Differences between Islamic Banking and Conventional Banking: Cases in Saudi Arabia
Date of submission
Table of Contents
1 Introduction 3
1.1 Research objectives 5
2 Literature review 5
2.1 Banking theory 5
2.2 Regulation 8
2.3 Differences between Islamic and Conventional Banks 11
2.4 Motivation for Islamic Banks 14
3 Methodology 15
3.1 Research Philosophy 15
3.2 Research Strategy 16
3.3 Research Methods 17
3.4 Data Collection 18
3.5 Ethics 18
4 Findings 19
4.1 Role of Islamic banks in Saudi Arabia 19
4.2 Governance at NCB 21
4.3 Regulation 22
5 Conclusion 24
Banking includes the practice of lending money to investors and citizens when faced by the need to raise money that they doesn’t currently have. Ancient emperors realized banking as a powerful tool to instigate economic reforms and as a means of funding the needs of the state. Banking has evolved over time to include money printing, regulation, financial instruments, among other banking innovations (Aldohni, 2012).
Modern convectional is founded on the model developed in Renaissance Europe. According to this model, companies a sole objective of lending money at some price. Convectional banking can therefore see money as a commodity that can be sold for some fee at a profit (Taylor & Francis Group, 2003). Convectional banking operates as a retailer only that money has to be taken back to the bank instead of keeping it for good. Convectional banking has established itself as the dominant form of finance over the world as they command control of more than 95% of the global financial system (Song &Oosthuizen, 2014).
Islamic banking, on the other hand, is a form of banking that complies to the religious stipulations of Islam. Islamic banking is a form of banking that puts the tenets of Islamic economics into practice. Just like Muslims do in their worship, they strongly believe that the commands of God must be applied in every aspect in life, banking inclusive (USA International Business Publications, 2005). Islamic banking prohibits the charging of interest on money lent to a customer and encourages financial inclusion in states where it is practiced. Though not much recognized, Islamic banking has become a key player in financial banking systems. Unlike contemporary banking, Islamic banks aim at fighting usury and monopoly and maximizing the owner’s wealth and that of the depositors who are the bank customers with a strict adherence to Islamic law in their operations. Islamic banks are much controlled by Islamic central banks (Kettle, 2011).
Banking, regardless of nature and form, has been a core part of the modern economy. Banking as is today has its roots in Italy, wherethe Medici family created what was perhaps one of the largest financial institutions of the 14th and 15th century(Richards, 2012). However, the practice of lending money to investors dates as far back as the Babylonian empire, four thousand years ago. Throughout history, banks have played a key role in the economic lives of the citizen and the emperor. The citizen needed a bank when faced by the need to raise money that he does not currently have while the emperor realized that banking was a powerful method of instigating economic reforms and funding the state’s needs(Richards, 2012). These roles continue to besatisfied in the modern economies. Over thecenturies, banking has evolved to include the printing ofmoney, regulation, financial instruments, among other innovations.
Modern conventionalbanking is founded on the model developed in Renaissance Europe. Under this model, companies are formed for the sole goal of lending money at a price.Therefore, conventional banking views money not only as a store of value, but also as a commodity that can be sold at a certain price(Pons, 2013, p. 231). Modern conventional banking operates in a similar way to a retailer, where a price is offered for a certain amount of money. The only difference is that money bought must be taken back to the bank, which is unlike the retailer where customers get to keep what they have bought. Modern conventional banking has grown to become the dominant form of finance in the world. According to statistics,conventional banking systems control more than 95% of the global financial system as measured in all economic aspects, from profits, revenues, to the asset base(Ernst & Young, 2015, p. 25).
In the secondhalf of the twentieth century, conventional banking saw a raft of changes thatsignificantlyreduced the amount of regulation over the industry. It is argued that theliberalizationof the financial industry during these years contributed to an increased in the amount of uncertainty and risk that was faced not only the bank and its customers, but also by the entire economies(Barut, Rouillé, & Sanchez, 2015, p. 93). It is to be noted that the years between 1930 and 1960, there were hardly any financial crises that befell economies(Laeven & Valencia, 2013, p. 230). Even countries like Japan managed to rise from the ashes of the world war to become prominent economies in the global financial systems. However, the second half of the century was plagued by crises that threatened to bring entire economies to their knees(Laeven & Valencia, 2013, p. 229). This has led toresearchers casting doubt on the apparent positive relationshipbetween liberalization of the financial industry and economic growth. This has turned the attention of both scholars, practitioners, andpolicymakers to other banking systems, mainly Islamic banking.
