THE IMPACT OF INTEREST RATE RISK ON THE PROFITABILITY OF ISLAMIC AND CONVENTIONAL BANKS IN UNITED KINGDOM

INTRODUCTION

The economic development of a country is inclined towards the stability of the finance that plays an important role. The financial intermediation model is based on the conventional banking whereby the banks generate profits from the deposit of the savers from their margin that they are depositing in the bank and the demand deposits, funds that are being lent to the individuals or enterprises. Some of the services that are being provided by the bank are risk management, foreign exchange, letters of credit, interest rates, commodities, trade guarantees, derivatives and custodial services are being provided to the depositors.

The conventional banks follows an efficient bank lending process through information asymmetry which gives rise to the ability of the borrowers who can operate themselves by withholding their own information and the position they hold(Dridi and Hasan, 2010). The loan agreement is specific other than this the loans can be obtained for some other purposes but it will create an exposure to the unknown risks for the banks. This can lead to the fraudulent activities by the banks as they can misreport their cash flows to declare as bankruptcy for those customers. During the Great Wall Street of 1929, the economic depression of 1930, the Asian financial crisis is a part of the global economic system for the conventional banks.

The Financial Supervisory Authority (FSA) in the United Kingdom led to the adoption of innovative and stricter control policy mechanism. The operation of Islamic banking is successful by the government of UK. The Islamic retail banks are operational to provide Islamic financial services. As per the report of UK, Islamic banks exceed from those of the western country and have a growth in the Muslim community. About 20 law firms provide services to the Islamic people by providing funds to them. The existence of the conventional banks has a greater access to the deposits and confidence of the customers before the Islamic banks erupted (Chowdhury, 2013). To serve a particular niche segment the conventional banks opened up a new product for the Islamic people. It created products for the financial transactions to suit the existing customers on their religion disposition. The HSBC Amanah is a blow for the development of the Islamic finance is held for the largest banking assets at the time of the announcement. An in-depth analysis of Islamic is compared to conventional banking in the UK.

LITERATURE REVIEW

Introduction:

In the mid 1990’s the Islamic financial institutions has grown widely. The conventional banks had increased its total assets with the financial institutions to service their offerings with the innovative products with the minority Muslims in countries like UK, France and South Africa. The clamour for Islamic products becomes more important than the conventional ones. The Islamic financial banks provided products based on the profit or loss among the parties of Islamic partnership as opposed to the receipt or payment of interests(Zulkifli bin Hasan., 2012). The literature review is based on the impact of interest rate risk on the profitability of Islamic and conventional banks in United Kingdom. The aim of the research is to understand the profitability that has been earlier documented.

The bank profitability also depends upon the external and internal factors. The classification of the internal factors is within the control of bank into financial statements as well as non-financial statements which includes the number of branches and employees. The balance sheet structure is dependent upon the balance sheet structure of the financial institution. The asset items have an association in the profitability whereas the liability has an adverse effect on the profitability of the financial institution(Salem, 2013). The bank’s profitability also depends upon the deposits made by the depositors when examined from the liability point of view. In the commercial banks time and savings has a negative impact on the profitability of the business. The relationship between demand deposits and profits has a positive impact on the profitability of the Islamic banks. The income statement as per the researchers is that the involvement of bank’s profitability has a positive relationship. The statements presented by the non-financial include the number of branches, banks size and location which creates a positive impact on the profitability of the bank.

The control of banks such as interest rate, competition, regulation, inflation and economic condition are based on the factors that include the profitability in the external environment. The control of banks includes the market concentration, ownership, market share, bank size and money supply inflation. The bank’s profitability has a significant association with the internal and external variables(Akhtar, Ali and Sadaqat, 2011). The income obtained for the profitability of Islamic banks has a considerable effect on the capital adequacy and liquidity for the deposits. The well-capitalized banks have a higher net interest margins and the profitability.  Banks with high non-interest earning assets are less profitable on deposits for their funding are less profitable in the banks. The inflation rate in the market is highly dependent upon the interest margins and higher profitability.The larger the loan and asset ratio the greater the leverage thereby the higher profitability takes place in the banks.

