Risk management in conventional and Islamic banks in Palestine: A comparative analysis

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1. “Risk management in conventional and Islamic banks in Palestine: A comparative analysis” AUTHORS Othman Sawafta ARTICLE INFO Othman Sawafta (2021). Risk management in conventional and Islamic banks in Palestine: A comparative analysis. Banks and Bank Systems, 16(2), 182-189. doi:10.21511/bbs.16(2).2021.17 DOI http://dx.doi.org/10.21511/bbs.16(2).2021.17 RELEASED ON Monday, 28 June 2021 RECEIVED ON Wednesday, 14 April 2021 ACCEPTED ON Friday, 11 June 2021 LICENSE This work is licensed under a Creative Commons Attribution 4.0 International License JOURNAL "Banks and Bank Systems" ISSN PRINT 1816-7403 ISSN ONLINE 1991-7074 PUBLISHER LLC “Consulting Publishing Company “Business Perspectives” FOUNDER LLC “Consulting Publishing Company “Business Perspectives” NUMBER OF REFERENCES NUMBER OF FIGURES NUMBER OF TABLES 20 0 3 © The author(s) 2021. This publication is an open access article. businessperspectives.org
2. Banks and Bank Systems , Volume 16, Issue 2, 2021 Othman Sawafta (Palestine) BUSINESS PERSPECTIVES LLC “СPС “Business Perspectives” Hryhorii Skovoroda lane, 10, Sumy, 40022, Ukraine www.businessperspectives.org Risk management in conventional and Islamic banks in Palestine: A comparative analysis Abstract Received on: 14th of April, 2021 Accepted on: 11th of June, 2021 Published on: 28th of June, 2021 © Othman Sawafta, 2021 Othman Sawafta, Ph.D., Assistant Professor, Business and Economics Faculty, Computerized Financial and Banking Science Department, Palestine Technical University, Palestine. The aim of the study is to compare credit risk between commercial and Islamic banks in Palestine. The study uses five commercial banks and two Islamic banks, so the Merton model is used to test the hypothesis regarding the research question. Also, cumulative logistic probability distributions are used to derive the probability of default from distance to default. The findings show that commercial banks encompass less credit risk than Islamic banks. Thus, the study recommends that financial institutions in Palestine master management skills and operational systems to cope with the financial environment. They need to increase research and training programs in risk management. Besides, there is a need to reduce lending to public sector (government). There is also a need for a focus on mergers, especially for smaller banks, to increase their capital, so that there are banking units that can compete in providing better customer services and contributing to the stability of the banking sector. Keywords credit risk, profit-loss sharing, financial institutions, financial services, banks JEL Classification G20, G21, G23, G24, G28 INTRODUCTION 21 years ago, the financial sector in the West Bank and Gaza Strip formally grew after the signing of both the Oslo Accord in 1993 and the Paris Protocol in 1994. The latter affirms the right of the Palestinians to manage and administer monetary and economic relations to support the expected economic growth of their territories. At that period, the Palestinian Monetary Authority (PMA) was established to put into practice and control the required monetary policies in Palestine. This is an Open Access article, distributed under the terms of the Creative Commons Attribution 4.0 International license, which permits unrestricted re-use, distribution, and reproduction in any medium, provided the original work is properly cited. Conflict of interest statement: Author(s) reported no conflict of interest 182 However, the Palestinian financial system, including all of its financial institutions, faces a set of risks that originate from various sources. The major and most dangerous of these risks is presented by the sustained existence and domination of the Israeli occupation in the Palestinian territories. As a result, the Israeli occupation made the Palestinian economy dependent on Israel as the dominant economy in the region, including its internal political, division, and the resulting adverse repercussions throughout the Palestinian territories. Further primary risks to the financial system reflect the financial difficulties the government faces, as well as the risks inherent in structural problems due to the failure to achieve the necessary legislative framework and governance measures by non-banking financial institutions. There are also risks of the neighboring countries that may affect the Palestinian financial system, especially the countries that suffer from a lack of economic and political stability. These countries may endanger Palestine with liquidity and affect the exchange rate. http://dx.doi.org/10.21511/bbs.16(2).2021.17
