Islamic banks and financial stabilityAbstract:Key words:Islamic banks, conventional banks, performance, profitability, comparison, financial ratios, financial stability.Research area: FinancePaper type: Research paperProblem statement: Pakistan is an Islamic country. Its people prefer Conventional banking system rather than Islamic banking system. Due to these preferences, conventional banking system is promoting continuously. That’s the reason behind the financial instability of Islamic Banks in Pakistan.Introduction:The purpose of conducting this research is to evaluate the performance of Islamic banks and conventional banks of Pakistan and compare their performance with each other to measure their efficiency in terms of profitability. For this purpose, comparative analysis of Islamic and conventional banks of Pakistan has been done. In order to conduct this research, sampling method of research is used. All the Islamic banks and commercial banks operating in Pakistan are taken as a population. Currently, there are almost 6 Islamic banks and 22 commercial banks, operating in Pakistan. For this research paper, all the 6 Islamic banks, named;1) Al-Baraka Islamic Bank.2) Meezan Bank Limited. 3) Dawood Islamic Bank Limited.4) Emirates Global Islamic Bank Pakistan Limited.5) Dubai Islamic Bank Pakistan Limited.6) Bankislami Pakistan Limited. and 9 conventional banks are taken as a sample. The list of commercial of conventional banks of Pakistan taken as a sample is as follow;1) National bank of Pakistan.2) First women bank of Pakistan.3) Faysal bank.4) JS bank.5) HSBC bank.6) Barclays bank Pakistan.7) Silk bank limited.8) Citibank Pakistan.9) My bank limited.Here is a brief introduction of Islamic and conventional banking system of PakistanIntroduction to Islamic banks:The Islamic banking system was started in the early 1970s. Islamic banking system had achieved amazing performance level over the last 25 years. During this period, a lot of research has been done on the Islamic banking or interest free banking system. (Akhter, Raza, Orangzab, & Akram, 2011). Aa22Basis for differentiation between Islamic and conventional banks:Islamic banks and conventional banks are different from each other in many aspects. Although both of them have same functions of lending and borrowing but their ways and objectives of lending and borrowing are different. Islamic banking has the purpose of stimulating the distribution of income, while conventional banks are working for the sake of maximizing their shareholder’s wealth. These are the two institutions that are operating in Pakistan. These banks operating in the same environment but both of them have different objectives and mode of operations. All the Islamic banks in Pakistan are working with the aim of increasing the wealth distribution of income among all the members of society and accelerating the business activities, whereas conventional banks are operating only for rich people who are already engaged in business activities. Conventional banks charge interest from their borrowers and then distribute it in their shareholders. This is the way conventional banks are operating to maximize their shareholder’s wealth. (Awan, 2009) aa11 Objectives of the research:1). To make a comparative analysis of Islamic banks and conventional banks operating in Pakistan.2). To check the performance of both of Islamic and conventional banks.3). To measure the financial stability of both Islamic and conventional banks.Research questions:1).Is there any difference between the performance of Islamic banks and conventional banks of Pakistan.2). Whether the Islamic banks or conventional banks have higher profitability and liquidity ratios?3). How much these banks vary from each other in performance?4). Which kind of bank has achieved more financial stability in Pakistan?Literature Review:The literature on the Islamic banking system, its functions, profitability and performance is expanding rapidly and a large number of researches had been done on this area of research. There is large number of empirical studies, which had been done on comparative analysis of the Islamic and conventional banking system. These researches measured and explored the performance and financial stability of both Islamic and conventional banks. Among these researches Moin (2008), Samad (2004), Samad and Hassan (1999) and Iqbal (2001) are most important.aa44Now let me to discuss what previous researches say about the performance of Islamic banking system. Sudin Haron (1996) described the determinants of the performance of the Islamic banking system. He stated that Islamic banks are performing well than conventional banks as they focus on short term financing. In this way they are using capital efficiently than conventional banking system, which do not consider short term financing. Munawar Iqbal (2001 to 2004) compared the growth of Islamic and conventional banks. He used ratio analysis and measures the annual growth rate of both Islamic and conventional banking system. He, than concluded that the Islamic banks are, in terms of ROE and ROI, higher than conventional banks. Aa11Metwally (1997) compared the 15 Islamic banks with 15 conventional banks of financial ratios including liquidity, credit risk, profitability and efficiency. He concluded that both of them are same in terms of profitability and efficiency, but there is difference between Islamic and conventional banking system in terms of credit risk and liquidity.aa44Jaffar and manarvi (2011) compared the performance of Islamic and conventional banking system by using CAMEL test analysis for the years 2005 to 2009. The conclusion of the research showed the assets of both Islamic and conventional banks have similar quality while the conventional banking system have better liquidity management and asset ability as compare to Islamic banks. 