Summary of the Research
This research paper compares the functioning of Al Rahji Islamic Bank and HSBC non-Islamic banks in Saudi Arabia during the global economic crisis of 2007-2010. This research aims to single out the most effective means of managing the banking system when turbulent times happen in the banking industry. The method of this research is purely qualitative. Its research will be based on the information, taken from such sources as bank documents, case studies, and articles about Islamic and non-Islamic Banking. Research findings reveal the supremacy of Al Rahji Islamic banking in Saudi Arabia in handling financial investments in the event of an economic crisis.
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Banking plays an important role in the economy of any country. In Saudi Arabia, bank investors constitute more than 80% of its population. These people possess strong faith in Allah, and they want to lead their lives as per the instructions, given in the Holy Quran and the way shown by the prophet Hazrat Muhammad (Sm). The economic relations in this country are also governed by the precepts of Islam.
However, the Islamic banking system though popularly known in the Kingdom, remains less favored by Saudi than the conventional banking system. Non-Islamic banking is fully based on interest, and it is commonly meant, as commercial banks. However, interest is prohibited by Islam. This paper will also demonstrate that the Islamic banking system is less vulnerable to the economic crises since it practically eliminates the possibility of fraud or any other unethical and illegal behavior among executives.
Review of Literature
Islamic banking can be defined as a system of banking that is governed by the principles of Islamic Law or Sharia, and by the conventional principles of risk management (Ariff, 2008). Its major distinguishing feature is the prohibition of interest. Interest-free banking is a narrow concept denoting the number of banking instruments or operations, which avoid interest. Islamic banks are expected not only to avoid interest-based transactions, prohibited in the Islamic Shariah but also to avoid unethical practices and participate actively in achieving the goals and objectives of an Islamic economy, which is to improve the quality of life in the community (Ariff, 2008).
According to Ariff (2008), the modern banking system was introduced into the Muslim countries at a time when they were politically and economically at low ebb, in the late 19th century. The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries, and they catered mainly to the import-export requirements of the foreign businesses. The banks were generally confined to the capital cities, and the local population remained largely untouched by the banking system. The local trading community avoided the “foreign” banks both for nationalistic as well as religious reasons.
However, as time went on it became difficult to engage in trade and other activities without making use of commercial banks. Even then, many confined their involvement in transaction activities such as current accounts and money transfers. Borrowing from the banks and depositing their savings with the bank were strictly avoided to keep away from dealing in interest which is prohibited by religion.
Based on the portfolio of Al Rahji Bank (2010), Al Rahji Islamic bank has several distinctive features as compared to its conventional counterpart. It is possible to single out the following properties of Al Rahji Bank.
Abolition of interest (Riba)
Since Riba is prohibited in the Quran and interest in all its forms is akin to Riba, as confirmed by Fuqaha and Muslim economists with rare exceptions, the first distinguishing feature of an Islamic bank must be that it is interest-free.
Adherence to the public interest
Ali (2008) stated that the activity of commercial banks being primarily based on the use of public funds, public interest rather than individual or group interest will be served by Islamic commercial banks. Al Rahji Islamic bank uses all deposits, which come from the public for serving the public interest and realizing the relevant socio-economic goals of Islam. The bank plays a goal-oriented financial house rather than merely a profit-maximizing role and should adjust to the different needs of the Islamic economy.
Another substantial distinguishing feature is that Al Rahji Islamic bank is a universal or a multi-purpose bank and not a purely commercial bank. This bank is conceived to be a crossbreed of commercial and investment banks, investment trusts, and investment -management institutions, and would offer a variety of services to their customers. A substantial part of Al Rahji’s financing would be for specific projects or ventures. Its equity-oriented investments would not permit them to borrow short-term funds and lend to long-term investments. It should make the bank less crisis-prone compared to their capitalist counterparts because it would have to make a greater effort to match the maturity of their liabilities with the maturity of their assets.
More careful evaluation of investment demand
Another very important feature of Al Rahji Islamic bank is its very caring attitude towards the evaluation of applications for equity-oriented financing. It is customary that conventional banks evaluate applications, consider collateral, and avoid risk as much as possible. Their main concern does not go beyond ensuring the security of their principal and interest receipts. Since the Islamic bank has a built-in mechanism of risk sharing, it would need to be more careful in how it evaluates financing requests. It adds a healthy dimension to the whole lending business and eliminates a whole range of undesirable lending practices.
Work as a catalyst for the development
Profit-loss sharing is a distinctive characteristic of Al Rahji Islamic bank that fosters closer relations between banks and entrepreneurs. It helps develop financial expertise in non-financial firms and also enables the bank to assume the role of technical consultant and financial adviser, which acts as a catalyst in the process of industrialization and development (Al Rajhi (2010).
