The German University in Cairo
Faculty of Management Technology

Research Methodology
“The Comparison between Islamic loans and Conventional loans in relation to Market Power”

Submitted By
Ahmed el-Farnawany 16-2641

Tutorial Number: T13

Professor: Raghda El-Ebrashi

Teaching Assistant: Hadeer Shawky
January, 6th, 2011
Table of contents

1. Introduction 1

2. Literature Review 2

2.1 Conventional loans 2 2.1.1 Interest and loan pricing 2

2.1.2 Types of conventional loans 3 2.1.2.1 General loan types 3 2.1.2.2 Business loans 4 2.1.2.3 Consumer loans 4

2.2 Islamic loans 5 2.2.1 Interest prohibition. 5 2.2.1.1 Riba (Usury) 5 2.2.1.2 Why is riba prohibited 6

2.2.2 Types of loans in Islamic banking 6 2.2.2.1 Qard al-hasan 7 2.2.2.2 Ijara 7 2.2.2.3 Murabaha 8 2.2.2.4 Musharaka 8

2.3 Effect of Islamic loans objective and economic incentives on its market power in relation to conventional loans 9 2.3.1 The effect of Islamic Loan Objective on its Market Power 9 2.3.2 The effect of Islamic Economic Incentives on its Market Power. 10

2.4 Research gap 11

3. Methodology 12

4. References 17

1. Introduction

Islamic economics and Islamic banks have grabbed the attention of millions of people around the world. That is because Islamic banks have assets that can be estimated as 300 billion USD around 75 countries in the world with 15 % annual growth rate (Weill 2010: 5). Islamic economics or banking systems are based on a set of morals and rules taken from the traditional Islamic sources. These rules are modified now to be able to act as a competitive substitute to conventional economics or commercial banking systems (Kutlughan 2010: 181,182).

This paper will examine the difference between Islamic loans and Conventional loans. The purpose of this paper is to measure the market power in regards to the effect of loans objective and the economic incentives for both Islamic and conventional loans to find out which has more market power in the current time and this is one of the most important key for economic development (Weil 2010:5.)

This paper is divided into five main sections. The first section is the and overview of the Conventional loans stressing on the interest rate, pricing the loan and the different types of Conventional loans. The second section is an overview of the Islamic loans stressing on the interest from the Islamic perspective and the different types of Islamic loans. The third section is the most important section as it observes whether Islamic or conventional loan has more market powet through observing the effect of loans Objective and the effect of economic incentives on the market power to find out which has more market power in this current time. The last two sections will describe the research design and the conclusion.

2. Literature Review

2.1 Conventional loans As Gardner et al. (2005:447) stated that as of August 2003 the commercial banks in the U.S had $4.448 trillion of loans with an increase greater than one trillion increase since 1998 Banks issued loans for customers to increase the fund consumption and to increase the rate of investment. This type of service needs internal and external monitoring all over the process, loans also are pretended as an incorporation process (Rose and Hudgins 2003:523)

2.1.1 Interest and loan pricing “Interest is the price of money or the opportunity cost of holding money in the narrow form” (Heffernan 2005:109). Rose and Hudgins (2003:199) defined interest as it is the credit price the lender takes as a compensation for lending money to a borrower, or it is the output of dividing the amount of money that will be paid for the credit over the actual amount of the credit obtained. Interest rate determination theories are divided into two major types the first type focuses on the equilibrium level of interest, The equilibrium level is the rest state where forces that can change the economy are absent, the second type is that which rely on several assumptions(Gardner et al. 2005:270). The interest rate is composed of risk free real interest rate which is the adjusted return on the government bonds added to risk premium which simply compensate lenders who accept loans (Rose and Hudgins 2003:201).

Loan pricing is most difficult task in lending process, due to the lender’s will to increase the interest rate to make the loan more profitable in the same time the lender must maintain the low interest rate to satisfy the costumer (Rose and Hudgins 2003:583). There are many methods for pricing the loan like the cost-plus loan pricing method where the interest is calculated through the sum of the marginal cost of raising the fund to lend to the costumer, operating costs, compensation amount for default risk and the desired profit margin this sum can easily calculate the interest rate throw the cost-plus method, another method that can calculate the interest rate avoiding the drawback in the cost-plus method is the price leadership method which is adding the cost-plus components to the default risk premium and the term risk premium paid by the long term borrowers which will give better value(Rose and Hudgins 2003:585). As stated by Heffernan (2005:156) under the title minimizing the credit risk the loan pricing is calculated through interest rate by adding the market interest rate to the risk premium and the fees. This calculations of interest shows that the interest and risk are positively related consequently risk takers will rush for high interest loans (Heffernan 2005:156). Banks are talking good care with the amount of loans given to costumers or businesses because the loan is a risky process that must be repaid to avoid any problems that can face either the bank or the costumer (Gardner et al. 2005:472).

