The initial analysis of the report would focus on the qualitative aspects of the product life cycle. It would provide the definition of product life cycle. It will also provide the overview of the different stages of the product life cycle. This would also cover the Islamic mortgage lending and conventional mortgage lending, giving their description and the difference between the two. Then we will analyze as to which type of mortgage lending is better from the point of view of the customer as well as the lender. Thereafter the major risks involved in the mortgage lending business and the risk management techniques that can be used to manage those risks are covered.
Thereafter, we will analyse the current mortgage product of Bank Muscat with the help of a real life case study. We will carry out an analysis on the volumes of the loans disbursed for past 6 years. Based on these analyses and comparison of financial statements, we will give our findings and recommendation for resolving the issues highlighted in the report.
The objective of this business report is to focus upon evaluating the current portfolio of Baituna home loans product of Bank Muscat and its volumes, focus upon the current standing of the product in Oman and its performance on the basis of its volumes. The report will also evaluate the Islamic and Conventional mortgage lending market covering the differences between the two markets, their impact on profitability of the banks and the analysis as to which type of market is better. The risks faced by the bank in the mortgage lending business will also be identified along-with the risk management techniques that can be used to mitigate/ manage those risks.
This report will help Bank Muscat in identifying the areas which require their attention for growing their mortgage lending business and making a larger part of its overall business. The volumes of the Baituna loans will be analysed and trend analysis of the volumes will be carried out to check the flow of loans over the years to determine its market share. Report will also include recommendations regarding the steps to be taken to revamp the product and to make it more competitive in the market.
This report will ensure that Bank Muscat is aware of the changes going on in the Islamic mortgage lending market. This report will also help Bank Muscat to keep a tap on its competitor's new strategies and the advancements they are making. It will also help Bank Muscat to ensure that their current strategies are in line with the business environment and if not, what changes can be brought it in order to keep it at par with the other competitors within the industry.
The final outcome of the project will assist Bank Muscat not only in maintaining their strong position within the industry, but will also help them in forecasting the changes in advance and develop their business plans accordingly.
Chapter 2: Background and brief history
2.1 Sultanate of Oman - An overview
Sultanate of Oman is middle income economy with decent oil and gas resources where the oil and gas products contribute around 64% of the total exports, 45% of the total government revenue and around 50% of the GDP. Sultanate of Oman has substantial budget and trade surplus. From 2003 to 2008 the economy witnessed its best growth on the back of high and rising oil prices and global prosperity during which period, it was able to build its budget surplus, trade surplus and foreign exchange reserves. Due to the global financial crisis in late 2008 and 2009 and the fall in the oil prices, the budget surplus of the country was significantly reduced. However, Oman was able to increase its production of Oil and Gas significantly in 2009 and gave the country more time to diversify across other products. Oman's economy is expected to at about 4% - 5% in the coming years in expectation of the global financial recovery.
During 2002 to 2008, Oman's economy grew two and half times of the level in 2002. The Nominal GDP growth in 2008 itself was 44% to USD 60 billion as compared to USD 41.6 billion in 2007. However, due to the global financial crisis, Nominal GDP shrank to USD 53.4 billion (fell by 10.9%). The estimated figure for the growth in 2010 and 2011 were encouraging as the economy was expected to grow to USD 67.8 billion in 2011.
(Zughaibi & Kabbani, 2012)
2.2 Bank Muscat
Bank Muscat (Bank) is one of the largest financial services providers in the sultanate of Oman. The reach of the Bank extends to various spheres of banking businesses like retail banking, investment banking, corporate banking, personal banking, treasury functions and asset management functions. The bank also has the largest branch network in Oman with 134 branches 405 ATM's and 4500 point of service terminals in the country. The total asset base of the bank is more than USD 18.7 billion as at December 31, 2011 thus making it the largest bank in Oman with respect to asset base.
(Bank Muscat, 2009)
Bank Muscat has also received many award and accolades for its performance over the years. The bank have been awarded the title of "Best Bank in Oman" for seven years by The Banker, FT London and for 9 years in a row by Euromoney and Global Finance. It was also the first bank in Middle East to receive the ISO 9000:2000 certification in 2004 (Bank Muscat, 2009).
