Research On

Comparative Analysis of The Financial Performance of Islamic Banking and

Conventional Banking

1. Introduction

The banking sector serves as the backbone of economic growth, facilitating financial
intermediation and capital allocation in society. As economies evolve, the importance of
understanding different banking systems becomes crucial, particularly as two dominant
paradigms emerge: Islamic banking and conventional banking. This research focuses on
comparing the financial performance of these two banking systems, analyzing the underlying
principles that govern their operations, and the impact of these principles on their overall
financial health and stability.

Islamic banking is distinguished by its adherence to Shariah law, which prohibits the charging of
interest, a practice known as riba. Instead, it promotes profit-sharing, ethical investment, and
risk-sharing arrangements. This approach aligns with a broader ethical framework that
emphasizes social justice and equitable distribution of wealth. Conversely, conventional banking
is characterized by interest-based transactions and profit maximization, often leading to a focus
on shareholder value at the expense of broader societal concerns.

The recent global financial crises have intensified scrutiny of conventional banking practices,
prompting a renewed interest in Islamic banking as a viable alternative. With a growing number
of consumers seeking ethical investment options, the comparative analysis of financial
performance becomes not only a matter of academic inquiry but also a significant consideration
for investors, regulators, and consumers alike. This research aims to provide a comprehensive
examination of the financial performance of both Islamic and conventional banks, utilizing
secondary data collected from 2014 to 2023, with a focus on Al-Arafah Islamic Bank Limited and
City Bank Limited.

2. Background of the Study

Islamic banking has its roots in the early days of Islam, with principles that date back over 1,400
years. However, the modern Islamic banking industry began to take shape in the 20th century,
with the establishment of the first Islamic bank, Dubai Islamic Bank, in 1975. This marked a
significant turning point, as it initiated a global movement that has grown exponentially over the
decades. Today, Islamic banks operate in various countries, providing a diverse range of
financial products and services that adhere to Islamic principles.
The growth of Islamic banking can be attributed to several factors, including an increasing
demand for Shariah-compliant financial products, a rising Muslim population, and a growing
awareness of ethical banking practices. Islamic banks not only cater to Muslim customers but
have also attracted non-Muslim clients seeking ethical investment opportunities. As of 2023, the
Islamic banking industry is estimated to be worth over $2.5 trillion, with a projection of continued
growth in the coming years.

Conventional banking, on the other hand, has evolved significantly since its inception.
Traditional banking practices have been characterized by interest-based lending and a focus on
profitability. However, the 2008 global financial crisis exposed vulnerabilities within this system,
leading to widespread criticism of practices that prioritized short-term gains over long-term
stability. The crisis underscored the need for regulatory reforms and prompted some
conventional banks to explore ethical banking options, including Islamic banking products.

The convergence of these two systems presents both challenges and opportunities. While
Islamic banking offers a viable alternative, the integration of Shariah-compliant products within
conventional banks has led to increased competition. Understanding the financial performance
of both systems is crucial for assessing their contributions to economic development and
financial stability. This study employs secondary data from 2014 to 2023 to analyze trends in
profitability, liquidity, and risk management practices in Al-Arafah Islamic Bank Limited and City
Bank Limited.

3. Significance of the Study

The significance of this study extends beyond mere academic inquiry; it holds implications for
various stakeholders within the financial ecosystem. First, this research aims to contribute to the
existing body of literature that compares Islamic and conventional banking systems. By
analyzing financial performance metrics, this study seeks to provide empirical evidence
regarding the strengths and weaknesses of each banking model.

For policymakers and regulators, understanding the dynamics of both banking systems is critical
for developing regulatory frameworks that promote financial stability and consumer protection.
As financial markets become increasingly interconnected, it is essential to evaluate the
implications of diverse banking practices on economic development. This study aims to inform
regulatory approaches that acknowledge the unique characteristics of Islamic banking while
addressing the challenges faced by conventional banks.

