Global Journal of Management And Business Research

Volume 11 Issue 1 Version 1.0 February 2011

Type: Double Blind Peer Reviewed International Research Journal
Publisher: Global Journals Inc. (USA)
ISSN: 0975-5853

Performance comparison of Islamic and Conventional banks in

Pakistan
By Muhammad Jaffar, Irfan Manarvi
Iqra University, Islamabad

Abstract- The study examined and compared the performance of Islamic and conventional banks
operating inside Pakistan during 2005 to 2009 by analyzing CAMEL test standard factors such as
capital adequacy, asset quality, management quality, earning ability and liquidity position. The
financial data for the study was mined from the banks’ financial statements existing on state bank
of Pakistan website. A sample of 5 Islamic banks and 5 Conventional banks were selected to
measure and compare their performance. Each year the average ratios were considered,
because some of the young Islamic banks in the sample do not have 5 years of financial data.
CAMEL test which is a standard test to check the health of financial institutions was used to
determine the performance of Islamic and conventional banks. The study found that Islamic
banks performed better in possessing adequate capital and better liquidity position while
conventional banks pioneered in management quality and earning ability. Asset quality for both
modes of banking was almost the same; conventional banks recorded slightly smaller loan loss
ratio showing improved loan recovery policy whereas, UNCOL ratio analysis showed a nominal
better performance for Islamic banks.
Keywords: CAMEL test, Islamic and Conventional banks, capital adequacy, asset Quality,
management quality, earning ability, liquidity position.
Classification: GJMBR-B: JEL Classification L15, E58, G21

Performance comparison of Islamic and Conventional banks in Pakistan

Strictly as per the compliance and regulations of:

© 2011 Muhammad Jaffar, Irfan Manarvi.This is a research/review paper, distributed under the terms of the Creative Commons
Attribution-Noncommercial 3.0 Unported License http://creativecommons.org/licenses/by-nc/3.0/), permitting all non-commercial
use, distribution, and reproduction inany medium, provided the original work is properly cited.
 Performance comparison of Islamic and

February 2011FF
Conventional banks in Pakistan
Muhammad Jaffar1, Irfan Manarvi2

61
Abstract —The study examined and compared the performance 1
Like other Muslim countries scholars who
of Islamic and conventional banks operating inside Pakistan
implied the concept of Shari’ah compliant financial
during 2005 to 2009 by analyzing CAMEL test standard factors
such as capital adequacy, asset quality, management quality,
system which became the base of Modern Islamic

Volume XI Issue II Version I

earning ability and liquidity position. The financial data for the financial and banking system, Pakistan also started
study was mined from the banks’ financial statements existing interest free financial system from 1970 with very limited
on state bank of Pakistan website. A sample of 5 Islamic interest free products. The actual work started during the
banks and 5 Conventional banks were selected to measure era of Zia-ul Haq governmentin 1980s when Islamization
and compare their performance. Each year the average ratios of financial system and economy gradually started
were considered, because some of the young Islamic banks in under government policy [4][5]. The period of 1990 to
the sample do not have 5 years of financial data. CAMEL test 2001 has seen the legal debates and cases in FSC and
which is a standard test to check the health of financial
SCP on the issue of ‘Riba’. The court decision against
institutions was used to determine the performance of Islamic
and conventional banks. The study found that Islamic banks
Riba forced the government to convert the interest
performed better in possessing adequate capital and better based financial system to interest free based financial
liquidity position while conventional banks pioneered in system. The government and many influential interest
management quality and earning ability. Asset quality for both based financial institution were not interested for the
modes of banking was almost the same; conventional banks abrupt change [6].
recorded slightly smaller loan loss ratio showing improved

Global Journal of Management and Business Research

From 2001 onward government and SBP fully
loan recovery policy whereas, UNCOL ratio analysis showed a supported Islamic Banking. Policies, framework,
nominal better performance for Islamic banks. structural support and rules of business for Islamic
Keywords – CAMEL test, Islamic and Conventional banks were established and Islamic Banking started in
banks, capital adequacy, asset Quality, management the shape of full-fledged banks and Islamic Subsidiaries
quality, earning ability, liquidity position. by commercial banks [7].
I. INTRODUCTION Like Conventional bank, Islamic bank is an
intermediary and trustee of money of people. On

