the origin of banking and the main purpose of starting the banking. Second section explains about Islamic banking and its main functions.
Chapter 3 discusses the current business operations of both the banks. I have given a detailed description of where both the banks invest their assets and how do they manage the risks. The purpose of this chapter is to find out how different investment and risk management techniques help the Islamic banks to give better performance.
Chapter 4 highlights the methodology used in this thesis. A detailed description of the research methods used in thesis has been given in this chapter. All the sources of data used in this thesis have been explained in details and at the end of this chapter; I have given a detailed description of different accounting ratios used in this thesis. In this chapter, I have given a detailed description about the research methods used in this thesis.
Chapter 5 comprises of different financial calculations. I have calculated various financial ratios for both the banks in order to do a side by side comparison to find out the reasons of poor performance of Islamic Bank of Britain.
Chapter 6 includes a side by side comparison of the financial ratios of both the banks calculated in chapter 5. In addition to this, regression analysis has been given between certain risk ratios and profitability ratios to find out the impact of risk levels on returns. The possible reasons of poor performance of Islamic Bank of Britain in line with literature review and results in chapter 3 have also been discussed in this chapter.
Chapter 7 discusses the conclusion of this thesis. All the research questions have been answered in an appropriate manner in line with the literature review and the results discussed in chapter 3, 5 & 6. At the end of this chapter, I have discussed any limitations of this research work.
Chapter 2: Literature Review
This chapter provides a review from literature. It has been distributed into three sections. The first section describes about origin of banking and the main purpose of starting the banking. The second section explains Islamic banking and its main functions. Lastly the third section explains the origin of Islamic banking in Dubai and United Kingdom.
2.2- History of Banking
The origins of banking are believed to have started after coinage, in the area between river Tigris and river Euphrates. People could keep their belongings safely in royal palaces and holy places. Within same period, some laws were developed and these laws are considered to be one of the earliest forms of laws (Glyn, 2002).
2.3- Banking Business
A business that provides financial services to different customers and businesses is called as banking. A detailed definition of banking business can be a financial institution that accepts, collects, transfers, pays, safeguards or lends money for its customers (Sobczak, 1997, pp 6).
2.4- Islamic Banking
A financial institution that operates under the principles of Islamic Shari’ah and it does not accept or pay out any interest (riba) is called an Islamic bank (Sadeque, 1980). Islamic banking is based on the idea of sharing profit and losses. Both the investor and the bank share any profits and losses as agreed at the time of opening the account (Venardos, 2006, pp 1).
2.5- History of Islamic Banking
A few decades ago, conventional banks and other financial organisations were not providing the customers with any Shari’ah compliant services. This led to the necessity of starting such a financial institution that could provide the Muslim clients with the Shari’ah compliant services. The original Islamic bank initiated business in 1963. During the later years of 1970’s, the Association of Islamic banks was established. Initially, Islamic banks were only operating in Islamic countries. In 1980, the first Islamic bank was open in a non-Islamic country and it further expanded into additional European and American countries. Within this short span of time, Islamic banks have progressed very well all over the world (Venardos, 2005, pp 65).
2.6- Services offered by Islamic Banks
Islamic banks offer a range of services to their customers. A detailed description of these services is explained below.
2.5.1- Deposit Accounts
Islamic banks offer three types of deposit accounts: current, savings and investment accounts. The customers are assured that they can withdraw their money on demand if agreed by both parties at the time of opening the account. In Islamic banking, demand deposits are places in a contract called Wadiah (trust). Islamic banks guarantee their customers to return their principal sum on demand. The banks cannot use this principal sum unless authorised by the customers. As the banks do not use this amount for their investments they do not pay back any profits on such accounts. Some banks offer some returns in the form of Hibah (gift). Islamic banks are using some innovative techniques for offering different products and most of the demand deposit accounts are structured within the contract of Mudharabah (Saeed, 1996, pp 101).
2.5.2- Current Accounts
Current or demand deposit accounts are the same as those of conventional banks. Islamic banks guarantee the principal amount on demand (Hassan and Lewis, 2007, pp 131).