Islamic banking is defined as a form of banking that is compliant with the religious requirements of Islam(Alexakis & Tsikouras, 2009, p. 93). Islamic banking has been also been defined as the form of banking that puts the tenets of Islamic economics into practice. Like conventionalbanking, Islamic banking has been used in the global financial systems for several millennia(Iqbal & Molyneux, 2005, p. 38). Its history can be traced to the first financial institutions that arose with the spread of Islamacross the world. As of the year ended 2015,institutions that were shariacompliant had an asset base of more than $2 trillion(Ernst & Young, 2015). Ernst&Young estimated that the Islamic banking system was growing at the rate of about 17% between the year 2009 and 2013(Ernst & Young, 2015). It is expected that the industry will grow at the annual rate of19% between the year 2014 and 2019(Ernst & Young, 2015).
Growth in Islamic banking is driven by the very principles on which the system is based. For instance, Islam prohibits the charging of interest on money lent to a customer(Abedifar, Molyneux, & Tarazi, 2013). This means that if the financial institution is to make money from the venture, it can only share in the profits and losses that arise out of the investments made using money loaned out.It is also argued that Islamic banking encourages financial inclusion in states where it is practiced. In addition, Islamic banking does not require the use of a collateral when seeking funding(El-Gama, 2000, p. 56). Based on these and many other merits, Islamic banking has grown to become a key player in the global financial and economic system, especially in countries with significantMuslimcommunities.Yet, the Islamic financial system is understood by few(Alexakis & Tsikouras, 2009, p. 93).Therefore, there is need to expand the existingbody of knowledge on Islamic banking and its application in the modern financial system.
1.1 Research objectives
The study seeks to pursue the following objective:
1. To compare and contrast conventional banking to Islamic banking.
2. To investigate the application of Islamic banking in Saudi Arabia.
2 Literature review
2.1 Banking theory
According to the International Monetary Fund, financial intermediaries serve five main roles(Imam & Kpodar, 2015, p. 7). One, banks have a key role in the polling and diversification of risk(Imam & Kpodar, 2015, p. 7). Firms in the insurance sector do this by borrowing money from customers in the form of premiums and compensating those who suffer from certain risks. However, the pooling of risks in a bank is less obvious. It is argued that banks pool risks by transforming short term liabilities into long term assets(Imam & Kpodar, 2015, p. 8). By taking customer deposits and lending them to investors, banks effectively transform on demand liabilities into assets whose claims settles in the very long term. In so doing, banks serve the second purpose of mobilizing savings and allocating them to the most deserving investors(Imam & Kpodar, 2015, p. 8). In agency theory, banks serve the role of supervisors to managers and exalters of control over companies(Allen, Gottesman, Saunders, & Tang, 2012, p. 593). In addition, banks are argued to enhance the transfer of goods and services in the economy by facilitating the transfer of funds between buyer and seller(Imam & Kpodar, 2015, p. 8).
Banks serve these roles under different capacities. Under the conventional banking industry, mutual funds collect savings and invest them in a professionally selected portfolio of assets. In return, mutual fund clients pay a fee that ranges between five and six percent for the service(Elton, Gruber, & Blake, 2003, p. 793). Mutual funds, then deliver returns from the investment to their clients through their bank accounts. Investment management services are offered to a select niche in the market, which is often the very wealthy. Investment management is similar to mutual funds, with the only difference being that investment management is more personalized to meet the risk and return needs of the client. Therefore, banks that offer investment management services are often in close contact with their customers. Banks also offer a variety of credit cards that allow clients deduct funds from their accounts whenever they go shopping or some other spending venture. The use of credit cards has increased within the KSA with the market just realizing the convenience that they can afford. Credit card use also comes with an increase in the number of automated teller machines that allow for the withdrawal and depositing of funds. Conventional banks also offer instant funds transfers. All these services are provided alongside the traditional current and savings accounts, of which there are as many types as there are banks.
The operation of current accounts in an Islamic bank setting is slightly different from that of a conventional bank. To begin with, current accounts is Saudi Arabia remain under the tight control of the kingdom’s regulators(Barut, Rouillé, & Sanchez, 2015, p. 93). In addition, these accounts can be held in the local or foreign currency. In adhering to Islamic teachings, banks that offer current accounts must maintain the assets in safe custody. Islamic banks are required to view deposits as a form of trust account where the bank takes care of customer deposits as it were its own money(Abduh & Omar, 2012, p. 36). However, the bank is not liable for damages that may occur to these assets, unless damage is caused by the bank’s actions of negligence. Islamic teachings also dictate that the bank is not to profit from these deposits unless the customer gives his/her express consent to such actions(Said, 2013, p. 3). In addition, customers in some Islamic banks offer profits made from the use of the funds held in current accounts. Unlike current accounts in conventional banks where the banks provide a return in the form of profits, Islamic banks lack this feature(Ernst & Young, 2015).