According to Ahmad (2002), the establishment of Islamic banks based on a joint-stock company is with limited liability. In his scheme, in addition to current accounts, on which no dividend or interest should be paid, there was an account in which people could deposit their capital based on partnership, with shareholders receiving higher dividends than the account holders from the profits made. Ahmad also spoke of possible partnership arrangements with the businessmen who seek capital from the banks. However, the partnership principle was not left undefined, nor was it clear who would bear the loss if any. It was suggested, that banks should cash bills of trade without charging interest, using the current account funds.
De Albuquerque (2005) stated that a non-Islamic banking system is one of the most important and inalienable parts of the market economy. The development of banks, commodity manufacture, and circulation went in parallel and was closely bound. Banks, making money accounts, crediting the economy, and acting as the intermediaries in the redistribution of the capitals, essentially raise a general efficiency of manufacture, promoting public labor capacity growth.
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Blair (2005), Bradley (2006) and Nathanson, (2009) claimed that a non-Islamic modern banking system is the major part of the national economy of any developed country. Its practical role is defined as the management of the state’s paying and accounting systems.
A greater part of the banking system’s commercial bargains is carried through deposits, investments, and credit operations. Along with other financial intermediaries, banks direct people’s savings to firms and manufacturing structures. According to Matyszak, (2007) commercial banks, operating by the monetary policy of the state, regulate cash flows and influence the rate of their turnover, emission, and general mass, including the amount of cash, is in circulation.
In contrast, HSBC non-Islamic Bank represents a conventional banking institution that aims to maximize its profits rather than improve the quality of life in the community. This organization does not prohibit interest; as a matter of fact, this component is crucial for the prosperity and functioning of the institution (HSBC profile, 2010).
The basic appropriation of HSBC bank is mediation in the circulation of cash resources from creditors to borrowers and from salesmen to buyers. At the same time, with the banks, the circulation of cash resources on the markets is realized by other financial and credit-financial establishments such as the investment funds, insurance companies, broker, and dealer firms. But HSBC banks as the subjects of the financial market have two essential features that distinguish them from all other subjects.
First, for HSBC banks, the dual exchange of the bills is characteristic: they place their bills (deposits, saving certificates, and so forth, etc.) and mobilize thus resources, place into bills and securities, issued by others. It distinguishes HSBC banks from the financial brokers and dealers, who do not release their bills.
Second, HSBC has an adoption to itself of absolute covenants with the fixed sum of debt for legal, and a physical person distinguishes banks. In terms of debt and loans, HSBC banks differed from various investment funds, which distribute all risks connected with a change in values of its assets and liabilities among its shareholders.
In Saudi Arabia, the creation and the functioning of HSBC commercial banks are based on Islamic law. By this law, HSBC banks act as the universal credit establishments, which accomplish the wide variety of operations on the financial market: the accordance of various in maturity and amount credits, purchase-sale and storage of securities, foreign currency, the attraction of means in the contributions, the realization of account, the issue of guarantees, sureties and other obligations, intermediary and confidence operations (HSBC, 2010).
Principles of HSBC commercial bank’s activity
Work within the limits of the actual existing resources is the first and fundamental principle of the activity of HSBC commercial banks. Work in the limits of the actual existing resources means that HSBC commercial banks must ensure not only the quantitative correspondence between its resources and credit investments but also to attain the correspondence of the nature of bank assets to the specific character of the resources mobilized by it.
First of all, this relates to their maturity periods. So if HSBC bank draws resources mainly for the short periods, and invests them predominantly into the long-term loans, then its liquidity occurs under the threat. The presence in the bank’s assets of a large number of loans with the increased risk requires the bank to an increase of specific weight of its resources in the volume of its resources.
The second most important principle of the activity of HSBC commercial banks is based on economic independence. This activity would mean that the economic responsibility of a bank for the results of its activity. Economic independence assumes the freedom of its own resources’ direction and drawn resources, the free selection of clients and depositors, the direction of the incomes of a bank.
Saudi Arabia’s current legislation allows HSBC commercial banks economic freedom at the disposal of its funds and incomes. The profit of a bank, which is remained at its disposal after payment of expenses, is distributed by the decision of the general meeting of shareholders. It establishes the standard and size of the deductions for different funds of the bank and also the size of dividends on the shares. On its obligations, HSBC bank answers by all belonging to its resources and property. The entire risk from its operations HSBC bank is directed to itself.
