Identities Of Banking

Published Date: 02 Nov 2017

INTRODUCTION AND RESEARCH STRATEGY

Introduction

In the beginning, should be identified two different identities of banking systems 'Islamic banking' (IB) and 'conventional banking' (CB). IB identifies financial institutions that provide products and services based on the principles of Islamic law (known as shari`a) and guided by Islamic economics. The two main principles are 'sharing of profit / loss' and the prohibition of the collection (giving) and payment (charge) of interest. However, CB identifies financial institutions that provide services such as accepting deposits from depositors, corporate bonds government bonds, and providing business loans to consumers and businesses. It is guided mainly by the profit maximization Principle.

Because of the special features of Islamic banking (IB), one cannot analyse IB lending policies and strategies by simply downloading models used to analyse lending policies in conventional banks (CB). Effective risk management in banks deserves priority attention. Risk taking behaviour entails many complex issues that need to be better understood in order to be successfully addressed. Islamic finance is now reaching new levels of sophistication. In this regard, many problems and challenges relating to Islamic regulations, lending instruments and risk taking behaviour must be addressed and resolved. Therefore, with recognition of growth in these new financial institutions, a comparison of managing risk and measuring performance of similar units within different organisations is the main objective of this study. The purpose of this chapter is to introduce a design/model of a study that attempts to compare Islamic and non-Islamic frameworks and contribute to knowledge about similarities and differences between IB and CB--theoretically and empirically--in issues relevant to risk taking behaviour and rational lending decision-making.

This chapter is organised as follows. Section 2 provides a brief descriptive background and introduces specific research issues in three areas: 1) banking history and principles; 2) banking growth and competition; and 3) the need for comparable banking systems. Section 3 highlights the specification of the study problem. In this section, the significance and motivation of the study, in addition to the theoretical basis and the study's conceptual framework is presented. An overview of the research methodology is offered in section 4. Section 5 introduces objectives and the study design. Contribution to the advancement of knowledge, and major findings and concluding remarks are provided in section 6. Finally, the organisation of the study is presented in section 7. Figure 1.1 provides a visual overview of the structure of this chapter.

Background and Research Issues

Both IB and CB systems have experienced substantial changes over the last 30 years or so (Levine, R, Loayza & Beck 2000)(Levine, Loayza & Beck 2000) as banks transformed their operations from relatively narrow activities to those of full service financial institutions. Business banking is broadly defined to include all aspects of financial activities including securities operations, insurance, pensions and leasing (Casu, Girardone & Molyneux 2004) (Casu, Girardone & Molyneux 2004). To this extent, the performance of financial institutions is, without doubt, significantly influenced by the actions of banks against risks and strategies guiding lending decisions[1]. It seems very important to evaluate whether the conventional banking (CB) system is different to the Islamic banking (IB) system in terms of risk-taking behaviour. The next section highlights the reasons for conducting research that involves the comparison of two different systems--CB and IB--in the banking and finance industry.

Islamic Banking: Basic Theories and Principles

Exclusively, prior research divided contracts governing economic activities into transactional and intermediation contracts in the Islamic banking and finance industry (Ahmad, K 2000; Anwar 2003; Fuad & Mohammed 1996) (Ahmad, K 2000; Anwar 2003; Fuad & Mohammed 1996). A combination of transactional contracts with intermediation contracts in these institutions offers a set of instruments with varying purposes, maturities and risk sharing aimed at satisfying a diverse group of economic agents. In reality, there is no absolute difference in products and services between CB and IB (Driver, Lomonaco & Zaidi 2005)(Driver, Lomonaco & Zaidi 2005). However, income sources need to be a foremost area of comparison due to the fact that CBs' and IBs' income sources are extremely different (Al-Jarhi & Iqbal 2001) (Al-Jarhi & Iqbal 2001). CB income comes from fees, commission and net interest (the difference between interest revenues from lending and the interest cost on deposits). In contrast, the main sources for IB profit derive from Morabaha, Mushraka, Modaraba and Ijara.[2]

Islamic finance differs from conventional debt finance. It is attractive to a large number of individuals--not only Muslims--who believe in a financial system with a socioeconomic development outlook that combines goals of efficient economic growth and social justice (El-Gamal 2006) (El-Gamal 2006). Islamic finance is governed by the precepts of shari`a, which are to establish social security, property rights and rights of progeny (Chapra, M Umar & Ahmed 2002) (Chapra, M Umar & Ahmed 2002). In addition, a study by Mondher and Siwar (2004 )(2004 )(Mondher & Siwar 2004 ) concluded that Islamic finance is directly involved with spiritual values and social justice through an equitable distribution of wealth which is completely absent from the conventional mode of finance.