3. Banks and Bank Systems , Volume 16, Issue 2, 2021 Regardless of the aforementioned obstacles, the banking system and the financial sector in Palestine proved their ability to resist these risks; as well as the sustained progress in banking infrastructure. Also, great efforts are being done to develop laws, regulations, and procedures that organize the operations of these entities (PMA, 2013). The fundamental principle for risk management could be achieved by protecting and increasing the economic value of both the banks and their stakeholders, customers, including, shareholders, suppliers, investors, employees, the public, and the PMA. Risk is defined as a prospective future hazard that possibly will occur from current action, like a failure to spot deadlines or cost overrun. Now, the loss is considered in terms of a loss in terms of credibility, direct financial loss, a loss of property, foregone future business, or a loss of life. Risk and failure are not always harmful, they could be necessary for economic development and are often the main element of learning to succeed. However, it is important to learn to weigh the possible negative outcomes of risk in favor of possible advantages of the associated opportunities (Van Scoy). Financial risk is a probability that the actual return of a venture will be less than the anticipated return. This risk is categorized as follow: capital risk, basic risk, default risk, country risk, economic risk, delivery risk, exchange rate risk, liquidity risk, interest rate risk, operations risk, political risk, payment system risk, reinvestment risk, refinancing risk, sovereign risk, underwriting risk, and settlement risk (www.businessdictionary.com). Conventional banks are financial institutions, owned by the private sector and accept time deposits and demand. They also make loans to both organizations and individuals. They also offer several services such as international banking, document collection, and trade financing. Interest is taken from clients on the borrowed money and the money earned on the deposited funds (www. absoluteastronomy.com). Banks charge interest on loans and pay interest on deposits. In contrast, the Islamic banking system works in harmony with the standards and principles of Islamic Sharia law. The Sharia law is a practical application in all Islamic economies. The main two Islamic banking principles are the sharing of both the profit and the loss. Add to this the prohibition of the collection and payment of interest, which is considered in Islam a taboo. Hence, Islamic banks operate mainly relying on Islamic principles regarding profit-and-loss sharing and other forms of investment. What is more, Islamic banks strictly avoid interest. Interest is determined as the root of exploitation and is responsible for large-scale unemployment and inflation. However, financing according to Shari’a means: “... the act of providing financial products or services that conform to Sharia, Islam’s law, and moral code. The defining characteristic of Islamic financial products is the avoidance of interest, known as ‘Riba’, derived from the Quran’s stipulation that only goods and services, and not money itself, are allowed to carry a price. Instead, Sharia-compliant finance promotes risk-sharing or profit-andloss sharing principles in all forms of business transactions” (Demirgüç-Kunt et al., 2013; Shihadeh, 2018). This paper empirically explores the assertion that Islamic banks have higher or lower credit risk than commercial banks. It explores which banks have the highest credit risk in Palestine. The article aims to provide empirical evidence from Palestine on the efficiency of Islamic investments and risks to explain the Islamic banks’ future earnings compared to the commercial banks. This paper is organized as follows: the next section provides a literature review, followed by methodology and results; the last section presents conclusions and recommendations. http://dx.doi.org/10.21511/bbs.16(2).2021.17 183
