risk management practices_pakistan

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American Journal of Scientific Research

ISSN 2301-2005 Issue 68 (2012), pp. 114-122 EuroJournals Publishing, Inc. 2012

http://www.eurojournals.com/ajsr.htm

Risk Management Practices: A Comparison of

Conventional and Islamic Banks in Pakistan

Mian Sajid NazirDepartment of Management Sciences, COMSATS Institute of IT, Lahore, Pakistan

E-mail: [email protected]: +92-322-4569868

Adeel Daniel

Department of Commerce, University of the Punjab Gujranwala Campus

Gujranwala, Pakistan

E-mail: [email protected]

Tel: +92-314-7852998

Muhammad Musarrat Nawaz

Hailey College of Commerce, University of the Punjab, Lahore, Pakistan

E-mail: [email protected]

Tel: +92-321-4217616

Abstract

The purpose of the research paper is to examine and compare the risk management

practices of Conventional and Islamic banks in Pakistan. A modified questionnaire on six

aspects understanding risk and risk management, risk identification, risk assessment andanalysis, risk monitoring, risk management practices and credit risk analysis, has been used

containing 45 questions of likert scale. A total of 300 questionnaires have been distributed

to collect the data on Islamic and conventional banks of Pakistan. Regression and one-wayANOVA has been used to estimate the results. The result found that Pakistani banks are

efficient in credit risk analysis, risk monitoring and understanding the risk in the most

significant variables of risk management. Moreover there is significant difference in risk

management practices of the Islamic and conventional banks of Pakistan.

Keywords: Risk management Practices, Conventional Banks, Understanding risk and riskmanagement, risk identification, risk assessment and analysis, risk monitoring,

credit risk analysis

1. IntroductionIn this modern world of the dynamic environment where life is full of zeal and risk with multiple

shades and the dimensions of the world are changing day by day. Presently the people merely not onlyinterested to take the risk but want to catch the optimum utility from rejecting the opportunity cost and

being more critical than the ancestors. In this regards, management of risk prevalent in investment

options is becoming an emerging issue not only for the academicians but also for practitioners. Onlythe risk has a long life in the business definition would be uncompleted without the inclusion of the


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Risk Management Practices: A Comparison of Conventional and Islamic Banks in Pakistan 115

risk. Efficient risk management practices are the need of the time nowadays because by using the tool

of the risk management techniques organization not only increase the return but competiveness of the

organization will also increase in todays world and less efficient risk management practices couldmake the situation of the organization more worse. As the globalization increase the exposure of the

risk is dire to increase on the organizations.

There are two types of the risk existing in the market, the systematic risk and unsystematic risk.

Systematic risk refers to the risk that is positive correlated with market and the can be minimize by

using different risk management practice. On the other hand the unsystematic risk is associated withthe value of the asset. Unsystematic risk cannot explain by general market moments and can be

avoidable through diversification. Oldfield and Santomero (1997) describe the three standards of riskmitigation strategies Eliminate or avoid risk be simple business practices, Transfer risk to other

participant and Acceptance of the risk.

Today all financial institution of the world claimed that its a business of risk and the bankbecome competitive by implementing the efficient risk management techniques. Carey (2001) study

opened new avenue of risk management by claiming the financial risk management is compulsory for

the financial institution. The main purpose of the financial institution is to increase the returns bymeeting the expenses of the financial institution and maximize the wealth of the shareholders. In order

to increase the wealth of the shareholder the financial institutions offer the variety of the financial

services that are full of risk (Hakim & Neaime, 2005). Importance of risk management increased overthe time especially after the global meltdown; liquidity crises emerged after subprime mortgage and theintroduction of the BASEL II (Al-Tamimi, 2008). The author further claimed in his study the efficient

risk management is not a costly process but the financial institution will suffer adverse effect like

failure of the banking system if not implemented at the right time.Pakistan Financial institution avoids specific type of activities, which may incur heavy losses of

risk. Pakistan bank follows the Basel II Standard of the capital adequacy ratio. This standard expresses

the limit of the capital must hold with the bank as the minimum capital requirement. The BASEL IIuses as a catalyst in the loaning decision and make the essence clear to efficiently manage the risk and

make the financial institution more competitive. A paper of consultative were issued by the Basel