Islamic banks are at the forefront of ethical and socially responsible finance. They are prohibited from funding gambling, prostitution, alcohol, nightclubs and narcotics activities which are often seen as the main vehicle for money laundering and terrorism (Fuad & Mohammed 1996) (Fuad & Mohammed 1996). Rather, Islamic financial institutions provide asset-based finance and closely monitor the business of their clients. An axiomatic belief in Islamic finance is that the payment of a fixed and/or determined rate of interest on deposits and loans--rib'a--conflicts with fundamental principles of justice and participation in a productive economic life (Hassan, M Kabir & Lewis 2007) (Hassan & Lewis 2007). Instead, capital is rewarded with a variable rate of return depending on the profit or loss made by the bank during a given period, and return on assets varies with the mode of financing.

The Growth and Competition of Islamic Banking

Islamic banking and finance have increased dramatically around the world. There are approximately 370 Islamic financial institutions (IFIs) which operate in Islamic and non-Islamic countries, managing assets estimated at over $270 billion (Hassan & Lewis 2007) (Hassan & Lewis 2007). While total funds under management are not, by themselves, considerable when compared to the volume of operation of large multinational banks, the average growth rate of 15% realised over the past three decades is impressive (Iqbal & Llewellyn 2002)(Iqbal, M & Llewellyn 2002). Several Muslim countries, such as Iran and Pakistan, have fully pledged their financial systems to shari`a principles and, in some countries such as Middle East countries, IBs operate alongside CBs. Indeed, the practice of IB is not restricted to Islamic countries (details in section 2.5), and major banking corporations such as Citibank and HSBC offer Islamic financial services.

Recently, the growth of IFIs was matched by progress on the legal, accounting and auditing, and regulatory and governance fronts. For example, in 1991 the accounting organisation for IFIs was mandated to prepare accounting auditing, governance, ethics and shari`a standards for IFIs (Kahf 1999) (Kahf 1999). Also, the Islamic Development Bank (IDB) took the lead in establishing the International Financial Market (IFM) in April 2002 to develop liquidity management instruments and create an Islamic financial market and, more recently, the International Islamic Rating Agency (IIRA) conducted research analysis and rating of the IF instrument and institutions (Kahf 2002) (Kahf 2002).

The Need for a Comparable Bank Rational Lending Decision Evaluation Methodology

Typically, conventional instruments of finance have exhibited considerable drawbacks, resulting in the emergence of a number of new requirements in the banking and finance sector worldwide. Among these requirements, risk management and making rational lending decisions are regarded as considerable challenges by financial institutions (Hakim, Sam et al. 2005; Hakim, S & Simon 2001) (Hakim, Sam et al. 2005). Although the discipline of IB and finance has progressed, it still faces the following major challenges.

Firstly, similar to CB, IBs have to deal with moral hazard and adverse selection problems. Entrepreneurs with bad credit risk may seek funding on a profit and loss basis and take advantage of the financier, even though religious principles govern honesty and contractual responsibility.

• A second problem with IBs is the lack of consistency regarding instruments that are legally permissible. It is not uncommon for the shari`a boards of IBs to have different views regarding the lawfulness of certain products and services, and cross border transactions may be hampered by this uncertainty.
• A third more serious and common problem of conventional and Islamic banking is the asset liability mismatch between sources and uses of funds. Deposits are generally of a short term nature, limiting banks' ability to engage in profitable long term investment.

Banking laws and/or regulations in most countries are fashioned on the Western model of finance. The recent expansion of IB, however, calls for re-assessment of these regulations on several fronts. For instance, IB in most countries operates under the supervision of central banks and IBs cannot receive interest on reserve requirements with central banks: other options are needed to provide them with fair returns. Therefore, central banks need to understand the nature of IB techniques which are different from debt-financing.