2.5.3- Saving Accounts
Saving accounts are different from conventional banks in Islamic banking. In some Islamic banks, the depositors authorise the banks to use their deposited money, however they are guaranteed that they will be returned the full amount back from the bank. No profit is guaranteed in this sort of accounts. The banks usually use these deposits for short term projects (Al-Omar and Abdel-Haq, 1996, pp 51).
2.5.4- Investment Accounts
Islamic banks accept the investment deposits for a fixed or unlimited time period. The investors agree at the time of opening the account to share any profit and loss at an agreed proportion. The banks do not guarantee to return the principal amount. Usually, the investment deposits have an expected maturity and expected rate of returns. Such investments are places under Mudharabah contract in which both the depositor and the bank agree at a ratio to share any profits or losses. This type of investment is totally different from conventional banks as there is no risk of losing any thing in those investments (Iqbal and Llewellyn, 2002, pp 198).
2.7- Financing modes in Islamic Banking
Different banks use different modes to acquire assets and finance different projects. These modes can be distributed into three different areas namely investment, trade and lending services.
2.6.1- Investment Finance
Khan (2009) says that Islamic banks can do investment financing in three different ways. First type of investment financing is called as Musharaka. In this type of investment financing, the bank can join another organisation or entity to open a joint venture. Both the parties participate in this venture in different roles. Both the parties agree on a set ratio of sharing any loss or profit before making such a venture. This type of venture is an independent entity and the bank can withdraw from this venture after an initial period. Second type of investment financing is called as Mudarabha in which the bank finances the projects and the clients provide with their expertise, labour and management. Both the parties i.e. bank and the clients share the profit but in case of any losses, it’s only the bank that will bear the losses. In third type of investment financing, the banks finance on the basis of an expected rate of return. If the profits are more than the expected rate of return, the bank shares it with the clients but if the returns are lower than the expected rate, the bank will accept the lower rates. In case of any losses, the bank will share it (Khan, 2009).
2.6.2- Trade Finance
Khan (2009) says that Islamic banks can do trade financing in different ways. The most common type of trade financing is called as Mark-up in which the bank buys an item for its client and the client agrees to pay back the bank the price and the agreed profit at later stage. In second type of trade financing, the bank buys an item for the client and then leases it to client for an agreed time period. At the end of the lease, the client pays the balance amount to the bank and becomes the owner of the item. Another type of trade financing is called as hire-purchase in which, the bank buys an item for its client and then hires it to the client for an agreed time period. At the end of this time period, the client becomes the owner automatically. Another type of trade finance in Islamic banking is called as sell-and-buy-back in which a client sells his property to the bank for an agreed time period at a condition that the client will buy back the property at an agreed rate.
2.6.3- Trade Finance
Khan (2009) says that Islamic banks have different types of lending services including loans, no-cost-loans and overdrafts. Islamic banks offer the loans by charging the service charge. The bank does not charge any interest but they apply service charges to cover their expenses. Some Islamic banks offer the loans to needy people at no costs. Some Islamic banks also offer the overdraft services to the customers subject to some limits. The banks charge a certain amount if the customer’s request higher overdraft limits.
2.6.4- Miscellaneous Services
Islamic banks offer additional services such as collecting the bills on behalf of different organisations, money transfers, trading foreign currency etc. Some banks charge a commission amount if their own money is not involved in such transactions.
2.8- Risks in Islamic Banking
Khan (2003, pp 130-131) says that Islamic banking faces certain risks like conventional banking. The nature of these risks varies with the structure of the bank. As discussed earlier, Islamic banks usually operate under two different kinds of models. First type of model is known as the two tier Mudarabah model. This type of model operates under the principle of sharing both the profits and losses. The latter model is known as the single tier Mudarabah model. In this type of model, both the parties share the profit just on the liabilities side. Lewis and Hassan (2007, pp 144) say that Islamic banks have to follow certain rules based on Islamic Shari’ah. Both the authors believe that in this kind of situation, the nature of risk changes for Islamic banks and only a careful management of these risks can result in the better performance of the bank. Islamic banks face following risks:
- Operational Risks
- Credit Risks
- Liquidity Risks
- Withdrawal Risks
- Legal Risks
2.7.1- Operational Risks
El-Hawary (2005, pp 21) says that this type of risk is caused when the people working for the bank fail to perform their duties appropriately or the systems used by the bank staff fail. Most of the time, this risk is caused due to the employees of the bank or any frauds. El-Hawary (2005, pp 21,22) has quoted the example of Dubai Islamic bank when the bank suffered huge losses due to an incompetent person during the later years of 1990’s. Iqbal et al (1998) considers that the Islamic banks face more operational risk than conventional banks as a minor problem in computer systems can cost them too much.