I
slam is the complete code of conduct for the contrary, it shares profit and loss with its depositors and
Muslims. Islamic finance has been in practice introduces the element of mutuality in Islamic banking
throughout the world and a few concept, instruments, [8]. Conventional banking follows Conventional interest-
and techniques of Islamic finance were adopted by the based principle, whereas, Islamic banking is based on
European Financiers and businessmen. A few visionary interest free principle and principle of Profit-and-Loss
individuals, scholars, bankers, Islamic economists and (PLS) sharing in performing their businesses as
Shari’ah scholars started Islamic banking system as a intermediaries [9].
universal banking in 1970. Although Riba-free business Islamic banks in Pakistan have showed good
transactions were in practice before this, a well defined performance. Many writers in the world have compared
working model for Islamic banking did not exist [1][2]. Islamic banking performance with Conventional
An Islamic bank carries out all known banking banking. The results showed that Islamic banks were
activities; it operates on the basis of profit and loss better in maintaining Capital Adequacy and Asset quality
sharing. Islamic banks were established against “Riba” than the Conventional banks [10][11].
which is forbidden in all forms and conditions. “Muslim Islamic banks are less profitable, more solvent
Umah want to eliminate “Riba” from their financial and less efficient comparing to Conventional banks. In
system but consensus on what includes in “Riba” could terms of liquidity, no major difference is seen between
not be attained. This has reduced the progress of the two sets of banks [12]. Islamic banks profitability is
implementation of the Riba free financial system [3]. positively related to equity and loans [13].
About- Department of management sciences, Iqra University,
Islamabad, Pakistan

©2011 Global Journals Inc. (US)

 Performance comparison of Islamic and Conventional banks in Pakistan

II. METHODOLOGY financed their operations, assets and growth through

more of equity and less of debt. This fact guaranteed
This study is basically based on the historical less risk and save returns for the shareholders of Islamic
February 2011FF

data. The population for this study are the all Islamic and banks.
Conventional banks that operate inside Pakistan. The On the other hand, Conventional banks D/E
sample size is comprised of 5 full-fledged Islamic and 5 ratio has been greater than 1.0 in the period of 2005-
Conventional banks. The Islamic banks selected are 2009. This is because the Conventional banks have
Meezan Bank, Albaraka Islamic Bank, Dubai Islamic aggressively depended on debt financing. As the ratio
Bank, Bank Islami Pakistan and Dawood Islamic Bank. goes bigger than 1.0 the volatility and risk of returns
The Conventional banks are ACBL, MCB, SCB, HBL and increase. The D/E ratios have increased and decreased
62 AL-Fallah bank. To measure and compare the in the alternate years of the study period with the
performance of Islamic and Conventional banks, greatest ratio of 2.1889 indicating the riskiest position in
CAMEL analysis is used, which is a standard test for 2005 and smallest ratio of 1.0724 showing the safest
performance analysis of financial institutions and the position in 2008 for conventional banks.
latest technique nowadays used. CAMEL test consists
Volume XI Issue I Version I

The mean D/E ratio for the period 2005-2009

of Capital Adequacy, Asset quality, Management recorded 1.5377 for Conventional banks and 0.5459 for
Quality, earning ability and Liquidity. The financial data Islamic banks. Comparatively, the Islamic banks had
of all Islamic and Conventional banks were extracted 2.82 times smaller ratio than the Conventional banks
from the SBP website for the period 2005-2009. For showing safer liquidity position for Islamic banks. On
better comparison, each year the average ratios for contrary, 1.5377 D/E ratio of Conventional banks
Islamic and Conventional banks were considered and 63 means
that they have followed the policy of higher risk1 leading
then the mean of each ratio for each modes of banking to higher return. This position is promising in the times
was calculated. when interest rates are low and may lead to bankruptcy
and DOG position in the times when interest rates are
CAPITAL ADEQUACY

I
III.
on rise.
Global Journal of Management and Business Research

This study analyses capital adequacy by using

the standard ratios of debt to equity and capital to risk Conventional Islamic

I
assets. The average and mean ratios for both Islamic 1.0
and Conventional banks are displayed in the figures 4.1
and 4.2. 0.8
0.6
Ratio