Like current accounts, savings accounts are subjected to the principles of Islam. In the traditional banking system, the bank provides interest based on the amount saved by the customer. However, the use of interest is not allowed in Islam, regardless of whom it favors. Savings accounts in an Islamic bank guarantee the saver of obtaining the exact same amount he put into the account when he has the need to withdrawal his cash(Ravikumar, 2012, p. 83). However, the bank can seek consent from the client on how to use these funds. Profits that arise from the use of these savings accrue to the bank while all risks are also attributable to the bank.
Apart from these traditional services, Islamic banks also offer a variety of modern services. For instance, banks that have been authorized as halal are allowed to offer investment management services. These services are very similar to those described previously in conventional banking. Owing to the various restrictions imposed by Islam, it becomes a challenge funding a bank’s activities. Therefore, Islamic banks offer a type of investment account where investors can deposit money that will be used specifically to fund the company’s operations. In return, the bank provides these investors with a form of return based on the profits generated by the investment pool.
Like conventional banking, Islamic banks are often subject to the control of the central bank(Mahmood, Khan, Mehmood, & Khan, 2014, p. 193). Control over these institutions is solely based on the theory of the central bank. Banking is a risky affair regardless of form and type. Banks are solely concerned with enhancing liquidity within the economy. They achieve this by transforming short term liabilities into long term assets, as explained in other sections of this paper. The transformation is not without risk. To begin with, banks hold current assets that can be demanded back at any time by clients. This creates the major risk of there being a bank run at any time there are signs that deposits may no longer be safe. Secondly, it is not likely that all the money lent out will be returned without default(Hassan, 2009, p. 25). This creates the risk of default. Despite the presence of these risks, banks play a critical role. Doubt quickly fades when it is considered the role of banks in the financial recession of 2007 and the economic depression of 1932(Said, 2013, p. 3). Therefore, there is a need for a bank to maintain adequate liquidity that will see it survive the negative impacts of a bank run. At the same time, banks need to be forced into adopting sustainable practices in their lending activities. Secondly, the central bank can step in and rescue those banks that are considered to be most critical to the economy(Buiter & Sibert, 2008, p. 2). This is by acting as a lender of last resort. Therefore, governments have often been compelled to establish a central bank that will oversee the operations of the banking sector.
The theory of lender of last resort is based on the seminal work done by Bagehot in 1873. According to the theory, the central bank is expected to act like a safety net for the liquidity risks that might face an economy’s banks(Bignon, Flandreau, & Ugolini, 2012, p. 593). Those who support the theory of lender of last resort correctly argue that asset prices depreciate rapidly during an economic crisis. For example, economic crises precipitate inflation, which harms the value cash held in current and savings accounts. Financial crises also lead to an increase in the amount of risk that is faced by investors as markets become increasingly uncertain and returns take a dip(Bignon, Flandreau, & Ugolini, 2012, p. 593). Under these circumstances, it becomes unfeasible for the bank to engage in the fire sale of existing assets in a bid to overcome the challenges of a bank run. Therefore, the central bank is urged to create adequate reserves that can be used for the intents of protecting banks from the negative impacts of a bank run. Besides protecting banks from sudden withdrawal demands by customers, central banks protect the entire economy from the knock-on effects of a bank run(De Grauwe, 2013, p. 523). This is due to the fact that banks borrow from each other. Therefore, fire sales affect the quality of assets held by each firm, even when it has adequate assets to meet customer needs. There are also the widespread losses that are felt throughout the economy when a bank engages in the rapid sale of its assets.
