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International Research Journal of Finance and Economics ISSN 1450-2887 Issue 82 (2012) EuroJournals Publishing, Inc. 2012 http://www.internationalresearchjournaloffinanceandeconomics.com

Gauging the Financial Performance of Banking Sector using CAMEL Model: Comparison of Conventional, Mixed and Pure Islamic Banks in PakistanRehana Kouser Lecturer, Department of Commerce Bahauddin Zakariya University, Multan-Pakistan Tel: +92-333-6102638 E-mail: [email protected] Irum Saba Ph.D. Scholar, INCEIF, Malaysia Tel: +60-12-3338548 E-mail: [email protected] Abstract The study is a comparison based on performance of Pure Islamic banks, mixed banks (we use this word for all those banks that have their Islamic as well conventional branches) and conventional banks using CAMEL model. It is an appropriate and simple model to evaluate the financial and managerial assessment of institutions. The ratios defined by CAMEL method are analyzed by using ANOVA to investigate any significant difference. The data analysis is done using SPSS. Based on our analysis, we found that Islamic banks have adequate capital and have good asset quality when compared to Islamic branches of conventional banks and conventional banks. Moreover, Islamic banks in general have good management competency in comparison to conventional banks. The earnings of Islamic branches of conventional banks are greater than full-fledge Islamic banks and conventional banks. Finally, it can be concluded that Islamic banks have a developing setup.

Keywords: CAMEL, Financial Performance, Banking, Comparison, Pakistan JEL Classification Codes: G20, G21, G29

1. IntroductionIslamic money market is operating in countries like Bahrain, Malaysia and some other countries of Gulf region in addition to conventional money market. Recently, a memorandum of understanding is signed between Bahrain, Saudi Arabia, Malaysia, Indonesia, Brunei and Sudan on the establishment of first International Financial Market with the participation of Islamic Development bank (Ayub, 2002). A liquidity management center is also operating in Bahrain with the objective to provide liquidity to Islamic banks in their needs and is in coherence with the Shariah. The Government of Pakistan, Iran and Sudan have introduced Islamic system of financing on country level. In Saudi Arabia, due to the legislation, banks are not permitted to perform Riba based operations although there are a small number of Islamic banks in the country. A number of countries have also made amendments in their

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legislation by taking Saudi Arabia as an example. The Islamic institutions and banks can be further divided into two categories: Islamic commercial banks and Islamic investment institutions. A list of some of the banks and institution falling in these two categories is provided in Table-1.Table 1: Error! No text of specified style in document.: Islamic commercial banks and investment institutionsIslamic Investment Institutions DaralMaal Al Islami (Geneva) Dallah Al-Baraka Group of Saudi Arabia The Islamic Investment Company of the Gulf The Islamic Investment Company (Bahamas) The Investment Company (Sudan) The Bahrain Islamic Investment bank (Manama) Islamic Investment House(Amman) Meezan Bank (Pakistan) National Investment Trust (Pakistan) Al-Baraka Islamic Investment Bank (Pakistan)

Islamic Commercial Banks Al-Rajhi Banking and Investment Corporation (Saudi Arabia) Kuwait Finance House (Kuwait) Al-Baraka Islamic Investment bank(Bahrain) Bahrain Islamic bank (Bahrain) Faisal Islamic Bank (Egypt) Dubai Islamic Bank (UAE) Jordan Islamic Bank (Jordan) Qatar Islamic Bank (Qatar) Islami Bank Bangladesh (Bangladesh) Bank Islam Malaysia Berhad (Malaysia)

Islamic financial institutions are becoming more popular. The current assets of Islamic banks and financial institutions are over $200 billion and the growth rate is 10%-15% per annum (Ayub, 2002). Figure-1 shows the number of Islamic banks operating in different countries across the world. It can be observed that Islamic banking is a small but a dynamic market. Moreover, it is spread across the globe and is not just limited to Middle East and South East Asia. This concept is also present in USA, UK and many other European countries. Many such institutions are present there since long. Some conventional banks have also their Islamic banking subsidiaries. A large number of banks in the world are now offering Islamic financial products and participating in capital market transactions. It is interesting to note that there is also an Islamic Market Index in Dow Jones. The deposits with Islamic banks are growing fast. It has been observed that Islamic banks are utilizing their funds efficiently and have introduced novel methods of financing and investment which are secure and lucrative.Figure 1: Number of Islamic banks in different countries