Another important principle lies in the fact that the interrelations of HSBC bank with its clients are constructed as usual market relations. Allowing loans, HSBC bank proceeds from the market criteria of profitableness, risk, and liquidity. The last principle behind HSBC bank lies in the fact that the regulation of its activity can be achieved only by indirect economic methods. Saudi government can determine only the “rules of the banking system for non-Islamic banks,” but it cannot give HSBC management orders.
Aly (2004) and Ayub (2006) reiterate that the notion and classification of non-Islamic bank products and bank service rest on the premise of Shariah but retains the bank’s commercial status. Non-Islamic bank services are aimed at the satisfaction of clients’ needs by conducting bank operations, which does not lead to a change in the form of labor products. Bank product is the result of the logical comprehension of the bank’s operation and bank technology lying on its basis, designed in the form of the final document and preserved on the specific material carrier. Non-Islamic bank product is a material part of the bank service formulation – credit card, saving book, and check-book.
The world economic and financial crisis that erupted in 2007 identified the weaknesses of conventional banking, especially in comparison with Islamic banks. In particular, indiscriminate lending and overreliance on real estate led many financial institutions in the United States to a very insecure position. The decline of real estate prices induced the depositors to withdraw their assets from the banks and subsequent bankruptcy of these organizations (Roberts, 2008).
On the one hand, many people are concerned that those responsible for the financial problems are the ones being bailed out, while, on the other hand, a global financial meltdown will affect the livelihoods of almost everyone in an increasingly inter-connected world. The problem could have been avoided if ideologues supporting the current economics models weren’t so vocal, influential, and inconsiderate of others’ viewpoints and concerns (Komert, 2002).
As with any large event in any field of human endeavor, it is never about just one thing. There were many causes of the financial crisis, some recent and some longstanding. I would like to focus on three of those causes today: the misperception and mismanagement of risk, the level of interest rates, and the regulation of the financial system.
Perhaps the most basic underlying driver of the crisis was the inherent cycle of human psychology around risk perceptions. According to Yom (2005), when times are good, perceptions of risk diminish. People start to convince themselves that the good times will go on forever. When the cycle turns, risk aversion increases again. It is often far beyond normal levels, let alone those seen during the boom.
The current financial turmoil is rooted in the subprime crisis. During boom years, mortgage brokers enticed by the lure of big commissions talked buyers with poor credit into accepting housing mortgages with little or no down payment and without credit checks.
When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run. Since banks lend out most of the cash they receive in deposits it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run may leave the bank in bankruptcy, causing many depositors to lose their savings unless they are covered by deposit insurance. A situation in which bank runs are widespread is called a systemic banking crisis or just a banking panic.
A situation without widespread bank runs but in which banks are reluctant to lend because they worry that they have insufficient funds available, is often called a credit crunch. In this way, the banks become an accelerator of a financial crisis (Pedro, 2009).
This topic is very interesting because of the on-going propaganda, which among the Islamic or the Non-Islamic Banks can outrun the global financial crisis. This research can contribute to resolving the issues confronting both Islamic and Non-Islamic banks in terms of their financial platform during the global financial crisis. There is a good opportunity for this research to go deeper and face the challenges of making critical comparative analysis and a detailed evaluation of these issues related to this type of banking system.
According to Iqbal & Mirakhor (2007), the global financial crisis has affected several aspects of human life. It is continuously creating disorder in commercial industries, living standards, public services, and financial institutions. El –Tablawy (2009) reported that several efforts have been exhausted, but the de-escalating trend is slowly creeping into each country’s economic development and sustainability. Ordinary citizens began to complain and aired out their discomfort amidst the high cost of living and high inflation rate. Added to this trouble is the lack of employment and salary deduction imposed by some companies to cut costs to keep the establishment from closing down. Reports of commercial and saving banks’ bank run brought panic and confusion to many depositors.
A good start in the analysis of this research begins with Azami (2008) on his proposition of the significance of Islamic banking during this time of economic crisis. He contended that before the international financial crisis, Islamic banking was marginalized and disregarded by international institutions. He also pointed out that International institutions, such as the Basel Committee on Banking Supervision (BCBS) and the International Accounting Standards Board (IASB) that are concerned with financial regulation did not take into account the differences between Islamic banking, and Non-Islamic banking, in the setting of these regulations. He reiterated that many Western financial institutions considered the Islamic banking system to be simple and rudimentary and not attuned to the modern times and new financial developments such as the innovative and complex financial tools that have dazzled the world.
There are some objections to Azami’s assumptions because he failed to recognize that the financial apparatus used nowadays in the non-Islamic finance industry is based upon mathematical equations and theories formulated by the foremost mathematicians in the world some of whom are Nobel laureates hired by large financial institutions to help boost their performance.