Main Body

The Islamic banking profitability indicates that a higher profitability can be obtained from a high degree of loans to asset ratios. The total liquidity and assets is directly proportional to the return on asset (ROA) is whereas, ROE is inversely proportional to the cost of interest and financial leverage. The interaction of gross domestic product (GDP)   per capita the loan to total assets in the profitability of Islamic banks is being concluded to have a positive impact on the other measures that are being employed such as net margin interest, return on equity and assets. (Ahmad, urRehman and Saif, 2010). In the macroeconomic environment and high growth rate of GDP have a positive impact on the performance measures of the Islamic banking profitability simultaneously the total assets have a negative impact on the profitability. The positive impact on Islamic banking profitability includes the capital ratio, stock market development and loans while the banks size has a negative impact. The integration of the time series technique and error detection needs to be evaluated for determining the profitability of the Islamic banks to influence both the internal and external factors (Pearce and Pearce, 2011). The asset structure variables have proposed an inverse relationshipin the funds investment in profit-sharing and funds investment are essential in the Islamic bank profitability.

Capital is an important feature for the bank’s profitability as the effect of bank specific and so an increase in the exposure of credit cards lowers the risk and profitability.The impact of the profitability is the labour productivity growth has an impact on the profitability, while the negative impact on the banking profitability is due to the operating expenses. The economies of scale do not affect the bank size in banking (Ahmed, 2011). The macroeconomic control variable such as inflation and cyclical output affects the performance in the banking sector. Thebank’s profitability leads to the efficient management thus affecting the asset size with the positive relationship of the banks. An important factor that increases Islamic banks profitability is to have favourable macro-economic conditions such as the size of the bank and equity capital. Furthermore, an increase in the owners’ equity decreases with the impact of financial crisis.

Since the 1970s global crisis started with the subprime mortgage in the U.S. It created a significant impact in the financial and operating performance in many banks of the world. After going through a detailed financial crisis on the Islamic banks profitability especially during the global financial crisis affecting significantly in the banks and financial institutions for their profitability. For instance, customers are interested to know the services that are being provided by the bank and what are the outcomes that the customers will get depends on the profitability of the banks(Sundararajan, Kohli and Ahmed, 2011). An awareness of the profitability with the policy makers is to formulate the effectiveness policies and regulations for the banking industry. The bank industry is constantly having a tough competition from the large and well managed Islamic banks that competes the already existing banks. As per the researchers the Islamic banks credit and assets are at least twice higher than that of the conventional banks.

Islamic banks to attain a higher profitability and trust from the customers have set their own standards and rules and regulations to ensure the supervisory and legal infrastructure include bank resolution is relevant to the rapidly changing Islamic developments globally and financial landscape. The efforts in this reform movement should interface with the global agenda. The sustainable growth, efficiency and development in the industry have a greater convergence and harmonization of regulations and products in the bank industry. The challenge that is required by the Islamic banks and supervisors will work together for the development of human capital(Dalhuisen, 2010).The various rating agencies reflect the Islamic banks are better than or similar to that of the conventional banks.Strong growths in the legal and regulatory framework for Islamic bank profitability are as follows:

• Progress in strengthening the legal and regulatory framework for Islamic finance;
• Strong demand for Shariah products;
• Capacity of the ban industry to develop a number of financial instruments that mostly met the needs of the corporate and individual investors;
• Conventional investors have a growing demand including those of diversification purposes.

The relationship between the conventional and Islamic banks is more stable and the specific in the bank industry. In recent years, Islamic baking has given a focus on the industry specialists and academics have a considerable growth in the bank industry. The type of assets that are being exposed to the total assets is closely associated with loses that takes place in the conventional banks has experienced during the crisis. The shield that protected the Islamic banking is based on the asset and risk-sharing nature of the Islamic finance(El Tiby, 2011). The Islamic banks like those of the conventional banks rely heavily upon the leverage that has undertaken risks for the profitability that makes them vulnerable during the global crisis. In comparison to the conventional banks and Islamic banks it is proved that the Islamic banks have performed better as the conventional banks have incurred by the conventional banks.The comparison of the two banks would lead to a reliable conclusion about the financial stability and resilience of the Islamic banking sector as because it allows for an appropriate control for the conditions across the financial systems worldwide.

Conventional banking utilises a comparison of debt and equity in financing the profitability of the Islamic banks. A fixed percentage of interest is expected from the debt finance. The equity in participation investment prescribed in the Islamic banking system. The Islamic finance has a distinctive feature is that it does not create of debt through the borrowing of money or other financial assets. The finance schemes are based on the sale or lease of real assets can only be created through debts(Gaillard, 2011). The debt cannot be sold or transferred to someone else and the asset that is being sold or leased must be real. The Islamic banking profitability is to do away unethical practices is prohibited in the Islam. The investment of the Islamic system prohibits the investment in the following – tobacco, alcohol, entertainment and pork related products. Thereby, it reduces the scope of investment for the Muslims. The banking sector has made an introduction in the innovative products which aims at satisfying its customers. The Islamic banks is considered to be superior to that of the conventional banking that concentrates on the social and economic advancement to the citizens rather than just only concentrating in the financial growth of the firms.