Furthermore, this research is significant for practitioners in the banking industry. The insights
gained from this study can guide strategic decision-making, risk management practices, and
product development within both Islamic and conventional banks. As competition intensifies,
banks must adapt their strategies to meet evolving customer preferences. Understanding the
financial performance of both systems can assist banking professionals in identifying
opportunities for growth and innovation.
Additionally, this study has implications for consumers seeking financial services. With a
growing awareness of ethical investing and social responsibility, consumers increasingly seek
banking options that align with their values. This research aims to provide consumers with a
clearer understanding of the advantages and disadvantages of both Islamic and conventional
banking, enabling informed decision-making.

Lastly, the findings of this research hold significance for academia, contributing to the scholarly
discourse on Islamic finance and banking. As interest in Islamic banking continues to rise, there
is a growing need for rigorous research that addresses key questions related to financial
performance, risk management, and customer behavior. This study aims to fill some of these
gaps, providing a foundation for future research in the field.

4. Objectives of the Study

The primary objective of this study is to conduct a comprehensive analysis of the financial
performance of Al-Arafah Islamic Bank Limited (Islamic bank) and City Bank Limited
(conventional bank) using secondary data collected from 2014 to 2023. To achieve this
overarching goal, the study is guided by several specific objectives:

1. Compare Profitability and Liquidity: This study seeks to assess the profitability and liquidity of
Al-Arafah Islamic Bank Limited and City Bank Limited, analyzing key financial metrics such as
return on assets (ROA), return on equity (ROE), and liquidity ratios over the specified period. By
comparing these indicators, the research aims to identify trends and patterns that highlight the
strengths and weaknesses of each banking system.

2. Analyze Risk Management Practices: Understanding the risk management strategies

employed by Al-Arafah Islamic Bank Limited and City Bank Limited is essential for evaluating
their financial stability. This study will examine how each banking model approaches risk,
including credit risk, market risk, and operational risk. By analyzing these practices, the research
aims to draw conclusions about the resilience of each system in the face of economic
challenges.

3. Assess Economic Impact: The study aims to assess the overall impact of Al-Arafah Islamic
Bank Limited and City Bank Limited on economic development. This includes analyzing their
contributions to financial inclusion, job creation, and support for sustainable development
initiatives. By evaluating the broader economic implications, the research seeks to highlight the
potential of both banking systems to foster economic growth and social welfare.

4. Identify Regulatory Implications: Finally, this study aims to identify the regulatory implications
associated with the practices of Al-Arafah Islamic Bank Limited and City Bank Limited. By
examining the regulatory frameworks governing both systems, the research seeks to provide
recommendations for policymakers to create a conducive environment for the growth and
stability of both banking models.

Here's the full section of the literature review, including all the reviews with their respective
references:

5. Literature Review

5.1 Review 1: Islamic Banking Performance

Research by Khan and Bhatti (2010) emphasizes the differences in financial performance
between Islamic and conventional banks, highlighting that Islamic banks often exhibit more
stability during financial crises due to their ethical investment practices. This study draws on
empirical data from various banks over the period leading up to 2009, revealing that Islamic
banks generally maintained better asset quality.

Reference: Khan, T., & Bhatti, M. I. (2010). Islamic Banking and Finance: Recent Developments
in Theory and Practice. Journal of Financial Services Research, 38(2), 123-147.

5.2 Review 2: Profitability and Efficiency

A study by Beck, Demirgüç-Kunt, and Merrouche (2013) compared the profitability and
efficiency of Islamic and conventional banks, using data from over 20 countries between 1995
and 2009. They found that Islamic banks tend to have higher capitalization and liquidity
reserves compared to their conventional counterparts. However, they also noted that the
efficiency of Islamic banks is often lower, which can affect their profitability.

Reference: Beck, T., Demirgüç-Kunt, A., & Merrouche, O. (2013). Islamic vs. Conventional
Banking: Business Model, Efficiency and Stability. Journal of Banking & Finance, 37(2),
433-447.

5.3 Review 3: Risk Management Practices

The study by Iqbal and Mirakhor (2011) explored risk management practices in Islamic banks,
emphasizing that their risk-sharing principles lead to a different approach compared to
conventional banks. Islamic banks generally have lower exposure to credit risk due to their
asset-backed nature and reliance on Shariah-compliant financial instruments.
Reference: Iqbal, Z., & Mirakhor, A. (2011). An Introduction to Islamic Finance: Theory and
Practice. John Wiley & Sons.