Committee on banking supervision (BASEL) in 1999, claimed that most of the loan are more risky in

the nature of credit (Calem & Rob, 1999). Pakistan has faced the large number of risk such as thecredit risk, liquidity risk, foreign exchange risk, market risk, interest rate risk and many more because

of the shaky environment of the Pakistan (Shafiq & Nasr, 2010).The major loans of the bank have

more credit risk exposure of the bank. The snapshot of the credit risk is not only the loan, but the otherof the financial institution have face the credit risk in Pakistani banks such as interbank transactions,

trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, the

extension of commitments and guarantees, and the settlement of transactions.The growing market demand and attention given to the Islamic and commercial banking and

finance industry has escalated the research interest in this area as well. Due to the relatively recent

nature of the Islamic banking industry compared to its conventional counterpart, many aspects of the

industry are not well investigated. Keeping in view the discussion the present study addresses the

following research objectives1. To examine the degree to which the Pakistani Banks use risk management practices and

techniques dealing with different types of risks.2.

To compare risk management practices between Public and Private Bank, Local and Foreign

Bank, and Islamic and Conventional Bank.

3. Based on study findings proper suggestions and recommendations to improve the weakerfinancial banking sector in Pakistan.


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116 Mian Sajid Nazir, Adeel Daniel and Muhammad Musarrat Nawaz

2. Literature ReviewIn the earlier of the twenty first century the Islamic bank with respect to risk management was

investigated by the Khan and Ahmed (2001). The sample size was seventeen Islamic banks across theten different countries. The primary source of the date is questionnaire has been collected at different

field level. The major finding of the study was the murabha contract which is really uncertain and

cannot be hedged by using the tools which will more likely to increase the sensitivity of the risk. Thehigh perception of risks may be an indication of the low degree of active risk management due to the

absent of risk control through internal processes and control, especially in the case of operationalrisk(Iqbal, 2007) . Also, Ariffin et al (2007) indicates that credit risk in Islamic banks perceived to bethe most important risk.

Another study was conducted in Tanzania by Richard et al (2008) for understanding the credit

risk management system for the commercial banks for the economy of less developed countries. The

main finding of the paper was the component of credit risk management differs in commercial banksoperating in a less developed economy than the developed economy. This implies that the environment

within which the bank operates is an important consideration for a credit risk management system to be

successful.Moreover, Koziol and Lawrenz (2009) about the bankruptcy and the failure of the risk. They

claimed that regulation of the banking stuff matters a lot for meeting the efficient criteria of Risk

management. The essence of the study was Uncover situation when the Credit manager will takefinancing decision. Because the major source of the earning for the bank is to lend the money(Koziol &

Lawrenz, 2009). They introduce the continuous- time model where banks chose the deposit volume in

order to trade off the benefits of earning deposit premiums against the costs that would occur at futurecapital structure adjustments. Major findings suggested that the dynamic endogenous financing

decision introduced an important self-regulation mechanism.

The study of the Hassan (2009) shows the level of the risk management adopted by the Islamic

banking in the in Brunei Darussalam. The variety of the products is differing from the conventionalbank the Islamic bank so the exposure of the risk varies from conventional product and the Islamic

product. Management of the Islamic banking are very much efficient of practicing the risk management

technique. The major dilemma regarding risk is Foreign Exchange risk, Credit Risk and operational

risk. Risk identification and risk Assessment and analysis were the most impelling variables of thetodays Islamic system in Brunei. A Regression model has been developed to show the result that these

variables need to attention and to tackle the alarming situation in the Islamic banking sector. Standardof Basel II Accord are not truly implemented by the Islamic banking of the Brunei Darussalam

Banking Sector, resultantly shakes of the efficient risk management practices.