4. Banks and Bank Systems , Volume 16, Issue 2, 2021 1. LITERATURE REVIEW Banks seek to increase their profits through credits and other financial services, while these facilities carry risks that lead to the loss of their assets, customer deposits and expected return (Shihadeh & Liu 2019; Shihadeh et al., 2018). The study by Ismal (2012) is aimed at formulating procedures to ease both bankruptcy and withdrawal risks. What is more, the balance point of revenue depositors sharing has been explained. For instance, a case of the Islamic banking industry has been employed in Indonesia. Financial mathematical formulas were used to assess the vulnerabilities of banks to withdraw and avoid bankruptcy and risk. It also deals with conditions of bankruptcy and solvency risks that decision-makers can use to lessen banks’ risks. Wiyono and Rahmayuni (2010) measure the impact of credit risk on the profitability of Islamic banks. The Islamic income and profit-sharing ratio were used and then determined if this occurred due to a moderating variable on the profit margin (PM), return on equity (ROE), return on assets (ROA), credit risk (credit), liquidity risk (liquidity) and the Islamic income variable’s (Islnc) profit sharing ratio (PS ratio). The results show that the profit margin of the Islamic income-and-profit-sharing ratio moderates the connection between profitability and risk. However, ROA and ROE at the Islamic income and profit sharing ratio are not moderating variables. The findings also show that increasing the sample banks and using quarterly data might offer better results. Nikolaidou and Vogiazas (2014) also examine the determinants of credit risk in the Bulgarian banking system by employing an autoregressive distributed lag model. They conclude that the soaring level of non-performing loans will lead to threatening the Bulgarian financial stability and its banking system to be under the domination of foreign commercial banks. On the other hand, there is an insignificant effect of the Greek debt crisis on the Bulgarian banking system. ratios on parameters such as liquidity, profitability, operating, capital, efficiency, adequacy, and leverage were employed. Empirically, the findings demonstrate that conventional retail banks, excluding Bahrain development banks, comprise steady performance in return on equity and assets. In contrast, the performance of Islamic retail banks at the Kuwait Finance House was considered reasonable in terms of profitability. The data also demonstrates that all banks had acceptable risk, as measured by their debt-to-asset ratios. The profitability of commercial banks and capital adequacy, their efficiency and profitability are correlated statistically. The findings confirm a significant difference in capital adequacy without a significant difference in profitability and liquidity of the listed commercial retail banks in Bahrain. Shafiq and Nasr (2010), applying primary and secondary data, explored risk management practices in commercial banks in Pakistan. The findings show that, on the one hand, risk monitoring comes to be the most significant variable. On the other hand, applying regression analysis independently on each variable, such as under-standing risk management, risk assessment, risk identification, and credit risk analysis, confirms a significant positive association between risk monitoring and risk management practices. The findings also shed light on some differences between private local banks and public sector commercial banks in terms of understanding and monitoring risk. 2. METHODOLOGY 2.1. Research procedure A quantitative methodology has been used to inspect the credit risk inherent in modes of nonperforming financing and financing in commercial and Islamic banks. It examines whether these banks’ profitability is influenced and measures the level of this influence. The secondary data are taken from the yearly and monthly-disclosed reports of commercial and Islamic banks published by the Palestinian Monetary Authority, the Central Bank Furthermore, the study by Hawaldar et al. (2017) of Jordan, the Association of Banks in Palestine comes to scrutinize the conventional retail banks’ and the Palestine Capital Market Authority. The performance, both conventional and Islamic collected data are taken from 7 banks; two of them banks in Bahrain from 2001 to 2015. Financial are Islamic banks, and 5 are conventional banks. 184 http://dx.doi.org/10.21511/bbs.16(2).2021.17
