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Free Research Proposal: Islamic Banks and Capital Structure

| October 22, 2011 | 0 Comments


Islamic banks are banking institutions that have been set up based on Islamic Sharia law. Since the establishment of theDubaiIslamic Bank in 1975, over 277 Islamic banks have been established in 70 countries the world over. As opposed to conventional banking institutions that operate based on interest income, Islamic banks operate based on profit and loss sharing agreements (PLS). Islamic banking has dominated the entire banking industry in countries such asIran,PakistanandSudan, and some large conventional banks such as HSBC and Citigroup have launched Islamic divisions in order to operate in these markets.

According to Olson and Zoubi (2008), Islamic banks differ from conventional banks in a number of ways:

  • Islamic banks are organized under and operate upon principles of Islamic law, which requires risk sharing and prohibits the payment or receipts of interest (riba).
  • Islamic banks also operate under the principle of risk sharing, and enter into agreements with depositors and lenders. Funds are received from the investing public on the basis of Mudaraba, and the bank is allowed to use the funds any how they see fit. They borrow the funds to entrepreneurs on the basis of Musharaka, and these entrepreneurs would use the funds to finance their businesses and share the profits with the bank, based on predefined ratios.
  • The bank then pools all profits from different investments, and shares these profits with savings depositors, based on predefined ratios.
  • Conventional banks use debt and equity financing, while Islamic banks operate mostly on equity financing and customer deposit accounts.
  • The cost of capital in conventional banking represents the cost of debt and equity, while that of Islamic banks is replaced by profit and loss sharing by depositors and equity holders in Islamic banks. Return on equity is more variable than conventional banks, but default risk of not repaying loan is eliminated.

However, Khan and Bhatti (2008) state that Islamic banks have the following problems:

  • Islamic banks are still very nascent compared to conventional banks. They are about 40% more liquid than conventional banks due to the unavailability of a wide range of Sharia compliant investment products.
  • They follow a varied range of accounting standards and practices.
  • They suffer a serious shortage of Shariah experts in the banking industry.
  • ¬†They face a crucial challenge of improving their risk management strategies and corporate governance as they face a wide sort of interest rate, liquidity and non-payment risks.
  • They have an unsatisfactory R&D and innovation history, as most of their products and frameworks are still based on conventional banking methods.

According to Olson and Zoubi (2008), since Islamic banks operate under similar conditions to conventional banks, then the difference in these banks should be easily distinguishable through their balance sheets, however based on international regulatory requirements and reporting requirements such as the Basel that regulate all banks, then it is possible that they have similar balance sheets.

Also, the difference in operating structures does not explain how well both types of banks differ with respect to their profitability and risks. For instance, does a profit sharing structure, as opposed to one that is primarily based on interest, result in more profitability? Does it depend on the business environment, and how does it affect the risk the banks are exposed to. Are Islamic banks regarded more or less risky than conventional banks because they have a stake in several businesses, and if so, how can that be ascertained?

Therefore, based on these theories and the following questions, this research would aim to study the capital structure of Islamic and conventional banks, and determine how exactly it affects profitability and risks.

This dissertation would entail three levels of analyses.

Before any of these analyses, about 20 Islamic and conventional banks would be identified and their annual reports would be obtained.

The capital structure of both types of banks would be studied by calculating the capital structure ratio: long term debt / (shareholders equity + long term debt). By identifying and obtaining the mean value of the capital structure across both types of banks, I would understand how the structure of Islamic banks differ to conventional banks.

Information on profitability would be obtained by calculating the following ratios:

1. ROA = return on assets

2. ROE = return on equity

3. PM = profit margin

4. ROD = return on deposits

5. NOM = net operating margin.

The mean value of these ratios in Islamic banks compared to that of conventional banks would give a descriptive picture of how the profitability differs in Islamic and conventional banks.

The same would be done for risk, by identifying the following ratios in both sets of banks:

1. DTA = deposits to assets

2. EM = equity multiplier

3. ETD = equity to deposits

4. TLE = total liabilities to equity

5. TLSC = total liabilities to shareholder previous capital

According to Olson and Zoubi (2008), financial ratios are the best way of distinguishing between Islamic banks and conventional bank, and that method would be utilised in this study.

Linear regression analysis would be conducted on data provided on all 10 Islamic and conventional banks (differently) to determine how well capital structure affects changes in profitability and risks. If results obtained show a coefficient of determination higher than 50%, then the research would go ahead to explain how differences in the capital structure, are likely reasons why profitability and risks are different within both types of banks.

Empirical findings would also be utilised in describing these phenomenon, in order to come up with a coherent argument on the relationship between capital structure, profitability and risks. Extensive literature review would also be conducted on this effect to know what other theorists have found. It may be possible that profitability and risks in both types of banks are indeed different, but not as a result of capital structure, but maybe as a result of economic activities within the Gulf region and developing countries where most Islamic banks are located. If this were the case, then it would act as a basis of recommendations for future research.

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