The bank also became the first organisation in the MENA region to be awarded as a global recognition in Investors in people organisation in January 2007 and also received prestigious Hewitt recognition as the "Best Employer 2009" in Middle East.
The consumer banking division of the bank offers the financial products and services which satisfy the financial needs of individuals and includes the retail banking and personal banking parts of the bank. The consumer banking division covers product such as accounts and deposits, Loans and Mortgage, Insurance, Card services, money transfers and remittances and other ancillary services. The segment assets for the consumer banking division as at December 31, 2011 was USD 6.10 billion (up 17.5% from the figure as at December 31, 2010) which represented around 32.50% of total assets of the bank. The Net income from the consumer banking division for the year ended December 31, 2011 was USD 111.94 million (up 42.62% from the figure for the year ended December 31, 2010) which also represented 36.66% of total net income.
The consumer banking division plays a central role in the development of the organisation and positioning of the Bank among the consumers. Bank Muscat believes in investing in state of the art technology and provides a comprehensive suite of world class set of products and services within consumer banking division to cater the financial needs of customers by introducing various products such as mortgages, remittances, Expat services etc, e-banking channels which include net banking and a leading network of CDM's and ATM's in the Sultanate.
According to Boleat and Coles (1987) Mortgage banks are financial institutions which provide finance for home purchase by raising funds from capital and money markets rather than from retail savings market. Bank Muscat also provides loans to its customers for the purpose of buying home. The housing loan offered by the bank is named as "Baituna - Home Finance" and the same is available in two separate products viz. Baituna Classic Home Finance and Baituna plus Home Finance. Baituna home loans are available to the customers for the purpose of purchase and construction of new homes, purchases of second homes or retirement homes and also for purchase of land for residential use at select locations.
2.3 Mortgage Lending Market
The mortgage lending market is normally one of the largest parts of the banks operation. They constitute the majority of a bank's total loan book. Hence, the product mix offered by a bank to its customers under the mortgage lending department should be extensive so as to cover various requirements of different customers. Hence, in such cases, the customers may have an array of mortgage products to choose from. The customer chooses the mortgage product that suits him and from which he can derive the maximum utility and savings. Similarly, the bank also has to evaluate its portfolio of the mortgage loans being offered so as to focus on expanding the most profitable product and also to change the plans in case of less profitable products to make them more profitable. The process of evaluation of bank's mortgage products is a very important part of the overall evaluation.
2.4 Baituna - House Loan offering by Bank Muscat
The housing loan product of Bank Muscat is offered under the name "Baituna - Home Finance".
Currently the Baituna Home loan product is being offered to Omani nationals, GCC nationals and other expatriates who seek to purchase/ build properties in Oman by obtaining the Baituna Home loans. Other options of refinancing are also available to the customers from the Bank Muscat, with existing mortgage facility from other financial institutions or organizations. The Baituna classic home loan product is offered to salaried individuals and Baituna plus home loan product provides individuals with home loans against mortgage of property (Baituna Home Loans, 2009).
Baituna Home loan products were launched by the bank in 2006. The product became a successful product in the market and was received by the consumers very well. The product Baituna has not witnessed any changes yet and is also running successfully in Oman. However, the product has reached a level of maturity and therefore it requires the process of assessment and recommendations for its reformation and also addition for future growth of the product.
Chapter 3: Literature Review
3.1 Conventional mortgage lending and Islamic mortgage lending
The concept of Islamic Banking is new for majority of population in this world. An Islamic bank refers to banking institutions directing all known banking activities including borrowing and lending without interest. It manages the funds on basis of Mudaraba and Wakala and accepts demand deposits as interest free loan these banks organizes funds on profit and loss basis (Al-Jarhi, 2001)
With regard to banking in Islamic countries, the banking system differs from the normally followed banking system that is prevalent all over the world. Hence the overall banking system can be divided in to two parts, viz. conventional banking and Islamic banking.