The performance and efficiency of both IB and CB needs to be studied and compared. Several studies have assessed the performance of IB (e.g. (Ahmad, AUF & Hassan 2007; Grais & Kulathunga 2000; Janice, Abdul & Peter 2005; Kahf 2002; Kuhn 1990)(Ahmad, AUF & Hassan 2007; Grais & Kulathunga 2000; Janice, Abdul & Peter 2005; Kahf 2002; Kuhn 1990), and others studies were applied on CB (e.g. (Beck, Cull & Jerome 2005; Berger & DeYoung 1996; Berger & Humphrey 1992; Berger & Humphrey 1997; Berry, RH, Crum & Waring 1993)(Beck, Cull & Jerome 2005; Berger, A N & DeYoung 1996; Berger, A N & Humphrey 1992; Berger, Allen N & Humphrey 1997; Berry, Crum & Waring 1993), but no comparative cross-banking system study has been conducted to compare the performance of IB with CB taking into consideration risk factor assessment, or to determine their influence on the rationality of lending decision.

Problem Domain of the Study

Research Problem

Risk, in general, arises from the uncertainty of a project's survival. The higher probability of insolvency, the higher the risk to banks that loans cannot be repaid. Operations and procedures of lending are somewhat different in conventional and Islamic banking systems (Powell et al. 2004) (Powell et al. 2004). This difference is a consequence of the nature, role and goals of both systems. Therefore, risks in both systems need to be considered from different angles, because risk assessment[3] and risk determination are also practically different. Today, the Islamic banking system is being given more consideration by investors, depositors, and researchers (Simon, A & Abdel-Karim 2006) (Archer & Abdel Karim 2006). It is important to determine how banking systems differ in terms of risk-taking behaviour and decision-making on lending; and whether these banks are capable of better control and rational decision-making when formulating and implementing lending decisions.

In general, rational lending decisions would be based on an in-depth study of several criteria. There are previous studies in the literature (Bessler, W & Norsworthy 2003; Deshmukh, S D, Greenbaum & Kanatas 1982; Stomper, A 2001)(Bessler & Norsworthy 2003; Deshmukh, Greenbaum & Kanatas 1982; Stomper 2005) wherein bankers reported some significant difficulties in both types of banking. These included difficulties in accumulating the information to evaluate customers and their projects, difficulties in encouraging borrowers to repay, and difficulties with seizing collateral and using legal action in collecting bad debts. Indeed, there are many variables surrounding lending decisions in banks which need to be considered (Andersen, Ewald & Northcott 2005; Jacobson & Roszbach 2003) (Andersen, Ewald & Northcott 2005; Jacobson & Roszbach 2003). Therefore, the process of making lending decisions in both systems needs further investigation and evaluation to fill the gap in the literature related to successful and safe lending decisions (Stanton 2002) (Stanton 2002). Many problems of risk assessment are universal, and others seem specific to banks' lending policies. Hence, this study aims to address the following research question:

How do banking institutions determine and assess risk factors and how do those factors influence the rationality of lending decision policies in conventional and Islamic banking systems?

To address this research problem successfully, three sub-problems need to be considered:

1. How do Conventional Banks and Islamic Banks determine and assess risk factors? In terms of:
• What risk factors are considered?
• How are they measured?
• What is the relative importance of each factor in lending decisions?
2. How do these factors influence the rationality of lending decisions policies in CB and IB systems?
3. Is there a difference in efficiency performance in lending between the two banking groups?

The sound assessment of risk factors increases the chances of making rational lending decisions and contributes to improvement of overall banking efficiency. The assessment of risk factors in CB and IB is investigated and the factors that influence the rationality of lending decisions policies in CB and IB are determined. The study also aims to identify how similarities and differences of lending policies and risk-taking behaviour influence banking efficiency in lending, thus further investigation has been taken to answer the third question which has been incorporated in order to provide contextual completeness to the analysis.