5. Banks and Bank Systems , Volume 16, Issue 2, 2021 However, some financial data were only obtained through formal requests to banks. The study also employed a mathematical approach to the formulas on credit risk: (asset drift rate, assets volatility or equity volatility, expected asset return, and the beta). What is more, the findings show some primary scenarios. itive or negative average net outcome. This idea is based on the possibility of information-based trading and data on the potential effect of individual Palestine-exchange-listed stocks, and then on the expected asset returns. The study by Greenwood and Shleifer (2014) also demonstrates that if possible returns (ER) The study also deals with the inquiry of credit risk are measured without noise, the model then between commercial and Islamic banks in Palestine will foretell a positive and perfect correlation where there are no prior studies examined this ques- between the ER and the investor expectations. tion in the Palestinian territories or other Islamic Then the probable asset return is calculated as countries. Doubtlessly, credit risk management is follows: considered as a vital domain for the banking sector. Hence, banking professionals have to preserve Expected Asset Return = R.F .R + (1) a sense of balance between their returns and risks. + ( M .P + B ) , Banks of greater customer bases have to provide a variety of products. It is worth mentioning that sound investment decisions mean harmonizing the prod- where R.F.R = Risk free rate; M.P = Market premiucts’ risks against the probable returns. This study um assumed; B = Beta. also raises a new research model to predict future earnings at commercial and Islamic banks in terms 2.3.2. Asset volatility of the performance on equity and debt financing. or equity volatility 2.2. Data This study calculated the historical asset volatility by employing the annualized standard deviation This section will explain the employed methodology of the Palestine Exchange (PEX) depending on the to meet the desired objectives. It measures the level of daily stock return over the past 252 days or more. credit risk in commercial banks and Islamic banks The historical asset volatility (the reflection of in Palestine. This includes the asset drift rate, asset the degree to which the asset price moves) is emvolatility (equity volatility), the beta, and the expect- ployed while selecting investment security. This is ed asset return. What is more, it demonstrates the intended to help determine the relative risk of a methods and models used to find the results, the da- likely trade. That is why a stock that retains a relta, and the factors analysis of the models used. atively steady value owns slow volatility (low risk), where a highly volatile stock is inherently riskier. Table 1. Banks included in the study sample Consequently, the volatility of assets is calculated as follows: Commercial banks Islamic banks Bank of Palestine Quds Bank Arab Islamic Bank Palestine Islamic Bank The National Bank – Palestine Investment Bank – Palestine Commercial Bank – AssetsVolatility = S .d (ln R ) ⋅ ( # O.T .D ) , (2) 0.5 where s.d (ln R) = standard deviation of share price returns for each year; # O.T.D = number of trading days. 2.3.3. Asset drift rate 2.3. Variables The anticipated annual rate of return or the drift µ is achieved by employing the unbiased estimator and the last results of the daily return given The expected return on assets is employed to de- by the following equation. The drift is considtermine whether an investment can have a pos- ered as a measuring trend in the price (possibly 2.3.1. Expected asset return http://dx.doi.org/10.21511/bbs.16(2).2021.17 185
6. Banks and Bank Systems , Volume 16, Issue 2, 2021 reflecting long-term inflation). Consequently, ered as the measures that maintain and deterthe drift may occur because of fees paid to mar- mine share prices. ket makers or transaction costs that put ready to buy or sell a certain stock at a publicly quoted 3.1. Islamic banks price on a regular and continuous basis. Table 2 illustrates the coefficient estimates sta0.5 tistically. The significant estimates demonstrate Asset drift rate = ln (1 + ER ) , that when the asset volatility, the beta, and the 0.5 (3) asset drift rate are high, then the expected stock ln (1 + ER ) = Squared Logitech’s returns are also high. The findings demonstrate normal expected return on assets. that the expected returns of Islamic banks are high when past stock returns are also high and confirmed by the impulse response function. 