An assessment of risk factors and their effects on the rationality of lending decision-making: a comparative study of conventional banking and Islamic banking systems

An assessment of risk factors and their effects on the rationality of lending decision-making: a comparative study of conventional banking and Islamic banking systems

The current turmoil in the financial markets raises important questions regarding the risk-taking behaviour of conventional banks and other financial institutions in Western countries. In this context, it is important to compare the risk taking behaviour of conventional banking to that of Islamic banking. Today, Islamic banking is increasingly being scrutinised and compared by investors, depositors and researchers around the world (Muslim and non-Muslim). Because of the differences in the nature of transaction instruments, goals and the obligations between conventional banking and Islamic banking institutions, it is important to differentiate which banking system is more efficient in terms of risk assessment and decision-making on lending. This study aims to identify the similarities and differences between Islamic banking (IB) and conventional banking (CB) systems on issues related to risk taking behaviour and the rationality of lending decision making. Hence, the research question is: How do banking institutions determine and assess risk factors and how do those factors influence the rationality of lending decision policies in conventional and Islamic banking systems?

The main objectives of this study are to investigate the differences between IB and CB in terms of (1) risk-taking behaviour (risk assessment), (2) making rational lending decisions and (3) lending policy effectiveness (banking efficiency). To achieve these objectives, two focus groups––Islamic and conventional banks––in five different countries in the Middle East region (Bahrain, Qatar, United Arab Emirates, Jordan and Libya) were selected to participate in this study. The study was based on a sample consisting of observations from annual reports and financial statements of 48 Islamic and conventional banks (24 banks each) for the period from 2002 to 2006. The study also utilised a questionnaire survey to collect data from five managers in each bank. Thus, primary and secondary data collection methods were used to obtain the required information for the analysis.

Multivariate and principal component analyses were conducted to evaluate how conventional banking and Islamic banking systems determine and assess risk factors. Furthermore, how those factors influence the rationality of lending decisions was investigated. The results revealed that each of these banking systems performed this function in different ways. The study also contrasts the lending policies and instruments under each system. Results show that risk factors influencing lending decision making are dissimilar between these banking systems. These differences in risk-taking behaviour may contribute banks‘ efficiency. To investigate this point, the Data Envelopment Analysis (DEA) technique was applied to banking groups separately in order to isolate technical efficiency scores (large, medium and small banks‘ categories). The analysis revealed that Islamic banks—with medium and small bank size—operate and allocate their resources with a higher degree of efficiency than all other banking groups. This finding raises some very interesting evidence that may surprise the stakeholders of conventional banks.