Yet, the theory of lender of last resort has some visible cracks. One, the theory is reactive as opposed to proactive(Buiter & Sibert, 2008, p. 6). In this case, the lender of last resort theory seeks to repair damaged pipes after the water has burst. The social cost of a financial crisis will have already been felt by time the central bank lends to troubled banks. By seeking to replenish capital held by banks after there has already been a financial crisis, the theory is argued to encourage the taking of unsustainable risks(Bignon, Flandreau, & Ugolini, 2012, p. 583). A more critical risk occurs when the central bank faces a bank run of its own. One of the key assumptions of the lender of last resort theory is that the central bank is always liquid. That is to mean that the central bank always has adequate funds to meet the needs of all financial institutions in an economy. Of course, the reality is a distant relative to the ideal situation as presumed by the theory. In this case, numerous banks undergo a liquidity crunch at the same time and are in dire need of the central bank’s help(Buiter & Sibert, 2008, p. 5). However, the central bank hardly has adequate funds to fulfil all these requirements. The result is undue pressure on the general economy, exacerbating the already bad state of social costs.
Other assumptions of the lender of last resort theory include that the central bank will apply punitive measures when lending to defaulting banks. Under the conventional mode of a banking, this is through the imposition of high interest rates. However, this does not apply to a financial institution that is based on Islamic laws. Therefore, central banks in these economies have to find alternative methods of ensuring that defaulting banks do not become repeat offenders(Grais & Rajhi, 2015, p. 209). The theory also assumes that the central bank will lend on an overnight basis. However, the recent financial crisis showed that this assumption is fundamentally flawed with central banks extending credit for prolonged periods of time.
An alternative to the theory of last resort is the use of regulations in ensuring that banks maintain adequate liquidity in the course of their operations. Liquidity can be defined as the ability of a bank to meet bridge the gap that exists between cash withdrawals and deposits made by customers. Ideally, a bank should be able to obtain sufficient long term funds that can be used to match the long term needs of its assets. However, the bank only retains a small portion of customer deposits and uses the rest in extending credit at a profit. A bank that stretches the amount lent out vis-à-vis the amount retained as available reserves soon finds itself facing liquidity problems. It is the aim of the central bank and other regulators to ensure that such a scenario does not occur.
As a result, the financial world has adopted a range of financial measures meant to bridge the gap between reserves held by the bank and the amount of lending that occurs over a period of time, usually one year. However, many of these regulations have been targeted at the conventional banking system. One of the key regulations to be implemented in the recent past are the Basel III set of rules over financial institutions. According to Schoon (2008) these rules were originally targeted at large financial institutions, which are more likely than not to be conventional banks. However, governments across the globe have adopted these provisions without taking into consideration the diversity of the financial industry(Schoon, 2008, p. 1). While Basel II and III regulations do not have a direct impact on Islamic banking, it is argued that it is only a matter of time before their impact in the sector is felt. One factor that leads to the difference between regulatory measures adopted by conventional banks and those adopted by Islamic banks is the gap in risk appetite. For example, Islamic banks are not allowed to use customer deposits in their lending practices, unless the customer gives explicit consent. This serves to reduce the possibility of the bank facing a credit crisis as some of the customers invariably prefer retaining their accounts by denying the bank access.
2.3 Differences between Islamic and Conventional Banks
The rise of Islam has been experienced in many fields, including the economic sector. This has led to the rise in Islamic banking(Grais & Rajhi, 2015, p. 212). There are some logistical and theoretical matters that Islamic banks are based upon. For example, they are based on the absence of the interest system and in its place a set of formulas for investment in Islam, speculation, participation, and the different versions of each formula’s features and scope.
The aspect of participation is based on money being in the possession of an individual or financial institution, and this money is transferred to another individual or institution based on a set of developed conditions and controls. Participation entails having a contract between the chairs of a company(Ernst & Young, 2015). There is usually capital some form of sustained involvement, which ends with ownership and some participation to finance the specific agency for a fixed term. Speculation is another method used by Islamic banks. It refers to the transfer of money from the party who has it to one who does not have. This transfer helps to improve some form of work and is usually not an investment in finances by the lender on the borrowing party. The profit that will accrue in such a case is shared between the two parties in a profit-sharing plan. Islamic finance supports a format where money is mixed with work. There are two types of speculation, individual speculation, and speculation made by some parties.
The third method or formula is the tout, which refers to a sale where there is an increase in price and subsequently the profit from the sale. The most notable differences between traditional and Islamic banking in terms of logic and theory are the application of the formulas(Barut, Rouillé, & Sanchez, 2015, p. 93). Islamic finance has an alternative system of trading debt, and profit different from differentials of interest rates derived from deposits and money lent common in traditional banking.