2.7.2- Credit Risk
Sundrarajan and Errico (2002, pp 5) believe that Islamic banks administer the profit loss accounts differently from conventional banks. Islamic banks determine the profit and loss ratios of different projects before the start of any agreement. On the basis of this expectation, Islamic banks set a share ratio that sometimes can cause them losses. In addition to this, Islamic banks carry on auditing the financial projects. In such situations, it becomes very difficult for the banks to standardise their financial products. Cihak and Hesse (2008, pp 5) believe that in PLS (Profit and loss sharing) accounts, the banks suffer losses as well if the profits are lower or the project ends in a loss. They believe that this is due to the reduced level of assets in the balance sheet. Sundrarajan and Errico (2002, pp 5) believe that in Mudarabah accounts, the banks can only share the profits but if the business ends up in loss, it becomes very difficult for the bank to recover the loans back due to some legal complications as the Mudarabah accounts do not allow the Islamic banks to interfere in the business. On the other hand, in the case of Musharaka account, Islamic banks can monitor the financed projects and it reduces the risk levels significantly.
2.7.3- Legal Risk
Haiwad (2008) says that Islamic banks have different kind of legal documents. He considers that due to compulsion of Islamic accounts to be Shari’ah compliant, the banks need to prepare a complex set of legal documents. In addition to this, the banks need to consider the local laws of the country as well before making any legal documents. Sometimes, it is very complicated to develop the legal documents that comply with both the Shari’ah law and the local law of the country. It ultimately increases the legal risk levels in the Islamic banks.
2.7.4- Liquidity Risk
Aburime (2009) says that Islamic banks face the liquidity risk when the banks fail to sell their fixed assets at the desired rates. The banks usually develop the need to sell their fixed assets to meet their liabilities. This risk is increased due to the fact that Islamic banks do not accept any loans on interest so the Islamic banks are unable to come out of this situation by taking loans from other banks. Aburime (2009) considers that this risk is dependent on the economy of the country. The destabilisation of economy increases liquidity risk.
2.7.5- Withdrawal Risk
Aburime (2009) says that sometimes, Islamic banks do not provide the customers with handsome amount of profits and it can lead to the customers withdrawing their money from the bank. In such situations, withdrawal risk is increased significantly. Aburime (2009) believes that this risk is more in Islamic banks as compared to the conventional banks.
2.9- Do Risk Levels affect Performance?
Mencia (2009) says that a business can produce more money if there is greater risk at the start of the business provided the risks are managed appropriately. Kunt et al. (2009) says that those banks that generate income without any interests are at greater risks and can give better returns as compared to those that generate interest money. Haque and Mirakhor (2006) say that in Islamic banks, customers are at greater risk to lose their money and the banks are at lesser risk as Islamic banks do not guarantee any return at the time of account opening and in few accounts both profit and loss are shared. This fact can deter customers, leading them to invest their money in those banks where they do not have any risk to lose their money.
Shim et al. (2000, pp 176, 177) has suggested that the extent of financing the business through debts is a useful indicator of risk levels in the business. They believe that if a business is financed more through debts, it is at higher risk. Helfert (2001, pp 128) has also same beliefs as that of Shim et al. (2000, pp 176, 177). He considers that financing the business through debts increases risks but at the same time it increases the probability of better returns as well.
Falkenstein (2009) conducted research to explore the effects of risk levels on the returns of different businesses. His research results showed that the businesses that used more debts to finance their assets were at higher risk as compared to those that did not finance their assets through debts. The businesses that were at higher risk and that managed their risks appropriately produced better returns than those that were at lower risks.