Conventional Banking
Under conventional banking system, the money is treated as a commodity and hence can be sold at a higher price than its face value and can also be rented. When the money is rented/ lent, the interest is charged on the basis of time value of money. The borrower has to pay interest irrespective of the fact whether it makes a profit or incurs a loss.
Islamic Banking
Islamic banking on the other hand doesn't consider money as a commodity. Hence, under Islamic banking, the money can neither sold at a price higher than its face value nor can be rented out. Interest cannot be charged on the money's lent, hence they work on the principal of profit and loss sharing, where in case of loss to the borrower, and the same will also be shared by the lender.
According to Newell & Osmadi, (2009) there has been significant augmentation in recent years in Islamic banking and financial products. In August 2005, Real estate investment trust (REIT) was established in Malaysia and by December 2008 the number increased to 13 M-REITS and in August 2006 there was one development which was very distinctive in the meticulous M-REIT market i.e. world's first Islamic REIT got established - The Al - Aqar KPJ REIT and since December 2008 in Malaysia the number of Islamic REIT's establishments increased to three. The first and foremost prerequisite of Islamic REIT is that property portfolios of these should be Shariah-compliant; its importance has significantly increased on a global scale as these Islamic banking financial products meet the Islamic law requirements. There has been increased demand in the Asia as well as Middle East in Islamic investors for Shariah-compliant financial products and services, due to this increasing demand more than 300 Islamic banks and financial institutions have been established globally i.e. in more than 75 countries for e.g. Bank Aljazeera, Dubai Islamic bank, Qatar Islamic bank etc, even conventional banks and other financial service providers for e.g. RBS, Barclays, HSBC etc have also started windows for Islamic banking and finance.
Points of differentiation between Islamic mortgage model with its Conventional counterpart
Due to the basic difference between the conventional banking and the Islamic banking, there is also a difference between the conventional mortgage lending and Islamic mortgage lending. There are major differences between the conventional mortgage lending and Islamic mortgage lending. Firstly, according to Hanif & Hijazi, (2010) under conventional mortgage lending system, when a customer purchases a property, the customer borrows money from various sources such as banks and money lenders. The borrowed money is then repaid to the lender with an additional amount over a period of time or after a particular period. The additional amount paid by the borrower is the amount of interest.
However, as argued by Usmani, (1999) under the Shariah rulings of Islam, the charging of interest is not allowed as it is against the Shariah Law. Therefore under the Islamic mortgage lending system, the Islamic bank enters into a sharing agreement with the customer in purchasing the desired property of the customer. Hence in such cases, the customer and the bank become the joint owners of the property in proportion to the share contributed by them in purchasing the property (Siddiqi, 2006). In such cases, in order to become the owner of the property and use the entire property, the customer will have to purchase the bank's share of the property over a period of time. In the mean time, they pay the rent for using the bank's share of the property. Over a period of time, by making excess payment then as required for paying bank's share of the property the customer purchases the entire share of bank in the property. Ultimately, the customer becomes the sole owner.
Secondly, another difference between the conventional mortgage and Islamic mortgage stems from the fact that in case of Islamic mortgage lending system, the rent is charged after the delivery has been taken by the lessee and it is in usable condition. In such cases, the rent cannot be charged from the day the price was paid to acquire the property/asset. Hence, if the supplier makes a delay in delivering the property after receiving the full price, the lessee will not be liable for the rent of the period of delay. However, in case of conventional mortgage lending system, normally the lease rentals start from the date the bank makes payment for purchasing the property/asset (Hanif, 2009).
3.2 Rise of Islamic Banking in Oman
As per news from Reuters by Vizcaino, (2012) "Oman Plans Islamic finance rules before year end" - The government bodies in Oman, Middle East are moving towards the new era i.e. a new authoritarian framework is being built in Oman for Islamic finance in order to meet the aim of the country of making Shariah compliant financial products this year so that they can be available to the public. After insisting for many years the Central bank, government bodies came to the stand in the year 2011 to have the completely conventional system of banking. However this year the country changed its stance and now the major focus is on the non-conventional banking system i.e. introduction of Islamic banking so that outflow of funds can be prevented to other shariah-compliant financial institutions in the Gulf. This also compliments the efforts which are being undertaken by the Central bank of Oman i.e. the passing of a law so that Islamic banks can be supervised. According to senior director of CMA Mr. Mohammed Al Abri, the law is in the finishing stages of review.
