FIN 601 Islamic Finance: Case Study on Non-Performing Loans Impact

This case study provides an analysis of the similarities and differences between Islamic and conventional finance, focusing on the concept of non-performing loans (NPLs). It explores how Islamic financial institutions manage NPLs, highlighting the risk-sharing principles inherent in Islamic banking and how these principles affect the stakeholders. The study contrasts equity-based Islamic finance with the debt-based conventional system, detailing the implications for risk management, profitability, and the treatment of assets and liabilities. It also examines the differences in how deposits are accepted and rewards are distributed, emphasizing the roles of Musharaka and Mudaraba in Islamic finance. Ultimately, the case study uses qualitative data to demonstrate the key structural and operational distinctions between Islamic and conventional banking systems concerning NPLs.

Running head: ISLAMIC FINANCE
Islamic Finance
Name of the Student:
Name of the University:
Author’s Note:

ISLAMIC FINANCE
Executive Summary
The main purpose of this assignment is to analyse the major similarities and differences
which exists between Islamic finance and conventional finance. The assignment will also be
pointing out the major areas which are there in an Islamic Finance. The analysis will be also
focusing on the various terms which are used in Islamic finance and also analyse whether such
terms are same or in any way related to the conventional system of accounting.

ISLAMIC FINANCE
Introduction
The main purpose of this assignment is to identify the similarities and differences which
are present between Islamic and Conventional finance framework. In order to understand the
difference between Islamic finance and conventional finance system, it is essential to first
understand what the key concepts which are used in Islamic finance1. Modern Financial
Institutions are solely based on interests which is as per Muslim law is against Sharia and it is
expected that Muslims do not keep money with such financial institutions.
A non-performing loan is a loan which was granted by the financial institution on which
no schedule payments have been made for a period of more than 90 days. Such loans are either
in default or at the risk of getting default. In other words, any loan amount which is expected to
be in default then the loan is termed as a non-performing loan. In addition to this, if the debtor
fails to make payments within specified period than also such will be considered as a non-
performing loan. In case of a non-performing loan the lender has the right to take necessary
actions to recover the principal amount of the loan. This is mostly seen when the loan is covered
by an asset as a security for loans. The conventional bank will take steps like seize the asset,
foreclosure process. In case of Conventional banks non-performing loans can be sold to
investors in order to reduce the risks associated with a non-performing loan and in the process
clean up their balance sheet. In the case of both Islamic financing institutions and conventional
institutions, non-performing loan affect the business and therefore it is up to the management to
manage the same effectively. In case of conventional banking system, where non-performing
loans have been identified and there is a risk of default which is related to the loan than the bank
in general cases creates provisions for such loans. Such non-performing loans are firstly
1 Rahman, I. and Sulfia, D.J., Islamic Banking and Finance. Anchor Academic Publishing 2015.

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classified on the basis of criteria which is substandard and doubtful debts. On the basis of such
classifications the provisions for such debts are created. The provisions which is created for
doubtful debts are generally more than the substandard category. In the case of Islamic financing
as well the banks need to effectively manage non-performing loans2. The purpose of identifying
of non-performing loan is to ensure that the banks are able to create provisions so that the impact
and risks which are associated with loan term loans can be averted. A case study shows that
Islamic banks are affected by non-performing loans and the essence of a non-performing loan is
because it reflects the channelization of the loans and financing. Moreover, research show that
high Non-performing loans for an Islamic bank and Conventional banks is a cause for the fall in
profitability of the banks. Thus, it is important for both Islamic and conventional banks to
effectively measure and maintain non-performance loans. As the risk and rewards are both
shared by investors the non-performing assets risks also fall on the investors or depositors of
such banks. In case of short term as well long-term loans which are to be issued by Islamic
financial institutions, the viability of the project is to be analyzed carefully by the investors and
then the loan amount is to be approved. As the risks of non-performing loans are to bear the
investors the system is that the loan needs to be approved by the investors after he is satisfied by
the viability of the project3. In case of further defaults in the payment of the non-performing
loans the banks can impose penalty on such non-performing4. The penalty which is imposed by
2 Abedifar, P., et al., Islamic banking and finance: recent empirical literature and directions for future
research. Journal of Economic Surveys, (2015) 29(4), pp.637-670.
3 Škarica, B., Determinants of non-performing loans in Central and Eastern European countries. Financial theory
and practice, (2014). 38(1), pp.37-59.
4 Makri, V., Tsagkanos, A. and Bellas, A., Determinants of non-performing loans: The case of
Eurozone. Panoeconomicus, (2014). 61(2), p.193.