Motivation, Significance and Innovation

Measuring risks has been a major focus in recent studies (Jimenez & Saurina 2003) (Jimenez & Saurina 2003). Thus, the prime motivation of this study is to identify, investigate and evaluate whether risk factors have influenced lending decisions in Islamic and conventional banks. Furthermore, the study provides a basis for understanding the reasons for the fluctuating level of decision quality and for examining factors that can be used to remove or reduce credit defaults in both systems. A review of the literature, for example, El-Hawary, Grais and Iqbal (2004) (2004)(El-Hawary, Grais & Iqbal 2004), Zaman and Movassaghi (2001)(2001)(Zaman & Movassaghi 2001) and Thomas (2000) (Thomas 2000), showed there is significant debate in Islamic countries about starting and operating financial transactions according to Islamic law-shari`a. Managing credits and measuring their risk is a basis of banks' performance and development. Thus, making a comparison between conventional and Islamic systems about managing risk and credit activities provides strong motivation to study credit risk evaluation and management in both systems (Hakim, S & Simon 2001) (Hakim, S & Simon 2001).

Making lending decisions has not always been successfully achieved (Elsas, Ralf, McNamara & Bromiley 1997) (Elsas, McNamara & Bromiley 1997). Furthermore, decisions need to be based on clear information and the possibility of drawing the objectives/variables as inputs and presenting accurate marginal contribution as outputs (Fujiwara 2003) (Fujiwara 2003). These issues have provided the impetus for this study which seeks to identify and reduce the volume of risk factors, thereby increasing the efficiency of decisions in Islamic and conventional banking systems. This can be achieved through gaining a better understanding of how risk factors impact on quality of decision-making and efficiency.

A previous study by Cowling and Westhead (1996)(1996)(Cowling & Westhead 1996) emphasised that credit risks are able to be controlled and managed in the public or private financial environment by applying a correct evaluation of costs and profits of loans. The study found that most default loans occur as a result of the loan's cost (input) being greater than the return on asset (output). Overall, the relationship between borrowers and the actions taken by banks at different decision-making levels is a relatively under researched area. This study will consider these aspects and provide a basis that may contribute to the avoidance of an increase in default loans as a consequence of weak decisions, which ultimately result in an increase in banks' losses.

Conceptualisation of Theoretical Framework

Theoretically, the study adopts a combination of four theories: 1) Transaction Cost Theory; 2) Decision-making Theory; 3) Agency Problem Theory; and 4) Social Theory, as well as the rationality of lending decision model (DGK) model. Joining of these theories has contributed a basis of methodology testing in this area. Also it implements Deshmukh Deshmukh, Greenbaum and Kanataset al.'s (1983)(Deshmukh, Greenbaum & Kanatas 1983)(1983) model: to discuss outcomes of risk factors/effects involving credit risk assessment which influence the rationality of lending decisions in banking institutions.

There are many different types of risk factors and they can be summarized empirically in groups. In the related literature, total risk can be categorised into five main areas: transaction risk, business risk, treasury risk, governance risk and systematic risk (see section 3.4). However, for this study, recognising that total risk can be classified into two groups (internal and external) may assist in effective assessment of the risk factors as presented in Figure 1.2.

The main consideration in this research is determining the conceptual relationships among risks in Islamic and conventional banking systems, and the conceptual relationships among those factors and the rational lending decisions in both systems. Hence, referring to the related literature survey and the nature of the research questions, the conceptualisation and theoretical research framework has been suggested above (Figure 1.2). Essentially, this framework illustrates that lending application processes begin with an evaluation of external and internal risk factors, and then banks seek successful loans by managing and controlling these factors. Basically, the framework is developed on the basis of the difference between banks that have considered risks and those that have not.

Overview of the Research Methodology The target population is CBs and IBs in five different countries in the Middle East region, namely, Bahrain, Qatar, United Arab Emirates, Jordan and Libya. These countries have undergone a variety of economic and financial experiences, making them an interesting case study to examine risk factors and the influence of risk factors on the rationality of lending decision processes (Zopounidis 2002; Zopounidis et al. 2002)(Zopoundis et al. 2002). Moreover, these countries in particular have directed much attention and resources to improving the scope and operation of their financial markets.

Sample selection: By early 2000, when there were at least 176 Islamic banks worldwide, only 47 of those banks were located in the ME region. According to recent statistics, in terms of assets, ME countries including GCC countries[4] held the largest amount of assets [67%] of IBs worldwide (Zaman & Movassaghi 2001) (Zaman & Movassaghi 2001). 48 banks (24 IBs and 24 CBs) have been selected for data collection. Because the banking population in ME is small, the sample of 24 IBs and 24 CBs consists 75% and 25% respectively from the targeted population. Banks that were considered to be dual-system have been excluded. This limits the number of banks. A sample consisting of at least 20% from the population is likely to be representative (Groves 2004) (Groves et al. 2009). Therefore, one can say a sample of at least 24 banks from each banking system is acceptable.