The next study is from Pakistan by Shafiq and Nasr (2010) to explore the current risk

management practices that are adopted by the Pakistani commercial banks. The study of data wascollected from both of sources primary and secondary. The deduction of the study was the significant

difference between the public sector and private banks. It further suggested that financial soundness

indicator differ in value for each type of commercial bank. It is no doubt that there is goodunderstanding of risk management among the employee of banks, but there is a gap of training courses

which needs to be tackle for risk management.Khalid and Amjad (2012) conducted a research on the risk management in Islamic banking in

Pakistan. The author use the same model suggested by Al-Tamimi and Al-Mazrooei (2007) of risk

management practices. The data was collected from the primary sources with the questionnaire

distributed in Islamic banks of Pakistan of 135 inclusive with very high response rate. The regressionhas been run to evaluate the result and finding suggests that Islamic banking system in Pakistan have a

positive and significant effect on risk management practices. The most influencing and significant

variable of the study was credit risk analysis, risk monitoring and understanding risk and risk

management.


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Hussain and Al-Ajmi (2012) conducted a comparative analysis on risk management practices

between the Islamic and conventional banking system in Bahrain. The data has been collected from the

questionnaire to generalize the finding of comparative analysis. The new modified dummy variablebank type has been used to make the optimum comparison. The finding of the study was to

Understanding risk and risk management, risk identification, risk monitoring, risk assessment and

analysis and credit risk analysis have a positive and significant effect on risk management practices in

Islamic and conventional banking of Bahrain. The comparative analysis of the study was that there is

only the understanding risk and risk management got the significant difference between the Islamic andconventional banking of Bahrain. The other entire variables were not significantly different in Bahrain

Islamic and conventional banking system.The above literature of all the past studies figured out the risk management practices adopted

by the financial institutions from all over the world in different types of banks. There are different

types of risk faced by different types of the bank. The Present study is conducted to explore the riskmanagement practices in Pakistan adopted by the Islamic and Conventional banks and try to figure out

the difference of adoption six aspects such as understanding risk and risk management, risk

identification, risk assessment and analysis, risk monitoring, risk management practices and credit riskanalysis.

3. Research MethodData has been collected from the banking sector of Pakistan. Target population of the study is Islamic

and conventional banks of Pakistan. Only the Scheduled Bank is consider for generalizing the facts of

the study with respect to the risk management. The next step is to choose the sample from the targeted

population. Data has been collected from the major cities of Pakistan where Islamic banking andConventional banks are well flourished. A total of 300 questionnaires have been distributed among all

the cities of Pakistan out of 20 questionnaires were return with blank responses and 30 questionnaires

were excluded because the respondents showed lack of interest to fill. All the 250 questionnaire areduly filled with 85% response rate to conducive for generalizing the findings. The questionnaires are

duly filled from the credit manager of the banks directly. However some of the questionnaires send to

the branch manager and the head offices and requested to give it to the concerned designated persons.The questionnaire are duly distributed to the person involve directly with the risk management

practices in banking industry.

The questionnaire used in the study was the same questionnaire that has been used in the study

conducted in UAE banking sector by Al-Tamimi and Al-Mazrooei in (2007). These questions areasked from the respondent to check the degree of the risk management implementation in Islamic and

conventional banking system. The authors developed a modified questionnaire having six aspects such

as understanding risk and risk management, risk identification, risk assessment and analysis, riskmonitoring, risk management practices; and credit risk analysis.

In order to answer the research objectives the following hypothesis are formulated. To evaluate

study purpose and the questions mentioned above, following hypotheses are formulated:

H1: There is a positive relationship between risk management practices and risk assessmentand analysis, understanding risk, credit risk analysis, risk identification, risk monitoring

and credit risk analysis.

H2: There is a difference between Islamic and conventional banks in practice of risk

management practice

H3: There is a difference between Islamic and conventional banks in the understanding of risk

and risk management.

H4: There is a difference between Islamic and conventional banks in the Practice of risk

identification.

H5: There is a difference between Islamic and conventional banks in practice of risk

assessment and analysis


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H6: There is a difference between Islamic and conventional banks in practicing of risk

monitoring and control

H7: There is a difference between Islamic and conventional banks in practice of credit risk

analysis

Following variables from the old study is extracted to generalize the finding of the Risk

management practices of the different types of risk faced by Pakistan Islamic and Conventional banks.