2603-8274-1-PBTheoretical framework:Variables:Profitability, Performance, Liquidity ratios, Coverage ratios, profitability ratios.Independent variables Dependent variables• Liquidity ratios • Coverage ratio performance of Islamic and conventional • Profitability ratios banks. Description of independent variables:Financial ratios.The following are the financial ratios and they are used to evaluate the performance or financial stability of both Islamic and conventional banks of Pakistan.• Liquidity ratios. Liquidity ratios are used to measure the ability of a firm to meet its short term obligations. Liquidity ratios are of two types;? Current ratio.Current ratio is a measure of liquidity. It is calculated by dividing the firm’s current assets by its current liabilities.Formula:Current ratio = current assets / current liabilities? Quick (acid test) ratio.Quick ratio is also a measure of liquidity. It is calculated by dividing the firm’s current assets minus inventory by its current liabilities.Formula:Quick ratio = current assets – inventory / current liabilities• Coverage ratios:Coverage ratios are used to measure the firm’s ability to pay certain fixed charges. Coverage ratios are further divided into two kinds;? Solvency (debt) ratio.These ratios are used to measure the proportion of total assets financed by the firm’s creditors.Formula:Long term debt ratio = Total Liability / Total Assets? Times interest earned ratio:It is also known as interest coverage ratio. It is ratio used to measure the firm’s ability to make contractual interest payments.Formula:Times interest earned ratio = Earnings before interest and taxes / Interest expenses• Activity Ratios. Activity ratios are used to measure the speed with which various accounts are converted into sales or cash. Activity ratios are further divided into two kinds;Inventory turnover ratio.• Profitability ratios:Profitability ratios are used to measure the firm’s profitability. This type of ratios are further divided into 7 parts;? Gross profit margin.Gross profit margin is used to measures the percentage of each sales dollar remaining after the firm has paid for its goods. Gross profit margin = Gross profit / sales * 100? Operating profit margin.The operating profit margin ratio used to measure the percentage of sales after meeting all costs and expenses except interest, taxes and preferred stock dividends.Formula:Operating profit margin = Operating profit / sales * 100? Net profit margin.The net profit margin ratio is used to measure the percentage of sales of a firm, which it has after paying the costs, expenses, interest, taxes and preferred stock dividends.Formula:Net profit margin = Net profit / sales * 100? Earnings per share.Earnings per share is a ratio that is used to represent the number of dollars earned by a firm during the period on behalf of each outstanding share of common stock.Formula:Earnings per share = Earnings available for common stockholder / number of shares of common stocks outstanding. ? Return on assets.Return on asset ratio is used to measure the overall effectiveness of management of a firm in generating profits with its available assets. It is also known as return on investment.Return on assets = Earnings available for common stockholders / Total assets? Return on equity.This ratio is used to measure the firm’s return earned on the common stockholder’s investment.Formula:Return on equity = Earnings available for common stockholders / common stock equity? Assets turnover ratio.This ratio is used to measure the firm’s asset turnover.Formula:Assets turnover ratio = Net sales / Total assets Methodology:This research is of descriptive type in which comparative analysis of Islamic banks and conventional banks of Pakistan, in terms of performance, has been done. For conducting this research sampling method, most common and simplest method of research has been used.Hypothesis:The hypothesis test is used to measure the differences in profitability and performance of both Islamic and conventional banks operating in Pakistan.Ho: There is no significant difference between the performance of Islamic and conventional banks of Pakistan.H1: There is a significant difference between the performance of Islamic and conventional banks of Pakistan.Ho: Islamic banks are not better in profitability and liquidity ratios than conventional banks.H1: Islamic banks are better in profitability and liquidity ratios than conventional banks.Ho: Islamic banks are not efficient than conventional banks in terms of performance.H1: Islamic banks are efficient than conventional banks in terms of performance.Ho: Islamic banks have not achieved financial stability in Pakistan.H1: Islamic banks have achieved financial stability in Pakistan.Data collection:All the data has been collected from secondary sources. In order to measure the performance, all the data about financial ratios has been taken from the balance sheets and income statements of the banks of Pakistan, taken as a sample for this research paper.Sample size:All the six Islamic banks and almost twenty two conventional banks of Pakistan are taken as a population. Out of these, all the six Islamic banks and 9 conventional banks are taken as a sample for this research paper.BibliographyAkhter, D. W., Raza, A., Orangzab, & Akram, M. (2011). Efficiency and Performance of Islamic Banking: The Case of Pakistan. Department of management sciences, lahore.Awan, A. G. (2009). COMPARISON OF ISLAMIC AND CONVENTIONAL BANKING IN PAKISTAN. lahore.