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the banks are used for the purpose of charity. As per the research the Islamic banks are
developing in most parts of Saudi Arabia, parts of the middle east as well.
In case of Islamic banks, equity-based sources of money are more preferred than debt-
based sources. The depositors of an Islamic banks are basically shareholders of the banks. A
bank which is more dependent on the equity sources like Islamic banks uses lending methods
like mudarabah which is one-party joint partnership and a multi-party joint partnership which is
known as musharaka. Moreover, the risks are shared by the depositors which is not the case in
debt financing which is majorly used by conventional banks. In case of conventional banks, the
risk are on mostly on the banks and not on the investors. another main difference between
Islamic banks and Conventional banks which uses Equity financing and debt financing
respectively is the basis of recording assets and liabilities in balance sheet. In case of Islamic
banks, the asset side will contain certain cash which are kept as fixed assets and cash reserves
and certain amount of equity as well and on the liability side investment profit and loss account
deposits.
As per the analysis of the work processes of a conventional banking system and Islamic
banking system, Islamic banks are based on the profit and loss principle and does not charged
interest whereas the conventional banks are dependent on the interest factor. The conventional
banks charge interest on the loan amount which it lends to clients whereas no such interest is
charged by Islamic banks and the main source of revenue is from the profits which are earned
from investments which are shared with the depositors of such banks5. The main principles of an
Islamic bank is based on the equity based policies which involves using the capital of its own
and also the capital which it acquires from deposits which is used for investments through which
5 Beck, T., Demirgüç-Kunt, A. and Merrouche, O., Islamic vs. conventional banking: Business model, efficiency
and stability. Journal of Banking & Finance, (2013) 37(2), pp.433-447.

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profits for the banks are generated6. In case of conventional banks, the structure is based on debt
policies. The major source of income for conventional banks is through lending of money as
debts on which the bank charges interests following the time value of money concept7.
As per the data which is available from secondary sources, it is clear that the Islamic
banks are not responsible for the risks which are associated with the investment. In the case of
Islamic banks, the risks are also to be bear by the investors same as they have share in the profits
of the investments8. This is a point of difference between an Islamic bank and a conventional
bank who borne all the risk part of the investors and also provides a fixed reward for the same.
Hypothesis
There is a wide range of differences between Islamic finance and conventional system of
finance. The hypothesis which is used for the explanation of the same depends on the secondary
data which is collected from various journals and works of other authors. The secondary data
helps in the research and also is useful in developing the reasons and points which makes Islamic
financing practices different from conventional system of financing9. The major difference which
arises is that the conventional system of financing by institutions are heavily dependent on
interest which is not the case in Islamic financing10. In the case of Islamic financing, the structure
is based on the profit and loss principle which means that even though Islamic financing
6 Ahmed, H., Islamic banking and Shari’ah compliance: a product development perspective. Journal of Islamic
finance., (2014) 3(2), pp.15-29.
7 Khan, M.S. and Mirakhor, A., Theoretical studies in Islamic banking and finance. BookBaby. (2015).
8 Waemustafa, W. and Sukri, S., Systematic and unsystematic risk determinants of liquidity risk between Islamic
and conventional banks. (2016)
9 Samra, E., Corporate governance in Islamic financial institutions. (2016).
10 Iqbal, M. and Molyneux, P., Thirty years of Islamic banking: History, performance and prospects. Springer.
(2016).