Last year as per data from Central Bank of Oman a newly formed Islamic bank (the first in the country) - Nizwa Bank along in collaboration with Al Izz International bank came into existence and obtained its license for banking thereby making the competition stiffer. Thus other conventional banks were allowed to use windows to offer Islamic products and services through their existing networks of offices and branches e.g. Bank Muscat, Oman's second largest private sector bank with the largest network of 130 branches started delivering Shariah-compliant banking products by applying cooperative strategy i.e. in cooperation with National Bank of Oman and Bank Sohar. HSBC Bank, Oman also merged with the fifth largest leader in market-Oman International Bank which also got approval this month to provide Islamic products and services (Vizcaino, 2012).
Though some of the commercial bankers even said that the process of conversion of conventional banks into non conventional banks could streamline the broad industry however there was no indication from the Central Bank whether it would be permitted and secondly it is not easy to make such advance conversions. This in turn would attract 10% of the customers who have not joined the banking industry in order to avoid interest related transactions because of their belief in Islamic religion and similar percentage of existing Omani customers would switch to Shariah-compliant banking and financial products as per prediction by Rafique (Vizcaino, 2012).
3.3 Various stages in the Life Cycle of the Product
One of the most known and followed theories identifying various stages in the product life cycle was presented by Cox, (1967) stating that "the concept of the life cycle of the particular product fundamentally illustrates the progress of the product in the market, measured by its sales with respect to the time". It can also be used as the models of marketing, marketing strategy or tool of product planning and control and would be beneficial to determine the PLC of our firm as well as competitors in order to perform the competitor analysis.
A model of product life cycle focuses on analysis of the evolution of the market offering where we can examine the recent position of the merchandise with respect to the past and future. We can also investigate each and every product in relation to the other different products marketed by the firm with the products of the other company's competing in the same market.
The most widespread hypothetical profile of the product life cycle has been urbanized by Hofer, (1975) because it affects the strategies of any business. Hofer also put forward and recommended various propositions which are of meticulous interest which are -
"The most elemental variable which is commonly used to determine the suitable business level strategy of any firm is the stage of the life cycle of the product". Secondly
"Most of the revolutionary changes in the business level strategy of any firm are usually made through the three phases of the product life cycle - Introduction, maturity and decline phase". Thirdly
"Hofer also developed vivid propositions for every phase of the life cycle, organizational and ecological features that put forth a key strategic influence at every phase and normative suggestions for the maturity phase".
Hofer also emphasizes that life cycle of the product is a framework for analysis by the management, however unsuccessful, in considering the problems which occur while measuring the PLC. The theory of the same has been made under some of the following practical assumptions -
Products and services offered in the market have a limited life.
Profits increase and decrease during various phases of the PLC.
Sales go through the various distinctive stages and pose different types of opportunities, challenges as well as problems to the vendor.
There is the requirement of different marketing, manufacturing, human resources, purchasing and financial strategies in each phase of the product life cycle.
http://hbr.org/hbrg-main/resources/images/article_assets/hbr/6511/65608_A.gif
Source: Levitt, (1965) Figure 1: Showing Life Cycle of the Product.
Kotler et al. (2009) in his book 'Marketing Management' explained that PLC is the qualitative concept and during the course of its existence each and every product goes through a series of phases, which can be termed as the life cycle of the product, these four phases can be termed as
Introduction Stage: This phase can be defined as when the new product is introduced in the market i.e. "market offering". Profits in this stage are negative or do not exists as sales are less because the product is newly launched as well as aligned with heavy promotional expenses incurred on its marketing in order to update prospective consumers; persuade the clients to try the product; and secure distribution to retailers.