2.1.2 Types of conventional loans Banks make a plenty of types of loans that can be used to operate a business to buy a car or an apartment or even for education loans will be helpful (Rose and Hudgins 2003:524).

2.1.2.1 General loan types According to the purpose of the borrower the loan type distinguished like the Real estate loans are specially made for the purpose of buying a piece of land or a house, but if the borrower’s purpose is an agriculture purpose so the agriculture loan will be good same if it is for an industry so industrial loan will be the best loan if the loan is for the personal usage or consumption it will be better to choose the individual loans lease financing loans if its for equipment or cars (Rose and Hudgins 2003:524,525).

2.1.2.2 Business loans Business loans are divided into two types the Shot-term loans and long-term loans short-term loans are like Self liquidating inventory loans specials for businesses willing to buy inventory or raw material that will be used for production another type of short-term business loans is the working capital loans is the loan that provide cash advance for companies that needs to cover season peaks for example to cover the increase of clothes demand in the back to school time, many other short term loans like asset based loans and syndicated loans (Rose and Hudgins 2003:556-559).as Gardner (2005:472) illustrated the working capital loans these loans are repaid after the selling of the inventory bought with the loan and collecting the accounts receivable with maximum one year.

Long term loans are loans like Term loans which is specialized for midsized businesses which is usually based on the project’s budget, this kind of loans is usually secured by a fixed valuable asset, another long-term loans is the project loans and it is considered the highest risk rate loans it is specialized by large funds and it’s high risk is due to the effect of any external values like weather, laws even interest rate can change through the project (Rose and Hudgins 2003:560-562). Term loans are used to buy assets that depreciation is applied on like machines that its maturity is between one and seven years(Gardner et al. 2005:473)

2.1.2.3 Consumer loans This loans is for individuals and families like mortgage loans which can be with fixed interest or with variable interest, another type is the installment loans which is short-term and its for the purpose of having furniture or to hold debt, opposite to installment is the noninstallment loan which is made for paying for vacations or medical care and its characterized by the small amount of money and its short time(Rose and Hudgins 2003:602,603)

2.2 Islamic loans

2.2.1 Interest prohibition. As Raquibuz and Movassaglii (2002:2429) stated that the Equality and Fair distribution in the economic transaction on al participants is the main objective of Islamic banking, that can be the main reason why Usury or “Riba” is prohibited in Islam because Usury causes the unfair distribution.

2.2.1.1 Riba (Usury) Usury has an old definition in The Oxford Shorter Dictionary on Historical Principles as the process of lending money in interest, while The Macquarie Dictionary stated that it is the excess amount of interest than the legal rate in the lending process (Mews and Abraham 2006:2), but the important question is Interest equals to riba and logically equal to usury? (Heffernan 2005:324)

The interest is not always like usury because simply usury is the excessive interest rate not the principle of interest (Lewison 1999:1), to test weather interest is excessive or not is arbitrary so the Islamic laws prohibited riba which is as well prohibited by Judaism and Christianity (Raquibuz and Movassaglii 2002:2429), another point is that there is no clear definition for riba in the holy Qur’an and for this reason it has many definitions by various Qur’an commentators consequently a classical commentator like Al-Tabari in his jami defined it with an example of a lending transaction for an amount of money and if the due date passed on the borrower that will lead to doubling the amount of the loan and this was known as “riba al-jahiliya” (Raquibuz and Movassaglii 2002:2429), that’s a risk that will make the transaction suffer from lack of “fair distribution”. That’s in the classical view of commentators

Islamic scholars defined riba as the fixed amount of money paid for a deposit or a cash advance (Weill 2010: 187). As well Wilson( 2008:183) confirmed that riba is referred to any excess to a principle sum; where both definitions can easily be applied on the current bank’s fixed interest loans, the point is gaining additional amount of money without any effort done by the lender where it can also be a risk for the borrower. Accordingly it will be comparable to “riba al-jahiliya” in principle. That can be a major reason of Islamic prohibition to interest in loans, because interest rate may lead to many problems and consequences.