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International Research Journal of Finance and Economics - Issue 82 (2012)

1.1. Objectives of Islamic Financial System Finance plays a major role in society and economic system. The aim is to provide all types of elements needed by the members of the society and economic system. The objective of Islamic financial system is to provide an economic system capable of doing economic justice. Islam has stressed that Adl (justice) should be done in every aspect of life. The justice according to Islam is a complete system of accountability which does not allow exploitation, unfairness and inequality; Ayub (2002). The ideal system of market economy is based on ownership, freedom of enterprise and competitive environment of business and industry. Islam as a religion supports the ideal system of market economy. Competitive price mechanism balances the demand and supply of goods in order to serve the society in an efficient way. Our Holy Prophet (Peace Be upon Him) has allowed the competitive price mechanism. One has to observe the constraints in an economic system imposed by Shariah so that the State ensures that norms of the system are being correctly followed. Economists studying economic system of Islam have pointed out two important objectives which are: Economic stability: A stable economic system helps in the reduction of inequities introduced by recession, inflation and unjustified changes in prices and exchange rates Economic growth: It is determined by level of output, growth of output, composition of output and efficiency in resources usage 1.2. Performance of Islamic Banks In general, Islamic bank are performing better than conventional banks (Iqbal, 2001). It has observed that the performance of Islamic banks slowed down during 1990s as compared to the performance in 1980s. The Islamic banking is expanding at a rate of 10% in absolute terms. The growth was observed to 15% in 1980s. Iqbal (2001) has listed following reasons for this phenomenon: In 1980s, the Islamic banks were a new trend so a higher growth was natural Conventional banks started offering Islamic products and services in 1990s which diverted customers Establishment of Islamic Mutual Funds may have diverted the Islamic banks deposits in the 1990s With the huge increase in number the Islamic banks, it became difficult naturally to maintain the same growth rate It has been observed that Islamic banks are well capitalized, profitable and stable due to their effective use of resources. In comparison to international standards in banking, Islamic banks are at par with them in terms of profitability ratios but their operations are not cost effective (Ayub, 2002). It has been commented that Islamic banks are suffering from excess liquidity. The study in Iqbal (2001) showed that it is not correct and Islamic banks are outperforming conventional banks in all areas on yearly basis. The growth and performance of Islamic banks ensures that interest-free banking is feasible. And an Islamic Money Market is highly desirable. Many entrepreneurs and depositors which were not investing due to religious bindings have found this type of banking very useful. Islamic banks and financial institutions need to think about enhancement of liquidity, development of secondary money, capital markets and introduction of public finance instruments in order to have a bright future. 1.3. Challenges and Problems Faced by Islamic Banks in Pakistan In general, Islamic banks are facing following challenges and problems; Sarkar (1999), Ayub (2002). Insufficient capital market and Islamic financial instruments Accounting principles and procedures are needed Unavailability of Islamic Inter-bank money market Lack of training institutes

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Bad debts Uniformity in operations of Islamic banks is needed. Political situation of country and economic slowdown Lack of legal protection Skilled manpower in Islamic Shariah banking is needed Unified Shariah ruling is absent Insufficient track record of Islamic banking New regulations for banking are desired Need of a central bank which supervises Islamic banks and check their compliance with Shariah Audit based on Shariah ruling is missing Corruption A small number of supportive and link institutions are present Collaborated research work on Islamic financial system is desired Insufficient co-operation between Islamic banks Islamic financial practices lack harmony Lack of training institutes Lack of links with training institutes Islamic banks hesitation to finance high-return projects Low research and development budget Shariah guideline manual is missing Risk analysis and measurement methodology Management problem related to Islamic operations

1.4. Conventional Banking in Pakistan Before 1947, the financial sector of Pakistan was dominated by branches of British banks. After t