Growth Stage: This phase can be defined as where the product is accepted by the consumers in the segmented market i.e. "brisk market acceptance". This stage is also marked by a vigorous increase in sales. Early adopters like the product offered whereas new customers start purchasing from the company. Attracted by the opportunities, new entrants enter into the market; bring in new market offering with better features, attribution of values as well as expand the circulation.
Prices remain constant or slightly fall, depending on how fast there is increase in demand, thereby firms maintain or increase their promotional expenses to some extent, in order to meet the stiff competition and carry on to educate the market. Sales also increase at a greater pace than expenses, causes a reduction in the promotion to sales ratio. This makes the substantial development in the earnings as cost of promotion is spread over the large volume and per unit cost of producing the product falls more than the declining price due to the manufacturer experience or learning curve effect.
Maturity Stage: This phase experiences the retard in the sales growth as the merchandise which was offered in the market has attained maturity i.e. has been accepted by the prospective consumers. This phase lasts longer as compared to the previous two stages and poses a number of challenges to the marketing managers.
This phase itself subdivides into three stages i.e. growth, stable and decaying maturity. In the first segment sales starts deteriorating and new competitive forces emerge. In the stable stage, as the markets are saturated sales flattens on basis of per capita whereas in the decaying stage customers switch to other products and sales growth falls at the absolute level thereby creating the overcapacity in industry (Kotler et al, 2009). Profits in the maturity phase become stable or start diminishing because of the many competitors in the market which makes the competition stiffer.
Decline Stage: In this phase there is a downturn in the sales growth because of many rationales such as change in consumer taste, technology advancement, augmentation in foreign market as well as competition at home etc. These also results in price cuts, overcapacity and even withdrawal of firms from the market. Profits also wear away in this phase.
Anderson & Zeithaml, (1984) also came up with suggestions that the notion of product life cycle would be best applicable if the company has multiple products and also operates within an array of different markets as there is a requirement to develop techniques so that the limited assets of the firm can be allocated in an optimized way. Therefore in this regard, "The model of PLC" would be an appropriate option.
3.4 An Analytical Approach towards selection of Bank loans for process of evaluation
Among the numerous errands of bank's regulatory bodies and the management of the bank, the cyclical or quarterly evaluation of portfolios of the bank mortgages stands out in its utmost intricacy and importance. There are two vital reasons as to why the process of evaluation of the portfolio of the bank's mortgage is considered as important, firstly the extent to which the percentage of mortgage is increasing to the assets of the bank and secondly the intrinsic risk of mortgage compared with the assets of the other bank. This is implied to the management of the bank individually as it is the aggregate measure of the regulation of the bank and quality of credit.
As it is pointless and unfeasible to evaluate each and every mortgage, it is viable to split the process into two ways. Firstly which sample of mortgages is to be selected; secondly to evaluate the mortgages which are selected. According to Orgler, (1969) the first process can be solved by using the analytical method with the help of linear programming method, where optimal sample sizes can be determined for a stratified sampling plan whereas the other aspects of the process of evaluation i.e. insurance coverage, time of the mortgage can also be simultaneously controlled with linear programming. Thereafter the results from the process can also be projected on the portfolio of entire mortgage and this in turn would provide with a suggested method to the executives of the banks such as mortgage officers, examiners and auditors to measure the quality of the entire portfolio of the bank's mortgage.
As per Fredricks, (1966) it is very important to evaluate the outstanding bank mortgages. There are many formal methods used by the banks in order to conduct a review; however a very precise method is used by the regulatory agencies of the bank to select mortgages for assessment. Executives not only evaluate the mortgages which have been criticized previously but also evaluate the loans which are due in the past. Apart from these some bank executives also evaluate mortgage samples which have smaller outstanding balances which consist of loans that have gone overdue and special cases.
However there are some deficiencies in the process of evaluation also e.g. the selection of the cut off procedure doesn't provide any information about the bulk of smaller mortgages, the recital of bank auditors who focus on the assessment of small mortgages and the portfolio of mortgage of several small branches whereas the awareness on many hefty mortgages is explained by the effect of their eminence on the short run risk experience of the bank. Realizing these insufficiencies, bank authorities have a tendency to lessen the cut off level in order to cover the 50 - 60% of the dollar amount of the mortgages. Another important dilemma associated with procedure of selection of mortgage is the determination of the level of cut off itself, which in many of the cases is left to the judgement of the authorities of the bank (Jacobs, 1964).