However, the financial crisis has some important message to the financial industry and specifically what Azami called “invalidity in many of the assets and theories and mathematic equations upon which much of the modern financial system is based”. If the literature of Azami would be highlighted, it would also appear that the main factors behind the creation, spreading, and impact of the international financial crisis could have been the proliferation of corrupt practices in several non-Islamic Banks in the Western world.
Based on the literature of Cox and Oliver (2007) and Doyle (2009) economic theorists and analysts gave several opinions about the current financial crisis that looms in every nation of the world today. It is not surprising to discover some opinions differ while others show resemblance. The World Bank, International Monetary Fund, the European Unions, and those distinct stock market exchanges issued relevant and reliable information surrounding the world economic dilemma. Speculations concerning the possible causes of the financial meltdown in the world today are published in the world’s major papers, academic journals, and web sites.
According to Clement (2009), the big question boils down to the causes of bank failure and bankruptcy. Before bank malpractices and mismanagement, greedy bankers were prevalent in enriching their pockets from the valued deposits of the people behind the failure of the banking industry. Some analysts reiterated that the individual greed of the bankers creates something approximating a successful economy only under carefully controlled conditions, inside their little detestable box.
According to Ali (2008, p. 193, 194), the disturbing economic parameters are too far and broke loose as each of the banking systems tried to save their investments and struggling to make their system into a stable state. In his turn, Clement (2009) claimed that the financial crisis and banks’ inability to correct the liquidation of their assets can be ascribed to the effects of globalization and increased interdependence in the financial world. To some extent, this information indicates that the management of financial institutions has to be based on ethical as well as commercial principles.
One of the examples that can substantiate this point of view is the bankruptcy of Lehman Brothers. In particular, the compensation, paid to the executives was reported to have increased significantly before filing for bankruptcy, and some of them were later subpoenaed on suspicion of fraud (CNBC, 2008). Itis one of those cases when conventional rules of management are not sufficient because they focus only on the maximization of profit rather than ethics and morality.
Abdulkader (2007) agree that at the heart of banking industry concerns is the fact that huge trans-national companies are becoming more powerful and influential than democratically-elected governments, putting shareholder interests above those of communities and even customers. Ecological campaigners say corporations are disregarding the environment in the stampede for mega-profits and marketplace supremacy. Komert (2002) claims human rights groups say corporate power is restricting individual freedom. Even business folk behind small firms have sympathy for the movement, afraid as they are that global economies of scale will put them out of work.
The stock price plunge and the severe credit crunch we are watching today in the global financial markets are byproducts of the developments in the US six years ago. In late 2001, fears of global terror attacks after 9/11 shook an already struggling US economy, one that was just beginning to come out of the recession-induced by the bursting of the dotcom bubble of the late 1990s ((Zawya, 2010).
According to Mamudi (2009), the companies affected were those directly involved in home construction and mortgage lending. Financial institutions, which had engaged in the securitization of mortgages, fell prey subsequently. Excessive lending under loosened underwriting standards, which was a hallmark of the United States housing bubble, resulted in a very large number of subprime mortgages.
Bradley (2006) claimed that high-risk loans had been perceived to be mitigated by securitization. Rather than justifying the risk, however, this strategy appeared to have had the effect of broadcasting and amplifying it in a domino effect. Hassan (2007) and Abdulkader, et al (2007) believe that damage from failing securitization schemes eventually cut across a large portion of the banking industry market and financial business and led to the economic crisis. The accelerating rate of foreclosures caused an ever greater number of bank clients to withdraw their bank investment and deposits. The resulting spiral underlay a developing financial crisis.
In Saudi Arabia, the financial crisis did not create much chaos in the economy because the government intervened in the financial activity of the banking industry. According to Saudi Arabian Monetary Agency (2010), the global economic crisis did not create many effects to the economy of the Kingdom because acts as a banker to the government; supervises commercial banks; manages Kingdom’s foreign exchange reserves; conducts monetary policy for promoting price and exchange rate stability, and promotes the growth and ensures the soundness of the financial system.
Definition of terms
The following words are used in research studies. The importance of these words highlights the significance of this paper.
- Islamic Banking – a system of banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics.
- Financial Crisis – a liquidity shortfall in the United States banking system. It has resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. In many areas, the housing market has also suffered, resulting in numerous evictions, foreclosures, and prolonged vacancies.
- Bank runs is when a large number of bank customers withdraw their deposits because they believe the bank is or might become, insolvent.