Islamic banks aim to fight usury and monopoly in addition to maximizing the owners’ wealth and that of the depositors who are the customers of the banks. This helps to achieve the social and economic development of the Muslim communities(Abu Hussain & Al-Ajmi, 2012, p. 217). When it comes to the relationships that exist between the banks and their customers who deposit money, Islamic banks have a commitment in ensuring that there are refunds in invested deposits in cases where there is mismanagement of funds. This way, the depositor does not bear any costs except if the bank has not participated in such mismanagement. This is the opposite of traditional banks where the deposit is committed to a response in the current interest rate(Choughury & Alam, 2013, p. 193). The depositor gets the return on the money deposited based on the amount deposited, the period of the deposit, and the interest rate. In Islamic banks, the depositor gets a return on the amount deposited based on profits realized by the Bank, the basis of the value of the money, and the duration that the money has been deposited.
In another comparison, as regards the relationship held by the users of money, Islamic banks rely more on speculation. There is also no need to provide a relationship tout when it comes to the establishment of companies. In traditional banks, the relationship with the user is predetermined. When it comes to investment activities, in traditional banks there is criminalization that involves trafficking in buying and selling of securities. This happens while the traditional banks strive to maintain appropriate levels of liquidity. However, in Islamic banks investments are usually diverse and multiple. This includes the formation of companies that do not violate the laws of Islam. The investments also involve trading in movable and fixed assets as well as other tangible goods.
In terms of the control mechanisms, Islamic banks are regulated by Islamic central banks. There are also other controls enforced by the banks’ owners through general assemblies. Government control, which is usually, handled by the central banks’ controls the legitimacy of the banks. Additionally, there is control from representatives of the banks’ depositors who are appointed to represent others in the various boards. There is special legislation that governs these representatives, and this legislation governs their nature of work. Islamic banks also do not use the central banks in liquidity cases as is nature with traditional banks.
The above facts reveal the fundamental theoretical differences between Islamic and traditional banking systems. Practically, there is no doubt that there are constraints and problems specific to Islamic banks. These differences paint the picture that shows the complexity in terms of the relationship and the conflict of ideas that arise when comparing Islamic and traditional banks. There is also a difference in the tools used and the forms of cooperation that exist for these two systems. Nonetheless, while evaluating the traditional and Islamic banking systems, the researcher addresses some important aspects that have to do with the modern variations of banks in general. The point of focus, in this case, is the fact that the processes and the challenges faced by the Islamic banks are mixed.
2.4 Motivation for Islamic Banks
Islamic banks are committed to the application of Islamic law in their operations. These based are founded on the separation of worldly matters and matters that regard religion. Muslims believe that the laws of God must be applied in their transactions just like they do in worship. There is no substitution for that which is permitted with that which is forbidden. Islamic law, in this case, is the basis for any application and is usually used as the reference(Maghyereh, 2012, p. 186). Based on these, Islamic banks ensure that there is the body controlled by the Islamic regime in their organizational structure. This body is independent of the executive departments and usually ensures commitment to hard work and work regulations by employees. The banks may at times use the management or this body for audits and control, but, this body acts as a link between the owners, the departments, and other branches of the specific Islamic bank.
There is no application of interest in Islamic banks. Interests are viewed as usury (riba), which is forbidden. Interest rates are practiced by traditional banks. According to the scientists and representative jurists from the Islamic Research Academy, thirty-five states from the Muslim world had decided that interest rates should not be allowed(Abduh & Omar, 2012, p. 37). This followed an extensive three-year research on various types of usury interest rates on all types of loans. The study reported that there is no difference between what are usually referred to as consumer loans. They also disputed the aspect of productivity, which is associated with these loans and, said that the texts of the Quran and the Sunni categorically prohibited these two aspects; consumer loans and productivity.
Research methodology is defined as an inquiry that follows set out scientific procedures in an attempt to formulate problems and hypotheses or the identification of set out methods that are meant to answer research questions (Kumar, 2010).
3.1 Research Philosophy
While formulating a research methodology, it is imperative to define clearly the research philosophy that will be followed. Research philosophies are categorized into two. The first is the analytical or descriptive philosophy. This is a type of philosophy where the researcher has the ability to evaluate the variables critically and can also influence them to define his research questions. The other type is the descriptive philosophy and is the type where the researcher does not have any influence over the variables. This type of research is also known as an ex-post factor type of research (Saunders, Lewis, &Thornhill, 2009, p. 123). This study will adopt the descriptive type of philosophy because there will be no influence over the study’s variables.