2.2.1.2 Why is riba prohibited As stated by Weill (2010: 187,188) Islam prohibited interest due to eight applicable reasons that can suit the current era and logically all reasons are based on one main principle which is affecting the society, The first reason is that riba can affect small businesses by losing innovation, second reason is that riba can cause bankruptcy that can affect the society by decreasing the productive potential which leads to decrease in employment rates, third reason is that it can lead to decreasing the ability of recovery in a depressed economy which also will affect the society in addition to other reasons like decreasing the bank incentive to participate in a venture and that developing countries will be stuck in debts due to the very high interest rates stating also the mortgage risk that was the main suspect behind the last global financial crisis last reason was that business men can also be retarded in growth due to the high interest rates that will affect the society badly as well. That can all be deduced by Qur’an verses like "God has made buying and selling lawful, and riba unlawful , , , (2:274), which is clearly encouraging investment and society building. Prohibiting riba or interest is also found in many traditions and civilizations before Islam (Iqbal and Mirakhor 2007:53).

2.2.2 Types of loans in Islamic banking

Despite that not all conventional banking usurious Islamic banks or Islamic economics has found the best modern substitutes for Loans and many other banking that will not be based on interest but on profit/loss loans or transactions (Raquibuz and Movassaglii 2002:2429), there are many types of loans in Islamic banking the major types are Qard al-hasan, Ijara, Murabaha and Musharakah noting that all those term are written in the Arabic rhyme writing.

2.2.2.1 Qard al-hasan Qard al-hasan is the interest free loan that is given to a person who is in need for the money without asking him for any interest charge, the organizations who gives this kind of loans is only allowed to charge the borrower with a service charge than is not based on amount or period of the loan (Farooq 2008:4).

As Kutlughan (2010:190) described Qard al-hasan as the beautiful loan the author also stated that it was made to help people in need and to increase the investment and the employment rate which will accordingly help the growth of the society also the author defined this type of loans as an interest free loan that has no benefits to the lender and its acquired when the borrower is able to repay it as done by Islamic banks that helps education and medical care.

2.2.2.2 Ijara Ijara and it is equivalent to leasing in the conventional banks but it is also has two types the first one is called ijara. Ijara is when the lessor owns the equipment and lease them for a certain period of time then he will still own them (Raquibuz and Movassaglii 2002:2436). Wilson (2008:185) stated that the lessor leas the equipment and will still hold the responsibility of the asset insurance while the second party will pay for maintenance of the asset like equipment or building to be applied.

Ijara has another type which is called Ijara wa iqtina the last is when lessee pays for all the insulation costs he also can own the leased equipment at the end of the contract (Raquibuz and Movassaglii 2002:2436) while Nayeem et al. (2009:23) stated that it is a lease and Acquisition contract, where the lessee can buy the use of the product after for a certain period of time and as well he can buy the product at the end of the period. As Wilson (2008:185) clarified it as normal ijara but with hire purchase and owning the asset at the end of the period. Ijara also attracts investors who are able to invest and lease with the conventional leasing due to the big similarities between them (Iqbal and Mirakhor 2007:84)

Both types of leasing in Islamic banking or loan types are made for the sake of the society where another objective of Islamic financing is applied which is risk sharing in order to decrease the liability of all parties and to be fair because if it is not applied one party will bear all the liability of the risky decision he took(Wilson 2008:184), this takes the paper to the main objective of the Islamic banking or loans which is helping the growth of the society.

2.2.2.3 Murabaha Murabaha is the third type of Islamic loans or Islamic banking transactions that is based on free interest principle its application was explained by Raquibuz and Movassaglii (2002:2436) by stating that it occurs when the bank buys a product then amortizes it for the borrower with profit while Nayeem et al. (2009:23) stated that it is when the first party buys the product whatever it is with a price known and approved by both parties then he resell it to the second party with a higher price adding to that Wilson (2008:183) stated that the first party which can be the Islamic bank can buy the product in bulk and then resell it with a discount to the second party, this kind of transactions is made in order to prevent the interest to take place and it also can protect the second party from the market’s impersonal vagaries (Mews and Abraham 2006:11), but Raquibuz and Movassaglii (2002:2436) stated that according to the author where the example was stated in his research murabaha can be considered as usurious.

2.2.2.4 Musharaka Another major Islamic loan or bank transaction is Musharaka it is like the joint venture in conventional banks, as Kutlughan (2010:196) stated that it is the purest Islamic transaction where both parties share loss and profit as the regular joint venture in relation to their contributions while it was defined in the same way by (Wilson 2008:186). In addition to that the second party can buy the first party’s share in the product over time(Nayeem et al. 2009:23).

