Market power, Stability, and Performance in Islamic Banks of Pakistan

RESEARCH PROPOSAL
Introduction
Islamic banking refers to the type of banking activity that is in accordance to the
principles laid down by Shariah. Another name used for such type of banking is
Shariah Compliant Finance. The practical application of these banking and financing
activities is done through the development of Islamic economics. Islamic banking is
different than the conventional bankings philosophies, practices and features. Five such
religious features can be obtained from the literature (Lewis and Algaoud, 2001). They
are:
1. Riba (usury) is prohibited in all its forms
2. Business should be undertaken only for halal (legal, permitted) activities
3. Maysir (gambling) is prohibited and all the transactions should be free from
gharar (speculation)
4. Zakat (charity) is to be paid by the banks to benefit the society
5. All activities of the bank must be in accordance with Islamic rules, principles, and
norms and a Shariah Supervisory Board must supervise and advise the bank on
its activities
The establishment of Islamic banking and the application of these rules and principles to
private and semi-private commercial institutions in Muslim countries can be traced back
to late 20
th
century. Although the efforts for the Islamization of banking sector in
Pakistan started a couple of decades ago, it was only in 2002 that the first full-fledge
Islamic bank, Meezan Bank Limited started its operations in Pakistan. Therefore, Islamic
banks are still quite new entrants in the banking industry of Pakistan.
This study will specifically deal with the market power, stability and performance of
Islamic banks in the recent unstable socio-political and a deteriorating economic
environment of Pakistan. Market power can be defined as the ability of a firm; in this
case a bank; to raise the prices of goods and services in excess of marginal cost and the
long-run average cost, thus, making economic profits. The firms having market power are
called price makers while those without it are called price takers. Another aspect of
the study is stability, which can be referred to as a state where the firms income
constantly grows and the firm does not go in to loss. Both of these factors, market power
and stability, will in turn be the indicators for the overall performance of the firm (bank,
in this study).
An essential feature of Islamic banking is that it is interest-free. But there is more to
Islamic banking than just being interest-free banking. It contributes towards a more
equitable distribution of wealth and income. The aim of this study is to judge the market
power, stability and performance of Islamic banks in Pakistan. There is little or no work
done earlier in this regard. Therefore, this study will contribute to the generation of
knowledge in this area as well as the results can be fruitful and used by the managers of
Islamic banks in particular and financial analysts in general.

Literature Review
Although it is hard to find any literature on market power of Islamic banks, a lot of
studies have been undertaken about the market power of banking industry. The Panzar-
Rosse H statistic has been used in various studies to evaluate bank competition in
different regions of the world. One such study was undertaken to analyze bank
completion in United States, Italy, Germany and France for a period of four years (1992-
1996). The results showed that large banks in these countries were in a state of
monopolistic competition while small banks were in a state of monopoly (De Bandt and
Davis, 2000).
Perera et al. (2006) examined the competition in South Asian banks over the period 1995-
2003. This study revealed that competition in the traditional interest-based product
market is greater in Bangladesh and Pakistan, while the fee-based product market in India
and Sri Lanka is more competitive.
Yet another study assessed the competition in banking industry in twenty-three countries.
The sample showed monopolistic competition (Bikker and Half, 2002). A handful of
studies have dealt with competition in Chinese banking sector. Yuan (2006) analyzed the
competitive condition of the Chinese banking industry over the period 1996-2000. The
results suggested that China's banking sector was already near a state of perfect
competition (that is, before foreign banks began to enter Chinas financial market).
A similar study to assess the competition in banking sector of Pakistan was conducted for
a sample of twenty-six banks from 1997 to 2007. Various tests on PR-H Statistics suggest
that banking sector of Pakistan, as a whole, is consistent with a monopolistically
competitive market structure (Khan, 2009).
The different competitive conditions found by these different studies are partly accounted
for by the fact that different researchers have used different reduced revenue equations to
measure competition. Further, the different results are closely linked with the banking
sector reforms over the specific period investigated and the banking regulations of a
particular country/ region.
Privatization of all national banks except one, capital strengthening, corporate
governance, liberalization of foreign exchange regime, consumer financing and the likes
are some of the banking reforms introduced by the State Bank of Pakistan which have
allowed the banks to operate in more freedom which have substantially led to the
increased competition among commercial banks of Pakistan. Legal difficulties and time
delays in recovery of defaulted loans have been removed through a new ordinance, The
Financial Institutions (Recovery of Finances) Ordinance, 200 1 (Husain. I, 2004).
Pakistan has allowed Islamic banking system to operate in parallel with the conventional
banking providing a choice to the consumers. Several full-fledged Islamic banks have
already opened the doors for business and many conventional banks have branches
exclusively dedicated to Islamic banking products and services. These factors have
further intensified the competition in banking industry of Pakistan (Husain. I, 2004).
Other empirical studies attempted to determine the determinants of market power in
banking industry. Fungacova et al. (2010) used Lerners Index to measure the market
power of Russian banks. The period of sample was 2001-2007. They arrived at the
conclusion that competition in banking industry has slightly improved over the period
under study. Furthermore, the findings suggested that bank size, risk and market
concentration are significantly related to the market power of Russian banks.
The market power of the Spanish banking industry over the period 1986-2002 was
investigated by Fernandez de Guevara and Maudos (2007). The results showed an
increase in market power from the mid-1990s. An empirical research attempted at
assessing the increase/decrease in market power of Chinese banks with the increase in
risk-taking behavior suggested that Chinese banks with higher volumes of non-traditional
activities have lower market power, while the technical efficiency improvement of
Chinese banks increases their market power (Tan and Floros, 2013).