It is the same model used by Al-Tamimi and Al-Mazrooei(2007) in his study comparison of Risk

management practices of UAE National and Foreign bankRMP = f (URM, RI, RAA, RM, CRA)

Where:

RMP = risk management practices;

URM = understanding risk and risk management;

RI = risk identification;

RAA = risk assessment and analysis;

RM = risk monitoring; and

CRA = credit risk analysis.

4. Results and DiscussionReliability Analysis

It was mentioned in the in methodology that there is 45 questions has been asked from the responded

on 5 likert scale. There are six different variables has been used in the study to generalize the finding.

Reliability analysis has been conducted to assess the chances of random error entered. Analysis willpurely support the study how much variation in scores of six different variables. Cronbach,s alpha has

been used for the reliability analysis and suggests that the value of coefficient greater than 0.7 would

be reliable data and can be used for further statistical analysis. The overall Cronbachs alpha of 6

variables is 0.915and considered a very strong indication for the reliability of data.

Table 4.1: Cronbachs alpha

Questions Cronbachs alpha No. of Questions

Understanding risk and risk management 0.695 8

Risk identification 0.567 6

Risk assessment and analysis 0.738 8

Risk monitoring 0.744 6

Risk management practices 0.778 10

Credit risk analysis 0.636 7

Descriptive Analysis

Descriptive analysis will provide the summary of all the six variables with respect to the respondent

such as mean, median, standard deviation and sum of the scores. The table 4.2 clearly suggests themean and median responses on the eight-research question under the variable of Understand risk andrisk management. The responses of eight questions indicate the Pakistani banking sector understand the

risk and risk management. The median 4 clearly suggest that different banks of Pakistan are ensuring

that banks are much better in understanding risk. Most of the respondents are agree that staff ofPakistani banking sector is understand the risk in their organization. The Banking industry of the

Pakistan will give the indication that risk management practices are efficiently managed in Pakistan.

All the respondent are strongly agree that success of the bank is solely depend upon the understandingof the staff towards risk. Among all most of the respondent believe that understanding and managing

the risk is most important for the banks to increase the success by hitting maximum.


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Risk Identification is important predicator of risk management. Risk identification comprises of

six research questions on 5 point likert scale (1 SDA, 2 DA, 3 N, 4 A, 5 SA). Table 4.2 shows the

mean, median, standard deviation and sum of the responses taken from the banking sector. Thedescriptive analysis clearly defines that the Pakistani Banking sector are well aware of identify the risk

with the given objectives and aims of the bank. The mean of 3.73 suggest that the Pakistani banking

sector has aware about the potential risk which is affected the banks. Most of the responses are refer to

the acceptance that the risk. Some of the respondent believe the bank of Pakistan dont have any

confusion to prioritize the bank which give the identification that Pakistani bank are efficient inidentification the risk.

Eight Research Questions has been asked from the respondent under the aspect of RiskAssessment and analysis. The table shows the mean, median and standard deviation of respondent on

risk assessment and analysis. The combined mean of all the 8 questions is 3.81 which refer of the level

of agree towards risk assessment and analysis. It is suggest that most of the banks are adopted theQuantitative techniques for accessing the potential risk face by the banking industry of Pakistan.

Table 4.2 illustrate that risk monitoring is the integral part of management reporting. The

efficient risk monitoring is very much conducive to detect the mistake at the early stage.Questionnaires include the 6 questions with explaining the variable on risk monitoring. The mean of

3.93 clearly suggest the effective monitoring of the risk practices will lead to the highest performance

of the Pakistani banks. Mostly the Pakistani banks are literate with respect to monitoring the riskcreated and implementation of the risk techniques. The median of 4 tells us that risk monitoring isimportant tool, which should be practice by the banks in Pakistan.

The integral part of risk management is refers to the practice, which is adopted by the bank. It is

not the case at all that most of the banks may sophisticate method of understanding the risk, clearlyidentify the risk, proper procedure of assessment and analysis are still not clear that banks are efficient

in risk management practices. Ten research questions have been asked from the respondent on the

aspect of risk management. In table 4.2 combined mean of all the ten research questions is 3.93 and itseems that Pakistan financial institution is very much conducive for risk management practices.