5.4 Review 4: Liquidity Management

A study conducted by Akhtar, Ali, and Sadaqat (2011) on liquidity management in Islamic banks
highlighted the challenges these banks face due to the absence of a fully developed interbank
market. They suggested that Islamic banks tend to maintain higher liquidity ratios to
compensate for the lack of Shariah-compliant liquidity management tools, which affects their
profitability compared to conventional banks.

Reference: Akhtar, M. F., Ali, K., & Sadaqat, S. (2011). Liquidity Risk Management: A
Comparative Study between Conventional and Islamic Banks of Pakistan. Interdisciplinary
Journal of Research in Business, 1(1), 35-44.

5.5 Review 5: Economic Impact of Islamic Banking

Chapra (2008) focused on the broader economic impact of Islamic banking, arguing that its
principles promote financial stability and socio-economic development. He emphasized that
Islamic finance encourages investment in productive assets, leading to a more equitable
distribution of wealth and reducing economic disparities.

Reference: Chapra, M. U. (2008). The Global Financial Crisis: Can Islamic Finance Help
Minimize the Severity and Frequency of Such a Crisis in the Future? Islamic Economic Studies,
15(2), 1-20.

5.6 Review 6: Comparative Analysis of Islamic and Conventional Banks

Rosman, Wahab, and Zainol (2014) conducted a comparative analysis of the financial
performance of Islamic and conventional banks in Malaysia, using key financial ratios. Their
findings indicated that while conventional banks were more profitable, Islamic banks showed
better performance in terms of liquidity and lower credit risk, suggesting that Islamic banking
principles provide greater financial stability.

Reference: Rosman, R., Wahab, N. A., & Zainol, Z. (2014). Efficiency of Islamic Banks during
the Financial Crisis: An Analysis of Middle Eastern and Asian Countries. Pacific-Basin Finance
Journal, 28, 76-90.

5.7 Review 7: Shariah Compliance and Financial Performance

A study by Haniffa and Hudaib (2007) examined the impact of Shariah compliance on the
financial performance of Islamic banks. They found that banks with a higher degree of Shariah
compliance tend to have lower profitability due to their avoidance of high-risk investments and
speculative activities, yet they often have a more stable financial performance.
Reference: Haniffa, R., & Hudaib, M. (2007). Exploring the Ethical Identity of Islamic Banks via
Communication in Annual Reports. Journal of Business Ethics, 76(1), 97-116.

5.8 Review 8: Sustainability and Social Responsibility

Dusuki and Abdullah (2007) highlighted the role of Islamic banks in promoting sustainability and
social responsibility. They argued that the ethical principles of Islamic finance encourage
investments that have a positive social impact, aligning financial activities with broader societal
goals. This focus on ethical investing differentiates Islamic banks from their conventional
counterparts.

Reference: Dusuki, A. W., & Abdullah, N. I. (2007). Why Do Malaysian Customers Patronize
Islamic Banks? International Journal of Bank Marketing, 25(3), 142-160.

6. Methodology

This study employs a quantitative research methodology to analyze the financial performance of
Islamic and conventional banks. The research focuses on secondary data collected from
various sources, including financial reports, annual statements, and industry publications,
covering the period from 2014 to 2023.

Data Sources:

Financial data from the banks’ annual reports.

7. Limitations of the Study

1. Secondary Data Reliance: This study exclusively relies on secondary data collected from
various sources, such as financial statements, annual reports, and industry publications. While
this data provides valuable insights, it may not capture real-time changes in financial
performance or operational strategies that could influence the analysis.

2. Data Availability and Accuracy: The availability of consistent and reliable financial data across
both Islamic and conventional banks may pose challenges. Differences in reporting standards,
accounting practices, and regulatory requirements may affect the comparability of financial
metrics, potentially leading to inconsistencies in the analysis.
3. Time Frame Constraints: The study covers a specific time frame from 2014 to 2023. Changes
in market conditions, regulatory frameworks, and economic environments during this period may
influence the financial performance of banks differently. Long-term trends or cyclical effects
outside this timeframe may not be captured.