The use of a deductive or inductive philosophy in answering the research questions is another important philosophical consideration. In a nutshell, these two opposing philosophies will have to be determined from the beginning of the study. In deductive research, the research questions are assessed using a top-down approach. These research questions are used in the determination of the data that will be collected, and they also prove some specific theory or model. Comparatively, in an inductive research philosophy, the research questions are assessed using a bottom-up approach where, the research questions are used in the formulation of hypotheses, theories, and models (Kumar, 2010, p. 17). This research will adopt a deductive approach while answering the research questions.
3.2 Research Strategy
Once the research philosophy has been determined, the next step is to determine the type of strategy that will be adopted. The deliberation of whether the study will adopt a primary or secondary research strategy is the most important of all strategies. A primary research strategy utilizes data that has not been previously used in any other study. It is also commonly referred to as a novel research strategy. The main benefit of this strategy is that the research questions are answered using data that will be specifically collected for them. Nonetheless, if there is no primary source, this strategy is not practical or effective. In such a case, a secondary strategy is adopted. This strategy involves the use of data that have been collected by other scholars, organizations or countries. This is an effective method since it saves time and provides data in situations where there is no primary source. However, if not properly implemented, there are bound to be errors (Flick, 2008, p. 79). This study is an investigation on accounting. Therefore, it is difficult to access primary data owing to the sensitive nature of financial information. A secondary research strategy will thus be used for this research.
3.3 Research Methods
Another critical decision that has to be made while conducting research is whether to adopt a qualitative or quantitative approach. Flick, (2008) defines a qualitative methodology as a procedure that attempts to collect and examine data that are not quantifiable. This approach is particularly favorable where the little measure is required. This is particularly true of explanatory and exploratory types of research. However, there is a many-sided aspect of the quality of information gathering, and the investigation are the main burdens of this type of methodology. Nonetheless, a qualitative methodology is important in research on the behavioral sciences. In the accumulation of qualitative data, the impression of how individuals feel is vital. On the contrary, qualitative studies are hard to embrace due to factors such as the dynamic use of direction in the investigation and accumulation of qualitative data. According to Flick (2008), the other option is a quantitative methodology. This technique is based on the quantification of information. Numbers, as well as decisions that can be tallied or produced, are characteristics of this methodology. This type of methodology stands out amongst the most commonly used techniques. Compared to the qualitative approach, the quantitative method is simpler because it is based on facts and the determination of decisions. In a quantitative approach, gathering of information can also be backed by polls that give coding. This is especially possible in the expansion of the information gathering space. There is also the use of software in data analysis since the technique depends on parametric or non-parametric tests that can be broken down experimentally. Quantitative are, however, expensive since the parametric or non-parametric parameters have to be met. This study will use a combination of qualitative and quantitative methodologies from a secondary source. Thus, this study will use a mixed type of methodology.
3.4 Data Collection
There are only two methods that can be used in the analysis since this study will adopt a secondary strategy. The first is a case study analysis, also known as past information research. A case study will usually identify a specific individual, organization or country as the basis of research. This is usually effective if the focus of the study is quite specific. The other method is past literature research. This involves the investigation of company reports, academic journals, and other information sources. The method of data collection usually involves the nature of the research. This study will investigate financial information from the onset of the crisis. This type of information is usually general and not specific to an organization. This information has to be accessed from financial reports and scholarly papers (Sarantakos, 2007, p. 9). An important aspect is the deliberation of the exact nature of the information to be collected. This information will be accessed from journal articles, financial books, legitimate websites, company annual reports, and conference proceedings on financial matters.
It is also important to ensure the ethics of the research are observed. Ethical measures and practices are usually applied in primary studies, though, secondary studies also require some degree of ethical observation while undertaking them. The first important ethical consideration is that all the information that has been collected from secondary sources has to be well cited and referenced. This will help to ensure that the sources of the information are given their due credit accordingly (Wayne Goddard, 2004, p. 62). The researcher also has the important task of ensuring that all the sources of information are reviewed. This will help to ensure that there is no extension of errors that had been made by the scholars of the sources where he is collecting the information. This will help to ensure that the study is conducted without a hitch and will also help to seal the gaps that were left in similar past studies.
4.1 Role of Islamic banks in Saudi Arabia
Leading firms that offer Islamic banking in Saudi Arabia include the NCB, Al-Rajhi investment bank, and Albilad bank. NCB is the largest bank in Saudi Arabia and in the Middle East by virtue of assets. The company has over three hundred branches in the kingdom of Saudi Arabia alone, making it the largest bank in regards of number of branches(National Commercial Bank, 2015). According to the annual reports made public by the NCB, the firm has assets worth 435 billion riyals as of the year ended 2014(National Commercial Bank, 2015). In addition, the bank made its highest profit yet in the year 2014 when it accumulated 8.7 billion riyals(National Commercial Bank, 2015). The NCB has made the strategic decision to become a fully integrated Islamic bank by the end of the year 2020(National Commercial Bank, 2015).