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institutions are does not deal in interest as in the case of conventional institutions but share in the
profits which are generated from the use of funds. The depositors of such Islamic institutions
also have a share in the profits generated at pre-determined ratios which is stipulated by the
institutions. The asset side of such Islamic bank show the transactions with the depositors in the
asset side and transaction with the investment clients in the liability side. Whereas in the case of
conventional institution shows taking deposits and paying interest and on the other side lending
and charging interest are shown. In addition to this Islamic financing institution are based on the
equity-based system, whereas the conventional banks are based on debt-based system. In case of
conventional system, the shares capital of conventional system is that the nature of the capital is
of permanent nature and in case of Islamic financial institution is that the capital is based on term
investments. The process which is adopted by Islamic financial institutions for the purpose of
accepting deposits from the public is quite different from the technique which is adopted by
conventional financial institutions. The system which is followed by Islamic financial institution
follows the sharia or the rules of Islam. All the collection process of deposits is same in both
cases of Islamic finances and conventional system of finance11. The point of difference lies in the
area where the rewards are distributed for the deposits kept with institutions. In a conventional
bank the rewards which are associated with deposits are fixed and generally provided in the form
of interests. Whereas in the case of Islamic finance, the rewards are not fixed and the deposits are
accepted through Musharaka and Mudaraba. Musharaka literally means to share profits in a
partnership whereas Mudaraba is also related to sharing of profits. The difference between the
two is that Musharak requires also involves sharing of losses strictly between the partners. Then
there is the risk and return factor which is a point of difference between the two. In case of
11 Gheeraert, L. and Weill, L., Does Islamic banking development favor macroeconomic efficiency? Evidence on the
Islamic finance-growth nexus. Economic modelling, (2015). 47, pp.32-39.

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conventional system of financing the entire risks are borne by the banks and they provide
securities to the depositors and the rewards totally belongs to the depositors. However, in the
case of Islamic finance the both the risks and returns are equally shared by the depositors12. Thus,
from the above discussions it can be clearly stated that there exists certain key difference in the
principles which are followed and the structure of Islamic banks and conventional banks.
Methodology
The general differences and similarities of an Islamic banks and conventional banks can
be analyzed through qualitative data analysis. Qualitative data refers to the facts and information
which can be obtained for the purpose of a research through the works of other authors or journal
other authors.
The first step will be involving collection of data from various sources such as journals
on conventional and Islamic banks which can provide information regarding the structure of the
banks and also treatments of various items in the financial statements which are prepared by such
banks. Then the next step will be involving detailed analysis of data which is collected from
various journals and works of other authors in order to determine the structure and processes
which are used by such banks and also the accounting treatments of deposits and payments and
all other related information. As per the research, the financial statements can also be used to
identify the difference in treatments of deposits and payments13. As per analysis, the partnership
for profits and deposits are placed in the asset side whereas the transactions between the bank
and the investment client are place on the liability side of a balance sheet. In case of a
12 Abedifar, P., Molyneux, P. and Tarazi, A., Risk in Islamic banking. Review of Finance, 17(6), pp.2035-2096.
(2013).
13 Wilson, R., The development of Islamic finance in the gulf cooperation council states. The Transformation of the
Gulf: Politics, Economics and the Global Order, (2013). 146, pp.47-76.