- Financial system – the system that allows the transfer of money between savers and borrowers. It comprises a set of complex and closely interconnected financial institutions, markets, instruments, services, practices, and transactions.
- Banking – generally, a highly regulated industry, and government restrictions on financial activities by banks have varied over time and location.
- Islamic economics – the body of Islamic studies that “identifies and promotes an economic order that conforms to Islamic scripture and traditions,” and in the economic world an interest-free Islamic banking system, grounded in Sharia’s condemnation of interest (Riba).
- Globalization or globalization – the process by which regional economies, societies, and cultures have become integrated through a global network of communication, transportation, and trade. The term is sometimes used to refer specifically to economic globalization: the integration of national economies into the international economy through trade, foreign direct investment, capital flows, migration, and the spread of technology.
- Market – any one of a variety of systems, institutions, procedures, social relations, and infrastructures whereby businesses sell their goods, services, and labor to people in exchange for money. Goods and services are sold using a legal tender such as fiat money. This activity forms part of the economy.
- Full-reserve banking is a banking practice in which the full amount of each depositor’s funds is kept in reserve, as cash or other highly liquid assets. In other words, funds deposited are not lent out by the bank as long as the depositor retains the legal right to withdraw the funds.
- The credit crunch is a reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from the banks.
- Sub-prime mortgage means making loans that are in the riskiest category of consumer loans and are typically sold in a separate market from prime loans.
The rationale for conducting this research
Because my major is finance, I deem it necessary to broaden my concept and critical understanding of the nature and process of financial industries. My involvement with different financial activities in our company business and relationship with some people in the banking industry triggered my interest to dwell on this particular topic. I have been reading a lot about the financial crisis and how it affected businesses and the standard of living of many people from all walks of life. It dawned on me about the impact of the financial crisis on the banking industry both Islamic and non-Islamic banks. Finally, I realized that I could contribute to a better understanding of Islamic banking and non-Islamic banking if I make a thorough research on them.
I am convinced that by making this research, I will improve my learning and exercise my competencies in doing research works. The topic may seem difficult, but several reading materials are before me that I can use to further my knowledge on this topic.
In the end, I would like to test the hypothesis according to which conventional rules governing the functioning of financial institutions are insufficient since they overlook the ethical principles of entrepreneurship. Yet, this is just an assumption that needs to be verified.
Objectives of the Research
The main objective of this research paper is to present a critical comparative analysis of the banking system of Al Rajhi Islamic and HSBC non-Islamic banking in Saudi during the financial-economic crisis. To achieve the main goal, the following sub-objectives need to be given proper focus.
- To establish a deeper, comparative analysis of the banking system between Al Rahji Islamic Bank and HSBC non-Islamic in Saudi Arabia
- To investigate the effect of the economic crisis on the banking system of Al Rahji Islamic bank and HSBC non-Islamic bank
- To provide proper recommendations to bank clients in which the banking system can efficiently prevent the risk of the financial crisis.
Methods of the Research
This research paper will rely on the use of secondary sources such as reference books, magazines, journals, articles from Internet websites dealing with the banking system. Properly cited secondary sources include a literature review of both Islamic and Non-Islamic Banking, case studies, and related researches on both types of the banking environment. The Internet search engine will also be used to generate fresher information about the current situation of Islamic and non-Islamic banking from a global perspective. This analysis will enable us to single out the similarities and distinction between these systems as well as their advantages and disadvantages.
The study requires a systematic procedure from the selection of the topic to final report preparation. To perform the study data sources are to be identified and collected, they are to be classified, analyzed, interpreted, and presented systematically, and key points are to be found out. This overall process of the methodology is illustrated using a flowchart that has been followed in the study.
Findings of the research and discussion will be presented, altogether, to support the explanations based on the literature of this research study. The researcher will then conclude the research paper by presenting both the Islamic and non-Islamic banking industry in Saudi Arabia based on the objective findings of the research paper.
Time Table of the Research
Given the limited scope and specific topic of this research, I am positive, that I can complete the research study on time. I use a table for a six-week plan to accomplish each phase of the research paper. The table below summarizes the entire procedure that I will undertake to complete the task on time.
|TASK||Week 1||Week 2||Week 3||Week 4||Week 5||Week 6|
|Complete First Draft||x|
|Complete Final Draft||x|
Ethical Considerations of this research paper
|1. Does the aim and methods of your research respect the|
|privacy of your interviewee?||X|
|2. Will confidentiality of the interviewee be ensured?||X|
|3. Are interviewees clearly asked to give consent to take|
|part in the research?||X|
|4. Can interviewee refuse anytime if they chose?||X|
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