According to Orgler, (1969) a thumb rule prevalent equates the level of cut off to the surplus and the percentage of capital stock. An assessment was conducted by the FDIC - Federal Deposit Insurance Corporation, which took the sample size of 100 commercial banks in order to identify the factors that determine the cut off level for mortgages on the basis of cross sectional analysis and came to the conclusion that the current level of cut off is based on the cut off used in the test conducted in past and on capital accounts. The variables used in the regression analysis such as independent variable includes the cut off level used in the past i.e. inter alia, the ratio of mortgages in overdue status to the total number of mortgages, the capital reserves level plus surplus, the ratio of classified or confidential mortgages to the total mortgage and lastly the ratio of total mortgages to the entire assets of the bank whereas the dependent level in the regression analysis consists of the current level of cut off.
It is obvious to use the stratified sampling technique as the mortgages of the banks plunge into different classes and vary in their terms, size and many other characteristics, secondly it also takes into consideration not only the characteristics of the portfolio of mortgage but also the time as well as the overall cost limitations on the mortgage evaluating officers or the executives of the bank. Another benefit of stratified sampling is that depending upon the portfolio of loan, objectives of the mortgage review and the type of the bank, additional subdivisions in terms of collateral are also feasible. Thus the concurrent measurement of all the variables needs to be done in order to obtain the optimal sample size of mortgage in each stratum i.e. the use of linear programming.
There are different steps in order to derive at the model, the decision variables need to be defined in the first step. As a matter of fact the portfolio of mortgage is divided into different types of sections or variables and this differs from bank to bank. Under such circumstances regulatory bodies delineate their variables as per the existing allocation of mortgage files in each scrutinized bank whereas may find it beneficial to subdivide their portfolio of mortgage at the branches level in order to compare their branch wise performance or to have individual level supervision and control.
After defining the variables of mortgage the next most important step is to obtain the constraints and the objective function, which can be represented as the cost of the evaluation of mortgage and how it can be reduced with respect to the trustworthiness, exposure and other institutional and policy controls.
3.5 Risks in Mortgage lending business and its management
There are many risk faced by a bank in the mortgage lending business. The most important risks which are present in the mortgage lending business are as follows:
Credit Risk: Valsamakis, Vivian & Du Toit, (2005), defined credit risk as the risk that a financial contract will not be finished in line with the agreement. It is the risk that the counterparty to an asset will default.
Operational Risk: Operating risk is the risk associated with Operating losses which may happen because of wrong valuation, low service fees charged or other expenses occurred at a high rate. (Heffernan, 2005)
Market Risk: Market risk refers to the those risk that results because of change in factors which are not in the control of the bank and may generally are in the form of reduced interest rate thereby reducing the profits of the bank and other one can be in the form of reduced property valuation which will decrease the value of security for the bank.
Risk management
One of the well known arguments in this regard had been put forward by Clickner, (1967) which states that "It is of utmost importance for the lender of mortgage to make the use of risk management techniques as the current usage of coverage of lender loss and insurance only protects and covers against insufficient security measures."
Hence in order to evaluate the credentials of the borrower, additional investigation or scrutiny should be deployed. Though the acceptance of the terms and conditions of the mortgage always depends upon the risk controls of the debtor, the creditor should always analyze the indemnity exposure conceded by the debtor, and provide recommendations in case of any deficiencies. Adoption of these techniques and extra security options will provide any bank with a superior quality portfolio of mortgages and debtors with both sagacious insurance coverage and a manageable loan.
One of the services provided by the bank such as any kind of extension of credit or financing of mortgage, is thoroughly concerned in connection with the problems of control and investigation of risk, therefore the relevancy and applications of principles of risk management to lending of mortgage events must merit such scrutiny and investigations. This review would also inspect and focus upon the present application of the ideology of risk management to lending of mortgage and also inquire whether extensive usage of these principles would be beneficial for the bank or not.