Data collection: To cover the study's requirements, two different methods were used for data collection: primary and secondary data. The first data set is for five financial periods from 2002 to 2006 that are available from financial statements such as annual balance sheets, operation income statements, administration documents and reports. This data--secondary data--typically focuses on a particular aspect of behaviour[5]. Thus, this study used this method to collect data used for banks' efficiency behaviour analysis to answer sub-question 3 of the study. The second data set is a questionnaire survey--primary data--which used to answer sub-questions 1 and 2. Five respondents in each bank were surveyed with a focus on decision makers in these banks: the credit department manager, financial department employees, executive manager and shari`a board member. The objective was to receive approximately 120 (5 x 24) questionnaire booklets from each banking group--IB and CB--which would facilitate a valid analysis.

Study instruments: The research develops the links between theory and model, and phenomenon by deductive methodology (testing theory). Neuman (2006)(2006)(Neuman 2006) argues that the deductive approach involves formulating a theory and model which is compared to observations of the phenomena that the theory and model seek to explain to discover if it is consistent with the facts. Statistical instruments will be used to test the hypotheses, and to make a statement about the statistical validity of the results (Sekaran 2000) (Sekaran 2000). There are, hence, three major constructs in this project: risk factors assessment, the rationality of lending decisions and banking efficiency in lending. Such constructs are multidimensional and they have multiple variables that incorporate multiple items of assessment for each variable. Accordingly, Multivariate Analysis was chosen for this study, because research statistics such as those yielded by Leedy and Ormrod (2005) (2005)(Leedy & Ormrod 2005) and Levine, Loayza and Beck (2000)(2000)(Levine, Loayza & Beck 2000) point to MA being more appropriate for assessing the direction and strength of relationships between independent and dependent variables.

Data analysis: The information obtained from 48 banks (24 banks in each group) using the questionnaire method was analysed using parametric statistical techniques with SPSS software. Accordingly, factor analysis and factor scores derived from the principal component (PC) were used to answer sub-question 1, and used as input values for the multiple regression analysis to answer sub-question 2 of the study. Regression was carried out to measure the association between the project variables which are measured by interval scales. Data gathered from five financial periods was used to answer sub-question 3 of the study. It was analysed using two analytical software packages: non-parametric techniques with E.Views econometric software and DEA-Solver performance software. Data Envelopment Analysis (DEA) was used to analyse the decision performance (efficiency and quality). Finally, this study used a non-linear Tobit econometric model to establish which factors are relevant to the lending decision-making process and, further, how much each factor affects the outcome.

Objectives and Research Design

Although, generally, decisions made in banking institutions are ultimately the responsibility of an individual, often a group of people participate in the decision-making process (Huczynski & Buchanan 1991) (Huczynski & Buchanan 2001). Also, typically, major errors in decision-making can arise because the original decision problem has been incorrectly formed (Davis 2000)(Davis, D 2000). In particular, in lending decision-making the decision can be formulated in a way which fails to take into account fundamental changes that have occurred and affect loans' compensation rates (Goodwin & Wright 2004) (Goodwin & Wright 2004). Therefore, the primary purpose of this study is to uncover risk factors which affect the banks' performance, especially credit policies, by evaluating the process of lending decisions in CB and IB systems, evaluating whether both banking systems are managing the different risk factors, and recognising the lending and risks relationships. This focus will offer a potentially powerful tool for clarifying how risk factors influence the rationality of lending decisions in both CB and IB systems. Moreover, there are many default credit issues referred to higher financial authorities and the courts, in addition to issues registered at the public/private supervision sector (Banks 2004; Bashir, A 2000) (Banks 2004; Bashir 2000). This study, thus, attempts to investigate reasons beyond these issues by exploring the particular risk factors which influence the rationality of lending decisions. A further purpose of this study is to illustrate and explain the similarities and differences between IB and CB systems in aspects related to the default risk field and performance. Thus, a comparison between both banking systems reflects each system's ability to administer default risks.