The objective of musharaka is to increase the capital gain between investors to make it easy for both parties to enhance their business, and it has some special rules like the agreement of the second party in case the first party wants to sell his stake (Wilson 2008:186). “However, unlike a loan arrangement the investors in musharaka do not earn interest”(Wilson 2008:187), they share the profit and loss together that means that losses have to be recognized in the same year it occurred

All those Islamic loans or bank transactions are based on one principle which is helping the society growth by encouraging investment and giving simple ways to help poor or ill economies to develop and to be more productive. That was the same principle that interest or riba was prohibited and as applied on current conventional banks ijara, mudaraba and musharaka will be the substitutes for many bank transactions while qard al hasan will be the only type that is made only for helping and not for any monetary interests(Weill 2010: 5)

2.3 Effect of Islamic loans objective and economic incentives on its market power in relation to conventional loans

Islamic and conventional loans has big differences between each other the first major difference is the objective of the loan it self and this objective can clearly affect the market power of both, another difference that can affect their market power is the economic incentives of Islamic and conventional banks (Weil 2010:11)

2.3.1 The effect of Islamic Loan Objective on its Market Power

Islamic loans and banking objectives are a bit different from the conventional objectives despite that profit is an objective in both types Islamic loans has another major objective which is building a perfect social order that clarifies that prohibiting interest is not an objective but it’s the tool to achieve the objective in addition to that mutual help and corporation between people in the society is also an objective for Islamic loans and banking systems(Hassan 2004: 17) also Islamic loans has an objective that is gain profit without harming or affecting others that means that reasonable prices must be provided by Islamic banks and that can affect the loans market power effectively by limiting the ability of increasing prices (Weil 2010:11) the same author also stated that Islamic loan rates can be similar to conventional loans, but as stated before Islamic loans are limited priced loans which will make conventional loans enjoy more market power.

2.3.2 The effect of Islamic Economic Incentives on its Market Power.

As the conventional loans aim only for profit and its own sake it gained more market power due to the increase of its values and rates it gained more market power, while Islamic banks may have bigger incentives based on Islamic rules and compensations that can let them avoid moral hazard behavior of borrowers, which will also lead to less rates than conventional banks (Weil 2010:11 ; Hassan 2004: 18). That was proven by Weil (2010:11) referring that lower rates will be easier in payment as a result of this it will decrease the moral hazard that can happen when the borrower involve in risky projects, that will provide the banks only by low risk takers so the only solution will be providing lower rates, as Islamic banks are based on profit and loss sharing system which will make it more risky which will lead to increase in the ability of moral hazard presence As a consequence, Islamic banks will offer lower rates which at the end will decrease their market power, additional reason for this decrease in market power is the strong market power gained from fixed payment system that makes the borrower feel safe during the loan period.

Due to economic incentives and loan objectives comparison its clear that conventional loans has more market power compared to Islamic loans but for people who tries to obey Islamic rules it will be their only choice to choose Islamic loans that’s why Muslim economists are working hard to enhance Islamic banking to suit and be a good competitor for conventional banks (Kutlughan 2010: 181,182 ; Weil 2010:9).
2.4 Research gap

During studying the Islamic banking and the conventional banking, one can illustrate easily the big differences between them in regard to loans or systems or even the objective. This is due to the key factor that made this difference very clear which is the interest where it is defined by various ways and the conflict will appear between scholars that may confirm the link between interest and riba or not even Islamic scholars can face opinion conflict in this situation.

Most of researchers concentrated on illustrating the difference between Islamic and Conventional loans in term of loan type or characteristics that can determine which has more market power. Yet, no research was studied people’s concerns and incentives toward Islamic loans or conventional loans from the middle eastern perspective.

Hence, the current study would aim at filling such gap by studying the concerns and the incentives of people toward having Islamic loans in Egypt as a middle eastern country. “What are the concerns and incentives hindering or motivating organizations or individuals to have an Islamic loan?”
3. Methodology

In order to measure the factors motivating or hindering the willingness of organizations and individuals toward having Islamic loans, a qualitative method will be used since the paper is aiming to interpret concerns and incentives of organizations and individuals toward Islamic loans which will need a small sample size where interviews will be the most suitable method as it will make the interviewer able to observe nonverbal and verbal behaviors of the interviewee and to help the interviewer to gain a deep insight about the interviewee and to make it easier to introduce the aim of the interview professionally as the interview will be for organizations and individuals (Cooper and Schindler 2008:162,165,170,171).