Conclusion

From the research review we can conclude that the profitability of the Islamic banks can be categorized under two groups – internal and external factors. The factors that are within the control of the bank are being considered as the internal factors of the bank management which when further being classified into two categories. They are – financial statement variables and non-financial statement variables.The income statement and balance sheet are the variables that fall under the category of financial statement variables. The employees in the bank and the number of branches are being considered as the non-financial statement variables(Chehabeddine, 2010). Due to the various external factors i.e. the rise in the economic conditions such as the inflation, competition among the rival firms, and the interest rate are being controlled by the management of the banks. The profitability of the conventional banks and the methodology is being applied to give a rise in the profitability of the Islamic banks. Islamic bank of profitability is growing at a faster pace in terms of financial services and it has captured the market which many other banks couldn’t do it. The conventional intermediation is based on the debt and allows for risk transfer whereas; Islamic intermediation is based on the asset and focuses on the risk-sharing activities.In addition to the Islamic banks the additional features serve the customers more accurately and definitely to the real economy and tend to reduce the contribution in excess.

From the above analysis, it suggests that the conventional banks served its customers differently than those of the Islamic banks. The weakness of Islamic banks is in the risk management practices that led to the decline in the profitability as compared to the conventional banks.The conventional banks have its competitors that triggered the global financial crisis that created an adverse effect to the Islamic banks from financing or investing in the kind of instruments(Bell and Kilpatrick, 2010). The framework of a neutral regulatory for the conventional and Islamic banks strengthens the risk management in some banks.Despite the pre-global crisis period the profitability of the conventional banks was similar to that of the Islamic banks suggesting that the profitability was driven by the strategy of risk-taking in a considerably greater degree. The size of the Islamic banks is far better than the small ones. The better performance is contributed by a better diversification, strong reputation and economies of scale leads to a better profitability.

A growing market share was moving forward and a large supervisory responsibility during the crisis. R-assessment of the Islamic banks has an external rating as risk is generally more favourable or similar to that of the conventional banks. The demand of the market is growing at a high speed which has a higher solvency facilitating the Islamic banking finance and maintaining stable external banks. A strong branding, customer relationship, asset growth and strong credit have helped the consumer a lot(Aronson, Thornton and Beseiso, 2014).Islamic banks have an opportunity to prove their resilience which has highlighted the need to address the important challenges. The importance of liquidity risks, has led to the greater recognition and the need for efficient resolution of bank framework. The functioning of the liquidity management infrastructure is a key priority to have profitability in the Islamic banks.

RESEARCH METHODOLOGY

The research methodologies of Islamic banking profitability are as follows:

First, the banking activities of the non-traditional Islamic banks is an important factor as the size of the bank is measured by the total assets is being employed. A correlation exists between the total assets and ROA. Anegative relationship exists in the size of the bank with a positive relationship for the Islamic banks and their profitability for the conventional banks.

Second, the total equity as a percent of the total assets is measured for the capital ratio. The structural ratio is a variable which is being used for assessing the safety and soundness of the banks. The amount of capital that is required by the banks is sufficient for the operations to perform and support the activities in a bank (Love and Turk Ariss, 2013). A significant positive relationship exists between the banks profitability and the capital ratio.It is therefore a correlation with ROA has a positive impact on the Islamic profitability banks.

Thirdly, the total loans as percent of total assets are measured for the loan ratio. The bank lending activityis related with the bank assets in the form of liquidity (Saeed, 2013). A loan ratio and profitability acts as a positive relationship in the Islamic banks of profitability.

Fourthly, financial leverage ratio is measured by the total deposits over the total assets. The customers, banksand financial institutions act as the deposits of the total depositsas a percent of total asset ratio. The importance of thebank’s profitability is to promote for the deposits is being calculated in the deposit ratio to the total assets.

Fifth, the cost of deposit ratio is an essential factor for the profitability. The interest expense as a percent of the total deposits is an interdependent variable for the deposits in the costs. The interest expense and ROA has a negative relationship in the cost of the deposits ratio.

Sixth reason is the total expenditure as percent of total assets is the profitability that is being measured in the Islamic banks. In the Islamic banks the expenses of the bank is exclusive of the cost of restricted investment deposits. The efficiency of a bank is measured in terms of total expenditures over the total assets(Omar, 2011). It operates the expenses and helps inn controlling the bank and managing and aids in analysing the indicators of the bank’s profitability which will thereby create an impact on the expenses of the banks.An impact on the performance of the banks is due to the high overhead costs in which the bank is being involved thereby leading to negativity because the banks are expects to get their work done at lower costs but with greater effectively and efficiency in the banks activity.