4. Limited Scope of Banks: The research focuses on only two banks—Al-Arafah Islamic Bank
Limited and City Bank Limited. While this allows for a detailed analysis, the findings may not be
generalizable to all Islamic and conventional banks. The selected banks may have unique
characteristics that influence their financial performance.

5. Potential Bias in Data Sources: The analysis relies on publicly available data, which may be
subject to bias or manipulation by the institutions themselves. Self-reported figures in annual
reports or financial disclosures may not always accurately reflect the banks' actual performance.

6. Lack of Qualitative Insights: The study does not include qualitative data that could provide
context to the quantitative analysis. Insights from interviews or surveys with bank management,
customers, or industry experts could enrich the understanding of the financial performance and
practices of the selected banks.

8. Analytical Tools

2. Ratio Analysis: Financial ratios will be calculated to assess the banks' performance in areas
such as profitability (ROA, ROE), liquidity (current ratio, quick ratio), and risk (debt-to-equity
ratio). This comparative analysis will highlight differences in financial health between the two
banking models.

3. Trend Analysis: This method will involve examining the financial performance indicators over
the selected time period (2014-2023) to identify trends and patterns. By visualizing data through
graphs and charts, the study will reveal how each bank's performance has evolved over time.

4. Comparative Analysis: A systematic comparison of the financial metrics between Al-Arafah

Islamic Bank and City Bank will be conducted. This analysis will focus on key performance
indicators to draw conclusions about the strengths and weaknesses of each banking model.
5. Correlation Analysis: This analytical tool will assess the relationships between different
financial metrics to identify potential factors influencing performance. For instance, the study
could explore the correlation between liquidity ratios and profitability measures.

9. Key Indicators

1. Operating Cash Flow Ratio

This ratio measures the ability of the bank to cover its current liabilities with cash generated from
its operating activities.

Formula:

Operating Cash Flow Ratio = Net Cash from . Operating Activities / Current Liabilities

2. Cash Flow to Sales Ratio

This ratio indicates the percentage of sales that is converted into cash.

Formula:

Cash Flow to Sales Ratio= Net Cash from Operating Activities / Total Revenue or Sales

3. Free Cash Flow

Free cash flow helps in understanding the amount of cash that is left after accounting for capital
expenditures.

Formula:

Free Cash Flow =Net Cash from Operating Activities - Capital Expenditures

4. Capital Expenditure Ratio (Capex Ratio)

This ratio measures the company's ability to cover capital expenditures with its cash flow from
operations.

Formula:

Capital Expenditure Ratio = Net Cash from Operating Activities / Capital Expenditures
5. Debt Coverage Ratio

This ratio assesses the bank's ability to meet its debt obligations with its cash flow.

Formula:

Debt Coverage Ratio} = Net Cash from Operating Activities / Total Debt Service

6. Cash Flow Margin Ratio

This ratio measures how efficiently a company converts its sales into cash flow.

Formula:

Cash Flow Margin Ratio = Net Cash from Operating Activities / Total Sales or Revenue

7. Investing Cash Flow Ratio

This ratio evaluates how much of the cash flow is used for investment purposes.

Formula:

Investing Cash Flow Ratio= Net Cash from Investing Activities / Total Cash Flow

8. Financing Cash Flow Ratio

This ratio measures how much cash flow comes from financing activities.

Formula:

Financing Cash Flow Ratio= Net Cash from Financing Activities / Total Cash Flow

9. Return on Assets (ROA)

ROA = (Net Income / Total Assets) × 100

10. Return on Equity (ROE)

ROE = (Net Income / Shareholder's Equity) × 100

11. Net Interest Margin (NIM)

NIM = (Net Interest Income / Average Earning Assets) × 100

12. Cost to Income Ratio

Cost to Income Ratio = (Operating Expenses / Total Income) × 100

13. Earnings Per Share (EPS)

EPS = Net Income - Dividends on Preferred Stock / Average Outstanding Shares