2.4 Conventional Islamic

2.0 0.4
R
1.6 0.2
a
1.2 0.0
t
0.8 2005 2006 2007 2008 2009 Mean
i
0.4 Year
o
0.0 Figure no. 4.2 Capital to Risk Assets Ratio
2005 2006 2007 2008 2009 Mean The figure 4.2 analyses the capital to risk asset
Year ratio of both Islamic and Conventional banks for the
Figure 4.1 Debt to Equity ratio period of 2005-2009. CRAR is also called capital
adequacy ratio (CAR). According to State Bank of
The figure 4.1 shows that in 2005 the Islamic Pakistan the minimum paid up capital for the banks is
banks’ D/E ratio was 1.1033 which is greater than 1.0. 5.0 billion rupees and minimum CAR for the banks is
This fact indicates that Islamic banks have financed their 10%.
operations primarily through debt. In 2006 this ratio has During the period of 2005-2009 the Islamic
considerably decreased to 0.6487 and further banks maintained a very high CRAR which means that
decreased to 0.2403 in 2007. This is because the they had abundant capital to manage any shock to the
Islamic banks have taken safer position and decreased balance sheet. Their high CRAR denotes their ability to
the risk by financing their assets and operations through maintain confidence in the Islamic banking system and
more of equity rather than debt. These banks gradually protect their depositors and lenders. In 2005 Islamic
increased their dependence on the debt financing in the banks had minimum CRAR of 12.84% which
Gl

years 2008 and 2009 but their D/E ratio still remained extraordinarily rose to 83.26% in the year 2006. From
below 1.0 (0.4236 in 2009) which signifies that they have 2006 the CRAR constantly fell down each year and
©2011 Global Journals Inc. (US)
 Performance comparison of Islamic and Conventional banks in Pakistan

recorded 23.73% in the year 2009. The high CRAR of asset quality in 2006 when the assets were most
Islamic banks shows their financial soundness. efficient to produce quality performance. The year 2008

February 2011FF
The CRAR of Conventional banks proved to be marked the weakest asset quality for Islamic banks
above the minimum requirement except in the year during the years 2005-09. Comparing to Conventional
2005. The Conventional banks were strong enough to banks, the Islamic banks asset quality was better in the
respond to the balance sheet shocks such as liabilities whole period except the 2005 year. This denotes that
payment, operational and credit risks or any other loss. Islamic banks had lesser uncollected income earned on
The best CRAR for the Conventional banks was 13.93% their loans and lesser money was blocked.
in 2009. The mean ratio for both banks shows a slight
The mean of Islamic and Conventional banks difference between their asset qualities. Lower ratio is 63
shows that both banks have been strong to cushion any favorable as the risks of loans to become uncollectable 1
loss and protect their lenders and depositors. The mean decreases and asset quality improves. The average
for Islamic banks was 38.37% which is approximately 4 UNCOL ratio for Islamic banks is lesser showing better
times of minimum requirement and at least 3 times of management of assets.

Volume XI Issue II Version I

the Conventional banks CRAR mean. This comparison Conventional Islamic
proves that Islamic banks have been many steps ahead
0.008
of Conventional banks and had more capital than them.
0.006
IV. ASSET QUALITY 0.004

Ratio
0.002
The study evaluates asset quality by the
UNCOL and loan loss reserve ratios. The figures 4.3 and 0.000
4.4 show these ratios for years 2005- 2009. UNCOL -0.002
ratio, whether high or low, shows the risk of loans -0.004
becoming non-performing. The lower UNCOL ratio the 2005 2006 2007 2008 2009 Mean
more efficient assets and loans are. According to the Year
figure 4.3, in 2005 the Conventional banks’ asset quality
was slightly better than Islamic banks’ asset Quality Figure no.4.4 Loan loss average ratio

Global Journal of Management and Business Research

backed by 0.04 UNCOL ratio for Conventional banks Loan loss ratio shows the ratio of loan loss
and 0.472 for Islamic banks. This superiority didn’t provision to total loans. Loan loss provision is the
amount of money set aside to meet the losses when
Conventional Islamic
people and entities default to pay the loans they have
0.072 borrowed from banks.
0.066 Islamic banks’ loan loss ratio in 2005 was 0.26%
which decreased to 0.18% and 0.07% in 2006 and 2007
0.060
respectively. This gradual fall was backed by the
0.054 decrease in loan provision denoting less loan risks and
Ratio