2.3.4. Beta The returns continue to decrease from 2009 to Beta is used as a fundamental analysis measure- 2013 due to decreases in the beta, asset drift rate, ment tool to determine the volatility of a portfo- and volatility. lio or an asset in the entire market. The beta is Table 2. Expected asset returns of Islamic banks widely employed in the capital asset pricing modSource: Banks annual reports. Author calculations. el (CAPM) to work out the anticipated return on assets relying on its expected market returns and Islamic banks beta. Hence, stocks that swing greater than the Arab Islamic bank Expected asset Assets Asset drift market will have a beta greater than 1.0. Whereas, Years Beta return volatility rate when a stock is less than the market, the stock’s 2013 0.50% 2% 2% 0.50% beta then will be less than 1.0. ve = Ba ⋅ Be, ( ve + vd (1 − T ) ) (4) where Ba – asset beta; Be – equity beta; ve – market value of company’s shares; vd – market value of company’s debt; ve + vd(1 – T) = after tax market value of company; T – company profit tax rate. 3. RESULTS The selected banks of this study that are listed on the Palestine Exchange showed a consistent time series of annual data from 2009 to 2013, and all of them used variables in the estimation. The dataset consists of accounting data such as balance sheets, book debt variables, income statements, equity price, and the book equity value. However, the Palestinian banking industry is considered as one of the few traditional industries in the world that managed to fully employ the new technology and adapt its services to suit clients’ preferences for online interactions and transactions. Consequently, stock holders must be acquainted with the bank’s return rates and the expected asset returns as these are consid- 186 2012 2011 2010 2009 2008 2007 0.70% 0.50% 0.60% 1.10% 1.80% 3.70% 2013 2012 2011 2010 2009 1.02% 0.85% 0.73% 0.32% 0.45% 3% 4% 4% 4% 6% 4% 3% 4% 4% 4% 6% 4% 5% 4% 7% 11% 9% 6% 1.00% 0.90% 0.70% 0.30% 0.50% 11% 9% 9% 1% 2% Palestine Islamic bank 3% 3% 3% 3% 2% Note: Expected asset returns to Islamic banks’ asset volatility, asset drift rate, and beta for two Islamic banks from 2007 to 2013. 3.2. Commercial banks Table 3 shows the coefficient estimates. The statistical significant estimates demonstrate that the anticipated stock returns are high when asset volatility, beta, and asset drift rate are high. The findings show that the expected returns of commercial banks are high when past stock returns are high, which is also confirmed by the impulse response function. Indeed, the returns continue to decline for the period 2009 to 2013 due to decreases in beta, asset volatility, and asset drift rate. http://dx.doi.org/10.21511/bbs.16(2).2021.17
7. Banks and Bank Systems , Volume 16, Issue 2, 2021 Table 3. Probable asset returns of commercial banks Source: Banks’ annual reports. Author calculations. Years Expected Asset Return 2013 2012 2011 2010 2009 2008 2007 0.90% 0.90% 0.70% 0.70% 1.20% 2.00% 4.00% 2013 2012 2011 2010 2009 2008 2007 0.52% 0.46% 0.23% 0.26% 0.65% 1.69% 3.87% 2013 2012 2011 2010 2009 2008 2007 0.99% 0.66% 0.41% 0.53% 0.83% 1.85% 4.66% 2013 2012 2011 2010 2009 2008 2007 0.80% 1.00% 1.20% 0.80% 0.50% 1.30% 3.90% 2013 2012 2011 2010 2009 2008 2007 0.50% 0.70% -0.01% 0.05% 0.49% 1.31% 3.47% Commercial banks Bank of Palestine Assets volatility 3.20% 3.20% 5.00% 3.10% 7.30% 9.00% 12.40% Asset drift rate Beta 0.90% 0.90% 0.70% 0.70% 1.20% 2.00% 3.90% 8.90% 10.20% 8.80% 8.80% 14.20% 12.60% 12.00% 0.50% 0.50% 0.20% 0.30% 0.60% 1.70% 3.80% 1.30% 1.30% -1.50% -0.60% 2.10% 6.20% 9.70% 0.01 0.007 0.004 0.005 0.008 0.018 0.046 11% 5% 2% 5% 6% 9% 26% 0.80% 1.00% 1.20% 0.80% 0.50% 1.30% 3.80% 6.58% 11.42% 17.76% 9.91% -0.30% -1.81% 9.79% 0.50% 0.70% 0.00% 0.00% 0.50% 1.30% 3.40% 0.81% 5.59% -6.10% -4.87% -0.98% -1.44% 1.88% Quds bank 2% 1% 2% 4% 5% 7% 10% The National bank 3% 3% 3% 4% 5% 9% 9% Palestine Investment bank 4.18% 3.14% 5.22% 5.44% 5.01% 7.74% 10.25% Palestine Commercial bank 1.20% 2.50% 3.30% 4.10% 6.40% 7.50% 5.40% Note: Expected asset returns, asset volatility, asset drift rate, and beta for five commercial banks for 2007–2013. CONCLUSION This study aims to measure the anticipated asset returns, asset drift rate, asset volatility, and beta, and explore the aspects of each bank compared to its peers. The study findings demonstrate that there are differences among the selected banks by their type (Islamic and commercial). Empirically, the study demonstrated that all banks in Palestine appear to show signs of a low degree of credit risk. In contrast, commercial banks show a lower credit risk than Islamic banks. http://dx.doi.org/10.21511/bbs.16(2).2021.17 187