Islamic loan is a bank-lending transaction that is based on free interest principle (Raquibuz and Movassaglii 2002:2436). The interview that will be applied for the organizations and individuals in this research will be divided into four main parts the first part will include general questions about the organization or the individual, the second part will be for the types of the bank transactions that the organization or the individual get involved in, the third part will be for the types of loans the organization or the individual prefer and the final part will be about the concerns hindering or the incentives motivating the organization or the individuals toward having any kind of Islamic loans. This interview will be structured with open ended questions to be able to compare the responses of the interviewees and to maintain neutrality of the interviewer (Cooper and Schindler 2008:171). This interviews questions are developed this way because the concerns and incentives is the main reason affecting the market power of Islamic banks or Islamic loans (Weil 2010:14). Incentives like avoiding usury through obeying the religious laws and concerns like the low price of the borrowed loan can affect the market power of Islamic loans positively or negatively (Mews and Abraham 2006:10 ; Weil 2010:8).

The sample of the study will be divided into two Egyptian groups the first group consists of ten chief financial officers (CFOs) of different midsized or big organizations in Cairo and Alexandria where all big factories and organizations are and because midsized and big organizations usually depend on banks dealings to operate the business financially, the second group will be divided into two subgroups of five individuals each the first group will be five individuals who involve in bank transactions like taking loans or mortgages with commercial banks the second subgroup will be of five also who deal with Islamic banks for their bank transactions in Cairo and Alexandria. The sample will include men and women, yet it is expected than the number of males will be exceeding the females since the majority of financial issues are left to males in Egypt. The target group was chosen to have direct loan experience like taking or issuing loans which will benefit the study. The ages of the participants must be from ages of thirty five to fifty five years old as this age is simply for the decision makers in banks or organizations or even individuals.

Non Probability convenience sampling will be the sample technique for the first group to give the interviewer the flexibility to choose whom ever available to be able to test ideas about different concerns that organization or individuals have, for the second group of the sample will fall under non probability judgmental sampling to be able to choose specific customers of Islamic or conventional banks to help to get biased points of view(Cooper and Schindler 2008:379,397) .

A total six months to complete the whole cycle of taking appointments and collecting information and finalizing the findings, during the first month of the study, various appointments requests will be taken to meet the chief financial officers of different organizations to find who ever will be available for an interview during the second month, the third month will be for gathering simple information about random costumers of commercial and Islamic banks and to request appointment with five customers from each bank type to be able to meat them in the fourth month. During the interviews the interviewer will start by stating the objective of the research as well as the aim of the interview and how the interview will flow before recording, then the interviewer will start asking the interviewee and collect answers and responses each interview will take approximately one hour. The data will be analyzed During the fifth and the sixth month to be

Limitations: The findings of the study cannot be generalized to all the Egyptian society as the sample will only be from the organizations and the individuals who live in Cairo and Alexandria, in addition to the inability to generalize the results for any other Arab country because in other countries in the Arab world Islamic banking is a must and most of the bank transactions are based on the Islamic banking principle stated previously in the research, also the findings could be biased socially by desire because each sample group will answer biased answers in the interview i.e. each bank costumer will answer biased answers to his bank that he can find it difficult to change his bank.

The Interview form for CFOs and conventional banks customers :

Section 1 1- Can I have your full name and your age ? 2- How long have you been working as a CFO ? (Only for the CFO’s interviews) 3- What is your current job ? 4- How long have you been dealing with banks ?

Section 2 1- What is the name of the bank that you deal with ? 2- What are the kinds of transactions that you involve in with your bank ? 3- Is there any problems between you and your bank ?

Section 3 1- What are the kinds of loans that you prefer to take ? (ex: Shot-term loans, long-term loans or mortgages) 2- Are you involved right now in any kind of loans with your bank ? 3- What is the interest rate of this loan ? (only if the answer for question 2 is yes) 4- In general do you prefer loans with high or low interests ?

Section 4 1- What do you know about the Islamic banking in general ? 2- Have you ever been involved in any kind of Islamic loans ? 3- Are you willing to have an Islamic loan in the following 5 or 10 years ? 4- What are the concerns hindering or incentives motivating you toward having Islamic loans ?

The Interview form for Islamic banks customers :

Section 1 1- Can I have your full name and your age ? 2- What is your current job ? 3- How long have you been dealing with banks ?
Section 2 1- What is the name of the bank that you deal with ? 2- What are the kinds of transactions that you involve in with your bank ? 3- Is there any problems between you and your bank ?
Section 3 1- What are the kinds of loans that you prefer to take ? (ex: Shot-term loans, long-term loans or mortgages) 2- Are you involved right now in any kind of loans with your bank ?

Section 4 (Islamic banks customers) 1- How long have you been dealing with Islamic banks ? 2- Are you willing to change to a conventional bank in the following 10 years? 3- What are the incentives motivating you toward having an Islamic loan ? 4. References
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