2.10- Effective Risk Management in Islamic Banks
Management of different types of risks is very different from conventional banks and due to some restrictions of Shariah laws it is very difficult to manage these risks. Effective credit risk management is a very complex procedure in Islamic banks as there is no permission of paying or receiving any interest. In addition to this, Sharia’s law does not allow to penalise the clients and this facility in Islamic banks is misused by some clients. In such situations, there are long delays in paying back the principal amount and it reduces the assets of the bank. Most of the Islamic banks use collaterals and take pledges from their clients. The best way to avoid the misuse of the facilities provides by Islamic banks, the banks can take more collateral before the start of different contracts. In addition to this, if the banks take personal guarantees before sanctioning the loans, it can help in reducing credit risk as well (Hawray et al., 2004).
Shariah law forbids dealing harshly with those people that are in bad financial crisis. This facility can be misused by the clients. This issue costs the Islamic banks and it should be taken seriously. A comprehensive system to credit score each client before offering them the loan can make a huge difference. Furthermore, the banks should ask the clients to sign on possible enforcement as within Islamic law a person can be enforced if he has signed before the start of the contract. In addition to this, Islamic banks working in United Kingdom can think about legal actions against those that were unable to pay back the loans (Wilson, 2007).
The nature of legal risks is very different in Islamic banks as compared to conventional banks as Islamic banks have to fulfil the requirements of both Shariah laws and local laws of the country they operate in. This makes the Islamic banking operations very complicated and legal risks are increased. The best way to come out of such situations is to make sure that prior to writing the contracts, requirements of local legislations are fulfilled as well. This can aid the banks in developing good knowledge about the possible ways of enforcement if a client fails to repay his loan. In Sharia law it is allowed to enforce those clients that file false claims. Bearing this fact in mind, Islamic banks should consider including this in the contracts. This will help the Islamic banks to reduce legal, liquidity and withdrawal risk as people will not attempt to misuse the lenient system (Djojosugito, 2008).
2.11- Diversification in Islamic Banks
The banks that provide diverse financial services or spreading different risks into different geographic areas are likely to achieve improved diversification. In the case of Islamic banks, geographical diversification helps in breaking the bank’s concentration in limited areas and the bank usually gets good borrowers. (Greuning and Iqbal, 2008, p 264).
Islamic banks mostly deal in the real estate business and most of these banks start their business from their regions and carry on working in that region. The real estate business has suffered huge losses in the past few years due to the effects of recession and interest rate variations across the globe. Due to this fact the investments in real estate have not proved very fruitful for such organisations. In order to gain good profits, Islamic banks need to diversify into different sectors and geographic areas as it will diversify the investments and the risks can be spread across different areas where the banks can get good borrowers and good investment opportunities (Islamic Investment Banking, 2009).
There are different sectors that can prove beneficial for Islamic banks. The most important sector for diversification in Islamic banks is Insurance (Takaful). This sector is highly under developed even in big Islamic countries such as Malaysia where this sector is not developed much. Concentrating on this sector can prove very beneficial for Islamic banks (Thomas, KPMG.COM).
Expansion of Islamic banks across different countries can prove to be very beneficial for them. Currently, Islamic banks are working in a lot of countries but their business size is very small. If these banks diversify into different zones of the world, it is inevitable to attain benefits. Furthermore, Islamic banks can consider to make strategic alliances with those conventional banks that wish to start Islamic banking as it will not only increase the size of Islamic banks but will help in obtaining a diverse work force as well. Finally, Islamic banks can get diverse competent staff that can help in improving different systems and it will ultimately result in reduced operational risks (Iqbal et al., 1998).
Making of strategic alliances with other banks that wish to start Islamic banking will also help in reducing the liquidity risk. Making strategic alliances will help Islamic banks to increase their assets and the current assets level of Islamic banks will increase. This will help the Islamic banks to pay current liabilities and liquidity will be improved. Furthermore, strategic alliances will increase peoples’ trust in Islamic banks and the level of investments will be increased that will ultimately increase current assets and better liquidity of the banks (Iqbal et al., 1998).
Chapter 3: Business Cases
This chapter will provide an overview of the current business operations of both the banks. Detailed descriptions of where both the banks invest their assets and how they manage the risks will follow. The purpose of this chapter is to find out how different investment and risk management techniques help the Islamic banks to give better performance.