Overall, investigating and developing more advanced techniques for risk factor assessment is an interesting and exciting field for research. Thus, in order to achieve the research objectives, Figure 1.3 shows the research design which has been developed as an achievement diagram of the study.

Major Findings and Concluding Remarks

The scope of the analysis is a comparison of banking systems: Islamic banks with conventional banks which operate in the Middle East region (Libya, Qatar, Bahrain, United Arab Emirates and Jordan). All banks in each banking sample are grouped together, and are stratified into small, medium and large size according to their total assets. Two different analyses have been performed in this study.

Firstly, questionnaire survey method (primary data), principal component analysis, t-test and regression analysis are used to test the relevant research hypotheses (H1 and H2) and answer the first and the second sub-questions of the study. After testing these hypotheses (H1 and H2), the main findings are:

• Risk factors assessment: To some extent, there is a difference between CB and IB in terms of risk visibility, but risk feasibility is almost the same. In addition, results indicate these counterparts of Islamic banking system are more efficient than non-Islamic banking system in terms of risk assessment. This means banks with Islamic law perform differently to banks without Islamic law in terms of risks assessment but, statistically, not significantly so. However, some differences were revealed: some risk factors which are applicable to CB, are inapplicable to IB (e.g. some transaction risks), and vice versa (e.g. sharing risk).
• Approaches and importance of measuring risk factors: There are no specific models of risk measurement that have been used by both systems to measure such types of risk. However, banks in both IB and CB systems often follow a similar pattern in terms of measuring risk factors. Moreover, results confirm that the incentive of quantifying risk models designed by researchers and practitioners in the finance fields for the agent principals is beneficial in controlling risk exposure and banks' consistency.
• Risk factors and rationality of lending decision relationship: Results reveal that relationships--positive/negative--exist between risk factors and the policies of lending portfolio management. Furthermore, results suggest that risk factors which influence the rationality of lending decisions are somewhat varied between IB and CB systems. Basically, to some extent, the results provide evidence that risk factors influence the rationality of the lending decision and these are different in IB and CB. Additionally, the rationality of lending decision is impacted by applying some risk measurement models/approaches that are broadly used in the finance industry. To sum up, even though the rationality of lending decision making in each banking system has been influenced by different risk factors, the correlation between some of them is not clearly formed.

Secondly, annual reports from 2002 to 2006 (secondary data) and Data Envelopment Analysis (DEA) technique are used to estimate scores efficiency (technical efficiency). Then, the efficiency scores are regressed as dependent variables with an independent explanatory variable to examine whether lending policies in the IB and CB are significantly different. At this stage, the relevant research hypothesis--H3--can be tested and answer the third sub-question of the study. The third hypothesis is tested and it was revealed that:

1. Banks' efficiency and competition: A profile of a bank's risk-return is affected by its mix of debt and equity securities used to finance its asset portfolio. In particular, no banks with lower efficiency are even remotely ready to enter into competition with banks of higher efficiency. At the same time, the growth and experience of the Islamic banking system has allowed it to operate closer to efficient scales and with comparable or even better levels of managerial efficiency than conventional banks. Even though the Islamic banking system was established later than conventional banking, it appears to be the very best competitor amongst other systems in the finance industry, whereas the results suggest that the Islamic banking system, even the large, medium or small ones, have proved to be the expected formidable competitor.
2. Risk Assessment Experience: Results revealed banks that have greater monitoring incentive and capabilities, higher risk, and greater control over borrowers, operate at higher yield efficiency and are sustainable for longer maturity of loans. Moreover, banks with lower monitoring of these factors actually attain lower performance. Islamic banks, despite their experience compared to conventional banks, appear to perform much better in terms of risk management and risk taking behaviour (risk sharing).
3. Lending Decision Success: In making efficient or rational lending decisions, results presented indicate that many aspects need to be considered, but the success in Islamic banking mostly results from using the unique rule (shari`a law). Along with this rule, the Islamic banking 'outperformance' may be attributable to the instruments of finance which have been used in this system.