Seventh principle loans as a percent of the total assets is being invested by the profitability of the banks is a mark-up principle acts as a determinant of the Islamic banks profitability. The profitability indicators have an inverse relationship in the banks profitability.

Eighth, the profit-sharing as a percent of total assets is linked to the total funds that are being deposited by the depositors in the bank. The funds that are being invested in profit-sharing or mark-up have an inverse relationship with the Islamic profitability indicators.

Ninth is the direct-shared investment to total assets which is the determinant of the Islamic banks profitability. The financial statement variables from an unrestricted investment deposits and the funds collected from the banks creates a linkage between the direct shared investments to the total assets. The direct-shared investments include affiliates, real estate, investment in the securities, investment funds, commodities and the financial portfolios. The profitability measures to that of the total assets are being negatively related to the Islamic banks profitability.

Tenth, the total deposits in the demand account and the current account acts as a percentage of the total assetwhich clearly defines the current account ratio (Loucks, 2012). ROA has positive relationship between the current accounts.

Eleventh determinants of research methodology are the deposits ratio that is being unrestricted in the Islamic banks of profitability. The savings and the time ac and It is being defined as the total unrestricted investment deposits in saving and the time act as the investment deposits is totally unrestricted. Time deposits with the profitability indicators have a positive relationship in the Islamic banks profitability.

Lastly, the deposit ratio as a percent of total asset is restricted in the investment. Restriction in the investment exists in the investment deposits as those deposits appear to be outside of t eh balance sheet against some special investments.

Table 1: Means value liquidity ratios

(Source: http://www.interesjournals.org/JREIF)

To calculate the banks liquidity condition the mean loan to deposit ratio this is the proportion of customer deposits. The Islamic banks profitability was less liquid. The loan to deposit ratios is nearly doubled in this study. The customers’ demands to be met by the short-term funds and the deposits in the mean cash and portfolio investment are higher than the Islamic banks. The higher the level of cash and portfolio investment has a greater utilization of the deposits. The average ratio increased at its highest level in the year 2011(Brodbeck, 2013). The proportion of the Islamic banks in the annual average loan to asset ratio is committed to the loan. The grater asset of the coverage and liquidity leads to the lower loan deposits ratio for the conventional banks. Islamic non-interest bearing loans cannot be converted to cash maturity and has a fixed duration.

                                          Table 2: Mean profitability ratios

(Source: http://www.interesjournals.org/JREIF)

The profitability ratios include return on asset, profit to expenses ratio and return on equity ratio. The average ROA of Islamic banks is lower than the conventional banks. This showed a negative and a steep decline in the attribute of the total assets especially in the loans as a substantial provision against the non-performing loans. The return on assets has a positive impact while the return on equity fluctuated in the conventional banks and the Islamic banks got worse in the profitability ratios(Khan, 2013). This affected the Islamic banks as they are smaller in size than the conventional banks. The consequence is due to the rules that the banks followed for the Muslim people and the aggressive strategy of the banks for higher booking loans led to the unstandardized hence increasing the operational costs relative to that of the conventional banks.

DATA ANALYSIS

The two groups of the banks is a challenging task for comparing the impact on the crisis for two reasons. First, detailed data analyses on the performance of banks in countries where the Islamic banks represent a significant portion of the banking system are not readily available. Second, the impact of the crisis is highly dependent and relied upon the pre-crisis sectorial and market excesses which createvulnerability in the Islamic banking system and the response to the policy in each country variesthus complicating cross-country comparisons. The market structure and the Islamic banking model has largely involved in the investment activities are not rigorously as a domestic banks(Cevik and Charap, 2011). The initial conditions of Islamic bank profitability have a higher capital adequacy ratio and have smaller investment in the bank which relies upon the wholesale deposits.The reliance on the wholesale deposits is based on the asset based finance, restricted lender-of-last-resort limit leverage and weaker interbank markets. Restrictions on the investment and the lack of financial instruments limit the size of the Islamic banks.