8. Banks and Bank Systems , Volume 16, Issue 2, 2021 The study recommends that financial institutions in Palestine work to improve their management skills and operational system to cope successfully with the current financial environment. However, the new developments in computing and mathematical finance and innovations in risk management techniques offer some technical and practical solutions. Banks also need to increase risk management research and training and place the right person in the right position. Banks are considered as a basic credit resource in local markets. This is because the capital market is limited and fragile. There is no opportunity to offer investors adequate funding sources. The results show that the public sector’s share of total credit by banks should reduce lending to the public sector or government sector, but this would increase banks’ exposure to high risk. AUTHOR CONTRIBUTIONS Formal analysis: Othman Sawafta. Investigation: Othman Sawafta. Writing – original draft: Othman Sawafta. Writing – reviewing & editing: Othman Sawafta. ACKNOWLEDGMENT The author is thankful to Palestine Technical University – Kadoorie for funding this research REFERENCES 1. 2. 3. 4. Abu-Rub, N., & Abbadi, S. M. (2012). Variables Used by the Palestinian Banks’ Managers to Measure Their Banks’ Performance. International Research Journal of Finance and Economics, 4(90), 124135. Retrieved from https://www. aaup.edu/publication/noor.aburob/ article/variables-used-palestinianbanks-managers-measure-theirbanks-performance-internationalresearch Altunbas, Y., Gambacorta, L., & Marques-Ibanez, D. (2009). Securitisation and the Bank Lending Channel. European Economic Review, 53(8), 996-1009. https://doi.org/10.1016/j.euroecorev.2009.03.004 Ariffin, N. M. (2012). Liquidity Risk Management And Financial Performance In Malaysia: Empirical Evidence From Islamic Banks. Aceh International Journal of Social Sciences, 1(2), 77-84. Retrieved from http://jurnal.unsyiah.ac.id/AIJSS/article/view/1530 Black, F., & Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of 188 Political Economy, 81(3), 637-654. Retrieved from https://www.jstor. org/stable/1831029 5. Boumediene, A. (2011). Is credit risk really higher in Islamic banks? The Journal of Credit Risk, 7(3), 97-129. https://doi.org/10.21314/ JCR.2011.128 6. Demirgüç-Kunt, A., Klapper, L.F., & Singer, D. (2013). Financial inclusion and legal discrimination against women: evidence from developing countries (Policy Research Working Paper No. WPS4616). The World Bank. Retrieved from http://hdl.handle. net/10986/15553 7. 8. Economic and Social Commission for West Asia (ESCWA) (1987). Palestinian Financial Sector Under the Israeli Occupation. Retrieved from https://digitallibrary.un.org/ record/141266 Froot, K., & O’Connell, P. G. J. (2003). The Risk Tolerance of International Investors (NBER Working Paper No. 10157). Cambridge, Massachusetts: National Bureau of Economic Research. Retrieved from https:// www.nber.org/papers/w10157 9. Gleason, J. T. (2000). Risk: The New Management Imperative in Finance. Bloomberg Press, Princeton, New Jersey. Retrieved from https://www. oreilly.com/library/view/risk-thenew/9781576600740/ 10. Greenwood, R., & Shleifer, A. (2014). Expectations of Returns and Expected Returns. The Review of Financial Studies, 27(3), 714746. https://doi.org/10.1093/rfs/ hht082 11. Gup, B. E., & Brooks, R. (1993). Interest Rate Risk Management: The Banker’s Guide to Using Futures, Options, Swaps and Other Derivative Instruments. Chicago, Illinois: Bankers Publishing Co. 12. Hawaldar, I. T., Lokesha, L., Kumar, A., Pinto, P., & Sison, S. M. (2017). Performance Analysis of Commercial Banks in the Kingdom of Bahrain (2001–2015). International Journal of Economics and Financial Issues, 7(3), 729-737. Retrieved from https://papers.ssrn. com/sol3/papers.cfm?abstract_ id=3504540 http://dx.doi.org/10.21511/bbs.16(2).2021.17
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