Organisation of the Thesis — hesis Outline

The organisation of this thesis broadly falls under two segments, firstly, the comparative theoretical component and, secondly, comparative empirical investigation and discussion of the study results. After surveying and integrating the information available in the existing banking and finance literature regarding the role and nature of IB and CB, theories and evidence, banking experiences and capability, contemporary banking crises are elaborated on further in Chapter 2. Next, the rule of risk management and control are presented in Chapter 3. Third, the theoretical and empirical perspectives of managing and making rational lending decisions in both IBs and CBs are provided in Chapter 4. Sets of sampling selection, data collection methods used and testing instruments are outlined in Chapter 5. The remaining two chapters are integrated to present the comparative discussions and results. Chapter 6, therefore, provides comparative discussions on how IBs and CBs assess risk factors and whether these risk factors influence the rationality of their lending decision polices, and Chapter 7 provides comparative discussions on the banks' efficiency in terms of making rational lending decisions. Lastly, the conclusion, limitations and suggestions for future research are elaborated in Chapter 8, along with a discussion on some of the implications arising from this study. Figure 1.4 provides a visual overview of the structure of this thesis.

ONVENTIONAL BANKING VS ISLAMIC BANKING SYSTEMS: THEORETICAL AND EMPIRICAL PERSPECTIVES

Introduction

The primary objective of this chapter is to review the literature related to Islamic Banking (IB) and Conventional Banking (CB) in terms of the structure of the respective financial systems. The secondary objective is to provide a contrast between banks that are providing similar financial products and services, but hold different policies and principles (IB and CB), with a focus on the relevance of Transaction Cost Theory and Agency Theory to Islamic finance and conventional finance. Approximately three decades ago, Islamic banking was virtually unknown. Now, more than 55 developing Islamic countries have some current involvement with Islamic banking and finance. According to the International Association of Islamic Banks, Islamic financial institutions are operating not only in Islamic countries, but also in non-Islamic countries and regions such as the North and South Americas, Europe, Cayman Islands, South and South Eastern Asia, and Australia (Ahmad, N & Haron 2002) (Ahmad, N & Haron 2002). Regardless of the location, however, Islamic banks are required to operate under Islamic financing principles.

The chapter is organised as follows. Section 2 reviews the classification of finance institutions by focusing on Conventional Banking and Islamic Banking contracts. Section 3 covers the similarities and differences between IB and CB systems. Section 4 discusses the relevance of selected theories to Islamic banking and finance. The foci of section 5, section 6 and section 7 are Islamic banks' experience, banking crises, and capability respectively. Section 8 provides a summary of conclusions. Figure 2.1 provides a visual overview of the structure of this chapter.

Classification of Financial Institutions

Banks perform many functions, some central to their main role in financial intermediation and others more peripheral. Practically, there are three major interrelated banks' functions:

1. The creation of money accomplished through lending and investing activities;
2. The holding of deposits; and
3. The provision of a mechanism for payments and transfers of funds or intermediation.

These functions match the different types of banks. Roussakis (1997)(1997)(Roussakis 1997) argues that there are several ways of classifying a system of banking/financial institutions. From a regulatory perspective, however, banks are classified on the basis of different market segments as shown in Figure 2.2. Basically, banks are classified into seven groups based on their scheme of involvement: activities, operational structure, bodies, ownership, location, performance and their main objective. Definitions of some existing banks are provided in Appendix C.

These groups are depicted in Figure 2.3. Consequently, a comparison of banking systems requires an understanding of the characters of such systems. More specifically, it requires an understanding of reason as to why each banking system differs from other systems. The first comparative observation on aspects of banking institutions shows that there is enormous variation of rules applicable to Islamic banking and other banks. The foremost aspect is that IB transactions are restricted to the concepts of Islamic law (shari`a)[6].

Conventional Banking

Conventional banks (CBs) are usually the major type of financial intermediary in any economy. They are the main providers of credit to households and the corporate sector. CBs are typically partnership and corporation ownership (joint stock) companies and may be either publicly listed on the stock exchange or often privately owned (De Lucia & Peters 1993) (De Lucia & Peters 1993). Furthermore, Casu, Girardone and Molyneux (2006, p. 5)(2006, p. 5)(Casu, Girardone & Molyneux 2006) state 'CBs deal with both retail and corporate customers, have well diversified deposit and lending bases and generally offer a full range of financial services'. While CBs refer to institutions whose main business is deposit taking an