Example Finance Essay: Stability of Islamic and Conventional Banks During the Financial Crisis

Example Finance Essay: Stability of Islamic and Conventional Banks During the Financial Crisis
The performance and the stability of banks can be quantified and measured through the analysis of their financial ratios. We can have several hundreds of ratios at our disposal. However, we will use only those that are common, and of some meaning for the analysis of the banks. Also, it is important to note that we should use only major and comparable ratios in order to fully understand the financial position of these banks as compared to all those ratios that may include some vagueness in the research.
Mainly five categories of these financial ratios are used to eliminate the vagueness created by redundant use of the financial heads and items from the financial statements. Hence, the five categories are: (CFA 2009, p498):

- Profitability Ratios
- Activity Ratios
- Liquidity Ratios
- Solvency Ratios
- Valuation Ratios

However, for the banking industry, which is our main concern, we will use only the first four categories, making an exception of the Valuation category. The financial stability department of the State Bank of Pakistan, which is the central bank of this major economy in the Muslim world, and actively involved in the promotion of Islamic Banking, suggests that the financial ratios fairly reflect the stability, health and the performance of the banks. Hence, these ratios can be used for our purpose.

2. Z-score

Instead of just doing the Financial Ratios Analysis, we should also do the analysis of the banks’ insolvency risk, which is measured by the z-score. This will be done for both the categories of banking systems: Islamic Banks; as well as the Commercial Banks. The statistic based on z-score is calculated with the help of the data on the bank’s expected profits, the riskiness or the variation in such profits and the capital base of the bank. In other words, the following variables help to calculate the z-score and test it, we need the profit margin, its likelihood of occurrence and the shareholders equity available to compensate in case of the negative margins (losses).

A z-score represents the number of standard deviations by which the return on asset have to decrease in order to incur a loss (a negative return). Z-scores can be measured by the following formula:

z = (ROA+CAP)/σ (ROA) where:
ROA (Return on Assets) = Net Income / Total Assets;
CAP (Capital to Asset Ratio) = Equity / Total Assets; and
σ (ROA) = standard deviation of return on assets (proxy for the variation of return).

According to the formula, the higher z-score means that the equity base and the return added on it is much higher than the potential risk to the earnings as measured by the standard deviations. Hence, such usage of the z-score testing as the test for measuring risk is recommended by many researches in the field. By the definition of the z-score here, we can say that it directly relates to the probability of a bank’s insolvency. It is necessary for us to evaluate and understand the extent to which Islamic banks are risky as compared to conventional banks. Z-scores will play an integral role in helping us identify the risk profile of Islamic banks.

3. Regression

One of the most extensively used statistical measure of conformity is the use of regression and correlation. The extent to which two different datasets match in terms of moving together is evaluated by a regression analysis. In this context, we will be looking closely at how the dataset we obtained for Islamic and conventional banks will be moving in tandem with the GDP and inflation (CPI) of their respective countries.

A pooled regression test will be used to perform the respective tests and statistics generated from the regression such as the R-squared value will be used to make judgments on the relationship between the profitability and growth of Islamic and conventional banks with respect to their national growth and inflation. This test is extremely as it is crucial to understand the synchronization of growth of these banks with their national economies. It would be difficult to make pre-assumptions about either Islamic or conventional banks however, it has generally been seen that while conventional banks were wiped of several billions of dollars, Islamic banks stood their ground and even grew in some countries. Thus, bearing this in mind, a pooled regression test will enable us to identify the polarity of growth of Islamic and conventional banks with their respective economies.

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