0.048 improved loan recovery policy. The ratio drastically

0.042 climbed to 0.73% indicating higher risk of bad loans and
0.036 inclusion of more capital to survive defaulted loans.
2005 2006 2007 2008 2009 Mean Conventional banks’ loan loss ratio in 2005 was
Year recorded 36% which fell to 0.1% in 2007, climbed back
to 0.35% in 2008 and again fell to 0.26% in 2009. The
Figure no.4.3 UNCOL ratio fluctuating ratio infers various levels of bad loans and
remain longer as the ratio rose to 0.06 in 2005, 2006 and risk for Conventional banks.
further increased to 0.07 in both 2008 and 2009 years. 0.26% was average loan loss ratio for Islamic
The increasing UNCOL highlights the decrease in asset banks meaning that they had to maintain a provision of
quality and weakness of management. As asset quality 0.26 PKR for each 100 PKR loan. This ratio has been
and loan quality has same basic meaning, the graph smaller for Conventional banks and was only 0.24 %.
movement for Conventional banks explains that their The difference shows better asset/loan quality
loan quality has became lower after each two years and performance for Conventional banks.
the amount of uncollected returns on loan has
V. MANAGEMENT QUALITY
increased. This fact supports the statement that more
money is blocked and remained unproductive which is a Management quality of Islamic and
negative sign for asset and loan quality. Conventional banks is measured by operating expense
Since Islamic banks were weaker to produce and cost per money lent ratios. These ratios are
asset quality in 2005, they managed to improve the

©2011 Global Journals Inc. (US)

 Performance comparison of Islamic and Conventional banks in Pakistan

displayed in the figures 4.5 and 4.6 for the period of Conventional Islamic
2005-2009.
0.0600
February 2011FF

Conventional Islamic
0.0525
0.8 0.0450

Ratio
0.6 0.0375
0.0300
0.4
Ratio

0.0225
0.2 2005 2006
2007 2008 2009 Mean
64 Year
0.0
Figure no.4.6 Cost per money lent ratio
2005 2006 2007 2008 2009 Mean The cost per money lent ratio highlights the
Year operating cost incurred to lend one unit of money.
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Figure no. 4.5 operating expense ratio According to figure 4.6, for Islamic banks the cost of
lending one unit of money increased from 2005 to 2008
The management quality of Islamic banks has making the loan disbursement process less efficient.
been quite different from Conventional banks during the This ratio remained unchanged in 2009, which may be
study period of 2005-2009. The operational ratio of due to no variance in the operational cost and amount
Islamic banks in 2005 was 1.37% which verifies a very of total loan disbursed as compared to 2008.
good management. Unfortunately, this ratio rose to Conventional banks too didn’t experience an
73.52% in 2006 marking a disastrous management efficient loan disbursement process and the ratio
quality by spending approximately three quarters of gradually increased from 2005 to 2009. The ratio
income on operational expenses. Gradual improvement recorded 2.33% in 2005 and consequently rose to
is seen from 2007 to 2009 as the ratio has decreased 3.51% in 2009. During 2005 to 2009 the loan
Global Journal of Management and Business Research

each year and management efficiency has got better disbursement expense increased approximately 51%
followed by greater profit for the investors/depositors in which is a negative sign for Conventional banks
the last 3 years of the study. performance.
Conventional banks’ time series represents a The mean cost per money lent ratio was 4.81%
rise and fall in their management quality during the for Islamic banks while 3.05% for Conventional banks.
period 2005-2009; showing a weak management in This evidently supports a well-organized loan
2005 as bigger percentage of return is used to pay disbursement process for Conventional banks.
operational expenses. The best year of management for
Conventional banks was in 2006 when operational ratio VI. EARNING ABILITY
was the lowest. Earning ability according to camel test is
A comparison of management quality is calculated by ROA and ROE. As the Islamic banks are
important to show the efficiency of one over the other interest free banking, only ROA is used to measure the
mode of banking. The mean operational ratio for earning ability of Islamic and Conventional banks. Figure
Conventional banks indicates that almost 33% of 4.7 examines the ROA ratio for the period of 2005-2009.
revenues were spent to cover the operational expenses,
whereas, Islamic banks spent about 48% of their returns Conventional Islamic
0.2
on operational expenses. This difference clearly denotes
a better management quality of Conventional banks. 0.0
This may be because Islamic banking is very young
-0.2
Ratio

industry and doesn’t have as much experience in

management as Conventional banks. Islamic banks -0.4
management has not been able to capitalize on their
new income properties, which requires lesser -0.6
maintenance expense. -0.8
2005 2006
2007 2008 2009 Mean
Year
Figure no. 4.7 Return on asset ratio
Exhibited in figure 4.7, Islamic banks return on
asset ratio was poor enough with the highest 1.37% in
2005 and the lowest -68.55% in 2006. In 2005 Islamic

©2011 Global Journals Inc. (US)

 Performance comparison of Islamic and Conventional banks in Pakistan

banks have earned only 1.37 rupees of each 100 rupees Both Islamic and Conventional banks exhibited
invested on assets. This value drastically fell to -68.55% high loan to asset ratio coupled with higher debt and
recording the worst earning ability during 2005 to 2009.