3.2- Islamic Bank of Britain
Islamic Bank of Britain started its business in UK in September 2004. This bank is the first Islamic Bank that started its business in UK. The bank is approved by FSA (Financial Services Authority).
The bank has 10 major shareholders holding different levels of share in the bank. The biggest shareholder of the bank is Al Amal Investment and Trading that holds 52% of the total shares of the bank. IIB European Investment Company is the second major shareholder of the bank and it holds 10% shares of the bank. BNP Paribas Bahrain holds 8% of the shares; Mr. Al Rajhi holds 7% of the shares. The remaining 23% shares are owned by 6 other shareholders.
The bank comprises of a board of directors and it is their responsibility to decide upon the investments. Most of the time, the bank invests its money in buying different properties, costly metals, different currencies etc. The bank mostly concentrates in buying the properties in United Kingdom. The board of directors decides all these matters in such a way that can be beneficial for its investors.
3.2.3- Services offered by the Bank
The bank offers three main types of services to its clients
3.2.3-1. Personal Services
In personal services, the bank offers current accounts, saving accounts and home purchase plans to its customers. In addition to this, the bank also offers personal finance to its customers.
3.2.3-2. Business Services
In business services, the bank offers its clients business current, business savings, business finance, charity accounts and commercial property finance.
3.2.3-3. Premier Services
The bank offers this service to those clients that are highly paid (at least £100,000 per annum) and to those who can deposit more than £75,000 in their account with a view to purchasing property in the UK that is worth more than £250,000.
3.2.4- Risk Management in the Bank
Islamic Bank of Britain manages its risks in a systematic way. Board of directors has the responsibility of managing the risks with the help of some committees assisting them. They have some written policies to manage the risks that are reviewed on a regular basis by an audit committee that is responsible to measure the risk levels and start the risk management after a certain risk threshold. The bank faces credit risk, liquidity risk, market risk and operational risk. A brief description of risk management is given below.
3.2.4-1. Credit Risk Management
The bank has a systematic approach to manage the credit risk. To manage this risk certain producures are put into place such as the following:
- The bank makes credit policies
- The bank sets credit limits after assessing the profile of each borrower
- Credit risk assessment before start of agreement
- Collaterals for a few loans but in most accounts the bank does not ask for any collateral
3.2.4-2. Liquidity Risk Management
The treasury department of Islamic Bank of Britain is responsible to manage liquidity risk. The bank uses following steps to manage liquidity risk;
- The treasury department maintains a portfolio of short term assets that can be liquefied. Comparison of liquid assets with asset maturity against any customer deposits
- Submission of any mismatches in liquid assets and asset maturity to financial services authority on quarterly basis
3.2.4-3. Market Risk Management
The bank has a systematic approach to manage the market risk. To manage risks, the following procedures are adhered to:
- Profit rates for few accounts are agreed at the time of agreement start. Maturity profiles are constantly reviewed.
- Rates are agreed on a monthly basis for consumer finance transactions.
- Long term home purchase plans and commercial property finance are benchmarked against market measure. Process is assessed every six months.
- Profit rates on Mudaraba account are reviewed every month.
3.2.4-4. Operational Risk Management
The bank has a systematic approach to manage the market risk. The board of directors of the bank is responsible to manage the operational risks. There are some risk committees that manage this risk under the guideline of the board of directors. The purpose of operational risk management is to implement such a system that can support the process efficiency and meeting the customer needs. To manage this risk the following procedure is respected:
- The bank aims to manage this risk by cutting down the costs on certain things.
- Getting reports from risk committees over regular periods of time
3.3- Dubai Islamic Bank
Dubai Islamic Bank was formed in 1975 and is considered to be the first fully-fledged Islamic Bank in the world. The bank uses the latest innovative technology in its day-to-day operations. The bank is considered to be the undisputed leader in the field of Islamic banking and sets its examples for new starters in Islamic banking. A lot of Islamic banks in the world including Arab countries follow Dubai Islamic Bank to start and run their day-to-day operations (http://www.alislami.ae/en/index.htm).
The Government of Dubai is the major shareholder of the bank and other shares are held by additional stakeholders in Dubai.
The bank invests its money all over the world and is open to any businesses that require financing through the bank. The bank invests in properties, c