Seven research questions have been asked from the respondent to align the risk management

practices with Credit risk analysis. The highest mean of 3.98 show in table 4.2 of among all the six

aspect is credit risk analysis which suggest that the Pakistani banks are very much sharp beforesanctioning the loan either it is Conventional or private. The CIB report contains all the details has

been prepared in the system of central bank in Pakistan for calculating the debt burden.

Table 4.2: Descriptive Statistics

Variables Mean Median Standard Deviation Sum

Understanding risk and risk management 3.98 4.0 0.50 1000.93

Risk identification 3.73 3.83 0.50 936

Risk assessment and analysis 3.81 3.87 0.50 958.5

Risk monitoring 3.95 4.0 0.53 991.5

Risk management practices 3.91 4.0 0.53 983.38

Credit risk analysis 3.98 4.0 0.58 1000.43

Hypothesis 1: There is a positive relationship between risk management practices and riskassessment and analysis, understanding risk, credit risk analysis, risk identification, risk monitoring

and credit risk analysis the OLS technique has been run to test the hypothesis. The first assumption to

run the OLS model is to find multicollinerity between the explanatory variables. The explanatoryvariables more than .70 correlated each other suggest that the model is not god fitted because of

positively correlated with each other. Present study uses the Pearson correlation instead of spearman

because our level of data is interval. Table 4.3 suggests that there is no potential multicollineritybetween the explanatory variables that could affect the results. It is because the value of correlation is

less than 0.70.


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Table 4.3.1: Pearson Correlation

Name of Variables URM RI RAA RM RMP CRA

URM 1

RI .536 1

RAA .487 .562 1

RM .540 .478 .622 1

RMP .509 .444 .547 .622 1

CRA .413 .339 .493 .487 .582 1

The next step is to evaluate the regression result and the value of R Square in table 4.4 which is.522 supports the study of all the explanatory variables such as understanding risk and riskmanagement, risk identification, risk assessment analysis, risk monitoring and credit risk analysis

explains 52% variation in risk management practices. Global testing of hypothesis 1 that there is

positive relationship of RMP with URM, RI, RAA, RM and CRA confirm it with high significance.The test statistic of global testing is F statistic with 5% level of significance in Table of 4.3.2 shows the

computed value from the F Test is 53.449 higher than the critical value and concluded that there is

significant and liner relationship between the Risk management practices with all the explanatory

variables.The next step of the multiple regression analysis is to check significance of all the 5

explanatory variables such as URM, RI, RAA, RM, CRA with the Risk management practices (RMP)

individually. The test statistics has been for individual testing is T. The Coefficients of all the 5explanatory variables in the table 4.3.2 credit risk analysis, risk monitoring and understanding risk and

risk management are the most significant effect with risk management practices in Islamic and

conventional banks.

Table 4.3.2: Regression coefficient Result

VariablesUnstandardized Coefficients Standardized Coefficients

t-value Sig. Std. Error

(Constant) 0.337 0.230 1.4565 0.144

URM 0.141 0.061 0.132 2.298 0.022

RI 0.068 0.061 0.064 1.107 0.270

RAA 0.113 0.067 0.104 1.684 0.093

RM 0.309 0.062 0.306 4.970 0.000

CRA 0.280 0.049 0.304 5.713 0.000

F-Value= 53.449, R2

= 0.522, R2-Adjusted= 0.512

In table 4.4 confirms second hypothesis that There is a difference between Islamic and

conventional banks in the understanding of risk and risk management. The results of p value in table

4.4 shows that p-value is 0.335 and indicate that there is no difference in understanding risk and risk

management between the Islamic and Conventional banks. The study is conducted to check anydifference on the basis on Conventional type and Islamic type in the perspective of understanding risk

and risk management. Based on the findings study do not reject null hypothesis and concluded that

there is no difference in understanding risk and risk management. Staff of both Islamic andconventional banks is well equipped with the understanding of risk in Pakistan.