NCB begun transforming itself into an Islamic institution in the 1980s, about 20 years after its founding(National Commercial Bank, 2015). At the time, the financial environment in Saudi Arabia was just beginning to take shape with material investments being made in the mining industry. The strategic goal at the time was to gradually transform the bank from conventional banking into a fully-fledged Islamic bank. Over the course of the net twenty years NCB would ensure that its 160 branches offered Islamic banking services only(National Commercial Bank, 2015). The following year, an additional 80 branches were made to comply with the guidelines of the sharia laws on finance. This strategic transformation has made NCB the largest Islamic bank not only in Saudi Arabia, but also globally. As a fully-fledged Islamic bank, it means that all its assets are based on Islamic laws.
NCB has several operating segments under its wing. Its retail arm offers financial services to natural persons as well as companies. Retail banking includes current and savings accounts(National Commercial Bank, 2015). As mandated under Islamic laws, current accounts are based the view that the customer can withdraw all deposits whenever there he wishes. NCB is also required to seek the permission of the client before investing the funds deposited in these current accounts. This is regardless of the whether the client is a natural person or company. NCB’s savings accounts allow clients to deposit funds with the bank for a given period of time before these funds are availed to the client. Once again, the client’s consent is to be sought before these funds can be used in other ventures. When these funds are used in these ventures and profits are made, they belong to the bank. The bank also retains the risk associated with these ventures, including the possibility that there might be losses made and funds lost.
NCB also offers investment services to its clients. One of its investment services is based on the client buying select commodities and then selling them to the bank. There is a difference between the buying and selling price, which leads to profits being made by the client. The bank can then sell these commodities at a profit. Another investment service comes in the form of a mutual fund. Like in conventional banks, mutual funds attract the interest of individuals willing to pool their funds together and pursue a particular investment. At NCB, the bank offers investments in a variety of areas that include equity funds and alternative investments. However, unlike conventional banks where risky investments might be made, NCB invests only in those areas that are allowed by sharia laws. That is to mean that the bank’s mutual funds do not go into investments that amount of speculation. For example, sharia implicitly prohibits the use of hedge funds that are considered to be speculative in nature. Thus, NCB does not make investments in this area.
Like other conventional banks, NCB also offers financial services that are targeted at the business community. These services include the management of payroll payments and letters of guarantee(National Commercial Bank, 2015). However, it is the escrow services that offer the best insight into the application of sharia in banking NCB’s escrow accounts are meant to provide for the east flow of cash from one person to the other. The service has been in use in the Arab world for several centuries(El-Gama, 2000). Using escrow services allows the bank to hold deposits for a limited period during which parties perform their duties. Once these duties are fulfilled, the bank releases funds to the select person. Other services directed at the corporate market include asset financing. Unlike conventional banking where interest is charged on these financing options, NCB uses a profit sharing formula that leads to the borrower paying some part of the gains made from using the asset to the bank. This is one of the core differences between conventional banking and what is offered at NCB. Under the traditional setup, the bank has no interest in how the asset is used or the benefits and risks that may arise. However, NCB takes measures to ensure that the borrower engages in practices that are allowed by the Koran. Apart from that, the bank takes an interest in the profits made by the borrower as a result of using the asset. In case the borrower makes losses, the bank also realizes its share of losses in the asset.
4.2 Governance at NCB
As is the case with other conventional banks, NCB has a board of directors that oversees the company’s general strategic direction(National Commercial Bank, 2015). These directors are elected at the bank’s annual general meeting with shareholders and in accordance with the regulations governing such matters in Saudi Arabia. NCB also has a management team that carries out the strategies pointed out by the board. The chief executive officer acts as the vital link between the board and the management and sits in both groups. The company also releases annual reports to shareholders and other interested parties. Like in the conventional bank, the annual report details the group’s performance over the last one year.