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conventional banks, funds for which the banks need to pay interest are placed in the liability side
and for the funds which are lend out and interest charged are placed in the asset side of the
balance sheet14. Moreover, in case of Islamic banks as they do not charge interest or pay interest
to the depositors of the banks, the treatments will be different for the profit sharing which is done
in an Islamic bank in the financial statements. Thus, information about the difference in
treatments can be collected by comparing the financial statements of both the types of banks.
Then there is a difference in the strategies which are followed by Islamic banks in case of risks
which are associated with the business. The risks are directly borne by the investors of the banks
and not by the Islamic banks as it is in the case of conventional banks. Moreover in case of
Islamic banks the principle of risk sharing is followed where the risks are shared by the
depositors of the business.
Results and Conclusion
The results which can be drawn from the analysis work which is done above, it can be
clearly stated that there exists difference between Islamic banks and conventional banks. There
are various point of differences but the most crucial one is the basis on which the bank functions
that is by charging and allowing interest from debtors and depositors respectively in case of
conventional banks and by means of sharing profits for the investors of the company in case of
Islamic banks.
The Islamic banks strictly follows the Sharia framework where in some activities which
are considered to unethical or prohibited in Islam are not allowed to be financed by such banks.
Some of the restrictions which are discussed above relates to the prohibition of Islamic banks to
allow or charge interest on the cash depositing and lending activities of the business. An aspect
14 Karim, R.A.A. and Archer, S., Islamic finance: the new regulatory challenge. John Wiley & Sons. (2013.)

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of Islamic finance which is not present in case of conventional banks is that the financing is
either made on the principles of sharing risks and rewards or those financing which are backed
by assets. Another unique feature of financing in an Islamic financing system is that it is in the
form of mudaraba which can play an important role for overall development of the society. In
Mudaraba form of financing a partnership is formed between funds which are provided by the
banks and the skills which are there in a person who lacks the capital to have him backed and
therefore it is an effective means to provide self-employment. From the analysis of the case it
can be stated that the developing Islamic banks are not just there as a copy of conventional
banking system. There has been difference in the working process of Islamic banks and
conventional banks due to the Sharia principles which are followed by the Islamic banks.
However, research shows that due to this sharia principle Islamic banks misses out on
opportunities which conventional banks are able to enjoy such interest factor which covers up for
the time vale of money aspect, investment in governmental bonds which bear significant amount
of interests are missed out by Islamic banks. In spite of all this, the growth and development of
Islamic banks have been tremendous in last two years in Pakistan and middle east countries. The
system which are followed by conventional banks are different from that which are followed by
Islamic banks.

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Reference
Abedifar, P., et al., Islamic banking and finance: recent empirical literature and directions for
future research. Journal of Economic Surveys, (2015) 29(4), pp.637-670.
Abedifar, P., Molyneux, P. and Tarazi, A., Risk in Islamic banking. Review of Finance, 17(6),
pp.2035-2096. (2013).
Ahmed, H., Islamic banking and Shari’ah compliance: a product development
perspective. Journal of Islamic finance., (2014) 3(2), pp.15-29.
Beck, T., Demirgüç-Kunt, A. and Merrouche, O., Islamic vs. conventional banking: Business
model, efficiency and stability. Journal of Banking & Finance, (2013) 37(2), pp.433-447.
Gheeraert, L. and Weill, L., Does Islamic banking development favor macroeconomic
efficiency? Evidence on the Islamic finance-growth nexus. Economic modelling, (2015). 47,
pp.32-39.
Iqbal, M. and Molyneux, P., Thirty years of Islamic banking: History, performance and
prospects. Springer. (2016).
Karim, R.A.A. and Archer, S., Islamic finance: the new regulatory challenge. John Wiley &
Sons. (2013.)
Khan, M.S. and Mirakhor, A., Theoretical studies in Islamic banking and finance. BookBaby.
(2015).
Makri, V., Tsagkanos, A. and Bellas, A., Determinants of non-performing loans: The case of
Eurozone. Panoeconomicus, (2014). 61(2), p.193.
Rahman, I. and Sulfia, D.J., Islamic Banking and Finance. Anchor Academic Publishing (2015).

ISLAMIC FINANCE
Samra, E., Corporate governance in Islamic financial institutions. (2016).
Škarica, B., Determinants of non-performing loans in Central and Eastern European
countries. Financial theory and practice, (2014). 38(1), pp.37-59.
Waemustafa, W. and Sukri, S., Systematic and unsystematic risk determinants of liquidity risk
between Islamic and conventional banks. (2016)
Wilson, R., The development of Islamic finance in the gulf cooperation council states. The
Transformation of the Gulf: Politics, Economics and the Global Order, (2013). 146, pp.47-76.