The findings enclosed in table 4.4 shows p value to take the decision for third hypothesis

There is a difference between Islamic and conventional banks in the Practice of risk identification. Itis a technique followed by both of the bank i.e. Islamic and Conventional banks. Based upon thefinding in table 4.4, p value is 0.502 and concluded that risk identification is not different in Islamic

and conventional bank. The fourth hypothesis of the study is There is a difference between Islamic

and conventional banks in practice of risk assessment and analysis.Once the risk is identified the nextstep is to assess the desired and risk and make the analysis of the risk. On the basis of the finding the p

value is 0.202 in the table 4.4 suggests that the assessment method and analysis method are same on


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both types of bank operating in Pakistan. The procedure of assessment is the same in both of the banks

such as Islamic and conventional banks.

Fifth hypothesis of study is There is a difference between Islamic and conventional banks inpracticing of risk monitoring and control. The method of risk monitoring is purely followed by the

risk management practices. Its a review system and access that the risk management techniques are

efficiently worked. The statistical analysis shows the p value 0.041 in table 4.4 suggest that there is

significant difference between the method of risk monitoring followed by the Islamic and the

Conventional banks of Pakistan. The method of risk monitoring is quite different from each other but itis proved from the study that there is difference between the Islamic and Conventional Bank of

Pakistan.The sixth hypothesis of the study is There is a difference between Islamic and conventional

banks in practice of risk management practice.One of the key aspects of the variables and it contains

10 questions on the risk management practices. The finding of the Study strongly in the favour thatthere is no difference in risk management practices in Pakistan between the Islamic and Conventional

banks of Pakistan. The findings of the p-value 0.112 shows the Risk management practice have a very

small difference but it is negligible and concluded that there is not much difference between practicingthe risk management between the Islamic and Conventional Banks in Pakistan.

The last hypothesis of the study is There is a difference between Islamic and conventional

banks in practice of credit risk analysis. Pakistani Banking system is full of credit risk and the methodused in analysis is credit scoring in Pakistan. The findings p-value in table 4.4 is 0.224 shows thatcredit risk analysis with respect to difference between Islamic and Conventional banks do not reject the

null hypothesis and concluded that there is no difference in doing the credit risk analysis and give the

identification that both the banks are using the same method for analysis.

5. ConclusionThe major results from the finding that most significant variables credit risk analysis, risk monitoring

and understanding risk management in the perspective of risk management practices in Islamic and

conventional banks operating in Pakistan. The second dimension of the study is to identify the

difference in Islamic and conventional banks with respect to six aspects understanding risk and riskmanagement, risk identification, risk assessment and analysis, risk monitoring risk management

practices and credit risk analysis and it is concluded in the study that there is only the method of riskmonitoring is different in conventional and Islamic banks operating in Pakistan.

It is suggested from the study that Islamic and conventional banks should be different in risk

credit risk analysis. But due to little innovation in credit risk assessment in Islamic banks the most of

Islamic banks has adopted the same procedure that is adopted by the Islamic banks. The newtechniques of assessing the credit risk analysis should be introduced in Islamic banks that must be

different from the conventional banks. The study covers the most important aspect of the risk

management but unfortunately did not address the credit risk management, Basel Accord and thedegree of efficiency of the banks. The study can also be done in the most of the developing countries of

Asia to find some interesting result because risk management practices are mainly depend upon factoreconomic conditions, competition and regulations.

Table 4.4: One Way ANOVA of Islamic and conventional bank

Variables Sum of Squares DF Mean Square F p- value

URM Between Groups 0.239 1 0.239 .933 0.335

Within Groups 63.782 249 0.256

Total 64.021 250

RI Between Groups 0.117 1 0.117 .452 0.502


Total 64.598 250


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Table 4.4: One Way ANOVA of Islamic and conventional bank - continued

RAA Between Groups 0.425 1 0.425 1.639 0.202


Total 65.002 250

RM Between Groups 0.935 1 0.935 3.591 0.041


Total 71.572 250

RMP Between Groups 0.736 1 0.736 2.546 0.112Within Groups 71.995 249 0.289

Total 72.731 250

CRA Between Groups 0.508 1 0.508 1.484 0.224


Total 85.831 250

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