However, a remarkable difference between the governance of an Islamic bank and the traditional bank is the presence of a sharia board. It is widely accepted that the Koran is highly subjective on financial matters, leaving some topics open for discussion. The sharia board is there to guide the board of directors on matters of Islamic law, banking, and other financial services(Abedifar, Molyneux, & Tarazi, 2013). As a bank that has made the commitment to become sharia compliant, the sharia board plays a key role in the development of products that adhere to Islamic law. NCB has also created an internal group that oversees the training of employees on matters of Islamic finance. The internal group is also charged with the coordination of activities across the company as compliance with sharia law touches on every aspect of the bank’s operations. In order to ensure continued adherence to the tenets of Islam on financial matters, the internal group conducts an audit of key activities and products that are offered to the market.
The Saudi Arabian Monetary Agency acts as the central bank in Saudi Arabia. The SAM is mandated with the duty of overseeing the conduct of companies that offer financial services. In addition, the central bank is charged with the responsibility of promoting growth and stability within the financial services industry. NCB falls under the umbrella of these duties. One of the laws that are pertinent to NCB’s operations is the requirement that the bank holds a given amount of deposits in its reserve accounts with the central bank. As of the year ended 2015, the central bank in Saudi Arabia requires banks to hold at least 15% of client deposits in a reserve account(Saudi Arabia Monetary Agency, 2015). The percentage may not go below 10% and must not exceed 17.5%(Saudi Arabia Monetary Agency, 2015). These provisions are necessary to prevent banks from holding too much cash in reserve accounts. At the same time, these regulations prevent a situation where the bank lacks adequate liquidity to meet client withdrawal demands.
As part of an ongoing program to adjust to global financial trends, the central bank of Saudi Arabia has introduced Basel regulations on the banking industry. Initially, Basel regulations on bank liquidity and regulation were targeted at large conventional banks with the aim of reducing risk taking and speculative activities. The application of these laws and regulations is mandatory in several major economies, including the US, Europe, and much of Asia-pacific region. However, it is a hotly contested topic on whether these rules should apply across the board(Alexakis & Tsikouras, 2009, p. 93). A key factor is that these rules were meant to apply to those banks that were deemed to be too significant to fail. However, the approach taken is that these regulations now apply to both small and large banks.
Despite the challenges encountered in applying a system meant for the conventional bank to an Islamic bank, NCB has adopted Basel regulations with gusto. Indeed, the bank makes quarterly announcements of its standing in regards to these ratios and financial measures. As of the year ended 2015, NCB was adequately financed and capitalized to handle severe liquidity stress. This is exemplified in its high tier capital ratios that are well above those stipulated in the Basel regulations. The bank is able to attain these high ratios on account of its prudent business practices that are guided by Islamic financial law. As stated previously, the bank takes special interest in investments undertaken by its clients. In addition, NCB is barred from engaging in speculative activities by Islamic law. The result is that there is a tremendous increase in the amount of capital available in the computation of these ratios.
The aim of this study was to present an understanding of the key differences that exist between conventional banks andIslamic banking systems. It is found that Islamic and conventional forms of banking share numerous similarities. Yet, they differ in significant ways too. The study finds that both systems of banking offer important services to the economy. They act as intermediarieswhile converting short term liabilities intolong termassets. Banks also pool risks through mutual funds. Despite these similarities, conventional banks differ from Islamic banks by virtue of the fact that Islamic banks are guided by the religious tenets of finance. Therefore, banks using the Islamic financial system do no charge interest on loans advanced to clients. Instead, Islamic banks use a profit sharing formula thatallows the firm to take some of the gains made from using the loan. Secondly, Islamic banks do not lend money if it is to be used in certain ventures that are considered to be contrary to the teachings of the Koran. Thirdly, Islamic banks do not engage in speculative activities with the aim of making profits.
The study’s second objective was toinvestigatehow Islamic banking has been applied in Saudi Arabia by taking NCB as the case example. NCB is selected owing to its position as a fully integrated Islamic bank. Therefore, its operations offer insight into how different Islamic banking is from the well-understood conventional banking.It is found that NCB has been able to extend critical financial services to both individual clients and companies. In many ways, these services are similar to those offered by the conventional bank. However, NCB differs from conventional banks in that its services are tailored along Islamic teachings. Therefore, the bank does not charge interest on loans to customers. Instead, the companyrecognizes profits made from these loans. In addition, NCB does not lend to ventures that are restricted by Islamic teachings. Yet, NCB has made efforts to merge the gap betweenregulations meant for conventional banks and its internal operations that are guided by Islamic law. The study concludes that while there are a number of differences between the operation of an Islamic bank and the traditional financial system, there are also profoundsimilarities between the two. It is suggested that future research be carried out to guide the use of regulation in the two banking systems, recognizing the differences that exist in risk taking and basic operational activities.
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