Islamic banks are non-performing loan ratios pre-crisis. This is due to the fact that the Islamic banks have a limited capacity to the loans as they are incapable of lending cash. The exposure to the risk-free government is limited in this sector and has a relatively high exposure to the consumer sector which has a high default rate. Later it exceeded the limit that is being imposed by the law for the banks, preventing conventional banks to that of the Islamic banks to increase the risk concentration(Bodie, Kane and Marcus, 2011). For instance, if the classification is based on the type of borrower rather than using loans and mortgage loans are a part of real estate loans while sometimes these are being classified with the consumer loans in excess while the real estate loans are mainly commercial real estate.

During the global crisis Islamic banks the assessment was strictly undertaken to draw a conclusion on the profitability of the banks. The requirement of the Islamic banks follows some code of conduct in doing business and sharing the risk, the availability of credit is primarily concerned by the purchase of real goods and services, short sales, excessive amount of uncertainty, restriction on the sale and the prohibition to sell the assets which is not owned by the consumers or the banks(Imam and Kpodar, 2010).The Islamic finance has its own strength which includes a close linkage between the productive flows, financial transaction and the built-in dimensions of risk management and government had contributed greatly to its resilience and its viability.Islamic banks have funded western corporations which may sometimes be risky and have low credit ratings without conducting the need to have a requirement of due diligence. Some companies provide Islamic banks than the conventional banks had an excess liquidity for the international crises are eager to place their funds quickly and maximize the profits. However, Islamic banks were well affected because the instutions have a direct exposure to the derivative instruments simply because the banking is related to the asset based transactions.

REFRENCES

Ahmed, H. (2011). Product development in Islamic banks. Edinburgh: Edinburgh University Press.

Ahmad, A., urRehman, K. and Saif, M. (2010). Islamic banking experience of Pakistan: comparison between Islamic and conventional banks. International Journal of Business and Management, 5(2), p.137.

Akhtar, M., Ali, K. and Sadaqat, S. (2011). Liquidity risk management: a comparative study between conventional and Islamic banks of Pakistan. Interdisciplinary Journal of Research in Business, 1(1), pp.35–44.

Aronson, J., Thornton, R. and Beseiso, F. (2014). The Developing Role of Islamic Banking and Finance. Bradford: Emerald Group Publishing Limited.

Bell, J. and Kilpatrick, C. (2010). Dalhuisen on Transnational Comparative, Commercial, Financial and Trade Law, Volume 3.Hart Publishing.

Bodie, Z., Kane, A. and Marcus, A. (2011). Investments. New York: McGraw-Hill/Irwin.

Brodbeck, H. (2013). Values in Internal Marketing. Baden-Baden: NomosVerlagsgesellschaft.

Cevik, S. and Charap, J. (2011). The behavior of conventional and Islamic bank deposit returns in Malaysia and Turkey. [Washington, D.C.]: International Monetary Fund.

Chehabeddine, F. (2010). Difference between Islamic banking and conventional banking.

Chowdhury, F. (2013). A comparative study of Islamic vs. conventional banks and financial performance in context of Malaysian banks. Halifax, N.S.: Saint Mary’s University.

Dalhuisen, J. (2010). Dalhuisen on transnational comparative, commercial, financial and trade law. Oxford: Hart.

Dridi, J. and Hasan, M. (2010). The Effects of the Global Crisis on Islamic and Conventional Banks. Washington: International Monetary Fund.

El Tiby, A. (2011). Islamic banking. Hoboken, N.J.: Wiley.

Gaillard, N. (2011). A Century of Sovereign Ratings. Dordrecht: Springer.

Imam, P. and Kpodar, K. (2010). Islamic Banking. Washington: International Monetary Fund.

Khan, M. (2013). What is wrong with Islamic economics?. Cheltenham: Edward Elgar Pub. Ltd.

Loucks, E. (2012). World Environmental and Water Resources Congress 2012. Reston, Va.: American Society of Civil Engineers.

Love, I. and Turk Ariss, R. (2013). Macro-Financial Linkages in Egypt. Washington: International Monetary Fund.

Omar, S. (2011). Islamic bankers’ perception of Al-IjarahThummaAl’bay (AITAB) Islamic hire purchase facility in Malaysia.

Pearce, D. and Pearce, D. (2011). Financial inclusion in the Middle East and North Africa. Washington, D.C.: The World Bank.

Saeed, A. (2013). Islamic Banking Efficiency.Saarbrücken: LAP LAMBERT Academic Publishing.

Salem, R. (2013). Risk management for Islamic banks. Edinburgh: Edinburgh University Press.

Sundararajan, V., Kohli, H. and Ahmed, J. (2011). Islamic finance. New Delhi: SAGE.

Zulkifli bin Hasan., (2012). Shari’ah governance in Islamic banks. Edinburgh: Edinburgh University Press.