February 2011FF
risk of default. On average Islamic banks got a ratio of
Lack of management is the main reason for this poor 75.71% which is lower than the average ratio of 85.80%
performance. Furthermore, Islamic banks are focused for Conventional banks. Lower loan to asset ratio means
on growth and expansion strategies which deviates that Islamic banks should pay lesser for loan settlement.
them from profit- oriented strategies. This fact reflects better liquidity position for Islamic
The Conventional banks return on invested banks.
asset could not surpass 2.03% during the period 2005 Conventional Islamic
to 2009. This result for Conventional banks is 65
comparatively better. Conventional banks lead the way 0.84 1
in earning on their invested assets. This determines 0.80
better investment decision, more profit for banks and
0.76

Ratio
shareholders.

Volume XI Issue II Version I

0.72
VII. LIQUIDITY
0.68
In this study the CAMEL’s two ratios of Loan to
Asset ratio and deposit to asset ratio are examined to 0.64
find out the liquidity position of the Islamic and 2005 2006 2007 2008 2009 Mean
Conventional banks. These ratios are shown in the Year
figures 4.8 and 4.9 for the period 2005 to 2009. Figure no.4.9 Deposit to asset ratio
Conventional Islamic
0.92 According to figure 4.9 Islamic banks had
intermittent deposit to asset ratios showing varying
0.88
amount of customers’ deposits to banks’ assets in the
0.84 study period. The biggest amount of deposits
customers left with the Islamic banks was in 2005
Ratio

0.80

Global Journal of Management and Business Research

making 74.23% of total assets of these banks. This ratio
0.76 means that Islamic banks had to dedicate comparatively
0.72 a bigger proportion of asset to the customers who
withdrew their deposits in 2005. Followed by the year
0.68 2006 when the amount of deposits to assets was the
2005 2006 2007 2008 2009 Mean lowest for the Islamic banks.
Year Similar to Islamic banks, the Conventional
Figure no. 4.8 Loan to asset ratio banks too noted the highest deposit to asset ratio in the
Islamic banks’ loan to asset ratio decreased in year 2005 and the lowest in 2007. During the whole
2006 and 2007. Reduction in loan to asset ratio coins study period the deposit to asset ratio of Conventional
comparatively better position and lower risk. On banks didn’t fell below 75% indicating that much of
contrary, this ratio constantly increased in 2008 and asset was spent for the payment of customers’
2009 indicating that Islamic banks were loaned up more deposits. This ratio may create liquidity problem for the
as compared to the past two years. In the whole period banks if the customers rush to withdraw their money in
of 2005 to 2009 Islamic banks had high loan to asset bad economic situations such as the 2009 economic
ratio which brings on a high risk if the creditors demand crisis.
repayment of debt. The highest ratio for the Islamic The mean deposit to asset ratio for the Islamic
banks was 83.94% in 2005 indicating that almost 84% of banks was 71.11% which is lower than 78.05% ratio of
the assets were financed through debts. Conventional banks. This supports the better liquidity
Similarly, in the year 2005, Conventional banks performance for the Islamic banks.
recorded 90.78% loan to asset ratio inferring that nearly
VIII. FINDINGS
91% of their assets were financed through debt. This
soaring ratio gradually decreased and finally in 2008 The Islamic and Conventional banks’
marked 83.38% which is still a high risk ratio and is performance was compared by evaluating CAMEL test
associated with great risk in the Conventional banks variables such as capital adequacy, asset quality,
operation. High ratios not only add to risk of defaulting management, earning ability and liquidity position for a
but also reduce the borrowing capacity which in turn period of 2005-2009. Each CAMEL variable was
lowers the Conventional banks financial flexibility. measured by relevant ratios and the following results
were found:

©2011 Global Journals Inc. (US)

 Performance comparison of Islamic and Conventional banks in Pakistan

 Islamic banks D/E ratio specified a safer turn reflects higher liquidity for Islamic banks.
position by financing their assets more through Furthermore, the mean deposit to asset ratio for
equity than debt comparing to Conventional the Islamic banks was 71.11% which is lower
February 2011FF

banks who followed the policy of higher risk than 78.05% ratio of Conventional banks
leading to higher return. The CRARs of both supporting a better liquidity performance for the
modes of banking proved to be higher than Islamic banks.
minimum requirement. Islamic banks’ CRAR
was at least 3 times of Conventional banks’ References Références Referencias
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