Hypothesis/ Research Question
In this study, we will attempt to understand the joint effect of technical efficiency and
risk on the market power of Islamic banks of Pakistan. Our study will be mainly
concerned with the following hypotheses:
Do Islamic banks in Pakistan hold market power?
Will assuming more risk result in greater market power?
Methodology
Estimation of Banks Market Power
Modern industrial organizations suggests the following methods to measure the market
power:
1. The Lerners Index
2. The Breshnahan mark-up Test
3. The Panzar-Rosse H Statistic
We will also use the concentration ratio to measure the competition in Islamic banks of
Pakistan.
The Lerner index represents the extent to which a particular bank has market power to set
price above marginal cost (Tan and Floros, 2013). The Lerners Index is easy to calculate
for each bank and for each year based on annual bank-level variables. The price will be
computed as a ratio of total assets to total revenues. The total cost will be calculated on
the basis of total assets, prices of labor, capital and funds. Then this cost will be used to
determine the marginal cost (ratio of total cost to total assets). Once these computations
are done, it is easy to calculate Lerners index as:

This index will be a direct measure of the competition of bank.
I mpact of risk on market power of I slamic banks
In order to study the impact of risk on market power of Islamic banks, we will run a
regression for Lerners index (Y) as a dependent variable and risk (X1), industry (X2),
macro (X3) as independent variables.
R = + Risk + industry + macro +
Here, R is the Lerners index. Risk will be obtained by the ratio of total loss to total
deposits. Industry represents the industry-specific variable (concentration and stock
market capitalization, in this case) while macro represents the macro-economic variables
like inflation and GDP growth.
Data description
Data will be composed of annual data for at least 20 Islamic banks of Pakistan over a
period of 2006 to 2010.
Scope
This research will focus on assessing the market power of Islamic banks operating in
Pakistan. This study will try to measure the market power of Islamic banks that are facing
more risk as compared to the conventional banks. In past there has been very little
exploration of this aspect of banking industry of Pakistan. Even if some work is already
done, it is mainly about the banking sector in general. We have a parallel banking system
in Pakistan, therefore it is important to understand both types of banks separately.
Limitations
Currently there are five full-fledge Islamic banks in Pakistan with their branch network
expanded across the country. Some conventional banks also have Islamic Banking
Windows operating in some of their branches. Therefore, the only limitation of this
study will be the small number of Islamic banks currently operating in Pakistan.

Expected benefits
This study will add to the body of existing knowledge about market power of banks and
competition in banks.
The results of this study can be replicated in conventional banks in Pakistan and in
Islamic banks of other countries.
The results obtained from this research can be equally used by the bank managers of both
Islamic and conventional banks.
The results and conclusions can also be used by the financial analysts.

References
Algaoud L and Lewis M (2001) Islamic critique of conventional financing
Bikker J A and Haaf K (2002) Competition, concentration and their relationship: an
empirical analysis of the banking industry, Journal of Banking and Finance, 26,
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De Bandt O and Davis E P (2000) Competition, contestability and market structure in
European banking sectors on the eve of EMU, Journal of Banking and Finance, 24,
1045-2066
Fernandez de Guevara J, Maudos J and Perez F (2007) Integration and competition in
the European financial markets, Journal of International Money and Finance, 26, 26-35
Fungacova Z, Solanko L and Weill L (2010) Market Power in the Russian Banking
Industry, Universite de Strasbourg, Working Paper no. 09
Husain I (2004), Banking sector reforms in Pakistan, SBP Research Bulletin
Khan M (2009) An analysis of degree of competition in banking sector of Pakistan
through a direct measure of market contestability, SBP Research Bulletin, Vol. 5
Perera S, Skully M and Wichramanayake J (2006) Competition and structure of South
Asian banking: a revenue behavior approach, Applied Financial Economics, 16, 789-801
Tan Y and Floros C (2013), Market power, stability and performance in the Chinese
banking industry, Economic Issues, Vol. 18, Part 2, 2013
Yuan Y (2006) The state of competition of Chinese banking industry, Journal of Asian
Economics, 17, 519534.Economic Issues, Vol. 18, Part 2, 2013