Kerwood & Pease, (1965) in his paper also conveyed that the legal implication of the distinctive transaction of mortgage and herewith provides a source for this analysis. He explains that the mortgage is a twofold legal instrument which consists of the bond, or note, also known as instrument of credit and instrument of security i.e. the mortgage proper. The mortgage also consists of that particular segment of instrument where property is pledged as collateral against the loan whereas the credit instrument i.e. note acts as a responsibility or obligation of an individual to pay the mortgage despite of the subsistence of the liened property. In the occasion of any non payment or default from the borrower's part, the creditor has the right or may impose his allegation under either the instrument of credit or security.
Risk management principles in the process of mortgage finance
Usage of Insurance
As said by Clickner, (1967) in his paper that in the past, though the banks and financial institutions has manifested less interest on techniques pertaining to risk management of mortgage except for his persistence upon "hazard" insurance in order to protect the collateral. As the amount taken by an individual against the property depends upon the market value therefore the creditor should be very much certain about the sufficiency of the same and he should also make sure that the borrowed amount must be expected to be repaid at a faster pace than the reduction or depreciation of the property during the mortgage term.
The author has also put forward one of the well-known arguments regarding the usage of standard fire policy with extensive coverage which gives protection against destruction of the property by other perils or fire as this produces loan without security and the lender preserves the lien on said collateral by requiring the material damage indemnity to the summation of his interest, the outstanding loan indebtedness. This would recompense the creditor for the diminution of the price of the security. Author again argues that as the value of the property is inadequate, indemnification for damages by insurance policy would still leave the creditor faced with expected losses.
It can also be said that the instrument of security which has been pledged by the borrower as collateral thereby permits the creditor to put the property up for sale if borrower defaults the payment however in contentment of the debtor's obligation. Hence the creditor also seems to believe that indemnity against physical damages as well as authority to sell the collateral cogently gives enough financial alternatives to the lender in case the borrower is not able to pay the mortgage. Here author argues that as a creditor, banks and other financial institutions are principally concerned in a long term lucrative investment with the borrower; however there are various possibilities of foreclosures, such as uninsured loss of property. In these kinds of consequences "hazard insurance" would not be able to avert any creditor loss and a forced sale wouldn't be perfect means of accomplishment.
Assessment of borrower's credit worthiness
According to National Credit Regulator, (2007) Credit risk has been recognized as the major risk that the banks are facing and can even result in the collapse of a bank due to futile decisions on credit.
It is, consequently, crucial for the banks to carry out credit risk assessment on existing customers as well as new applicants in order to verify the level of affordability and mitigate credit risk. Buyer's credit information plays a vital role in credit risk assessment as it can precisely detect and foresee default. Consumer credit information that is imprecise can also have a harmful impact on operations of the bank in terms of higher pricing, consumer disputes and over indebtedness. Additionally, inexact individual credit data hamper access to loans by clients.
Retail business of any bank comprises of unsecured and secured loans. A credit backed by security is secured i.e. mortgages and also plays a chief role in investments in emerging as well as developed economies as it encourages the credit extension by providing relief to banks and also acts as buffer in case borrower defaults. As suggested by Ferraris and Watanabe (2008) in industrialized economies, secured loans are more in number as compared to other loans. Subprime mortgage crises occurred due deprived mortgage lending policies and practices adopted by various banks which consequently resulted in their breakdown such as Merrill Lynch & Co., Lehman Brothers etc. (Bonorchis, 2008). The consequences of distress were loss of confidence in banking industry and global recession. In order to decide the cost of credit and to make sure that the borrowers are not over-indebted, credit information plays a critical role in measuring the credit worthiness of the customers. Therefore before approving any mortgage application, banks usually makes a credit check or review individual's credit history by asking for the credit reports from credit bureaus so as to mitigate the credit risk.
Chapter 4: Methodology
The various methodologies had been used in this report ranging from quantitative methods to qualitative methods.
Under quantitative methods, we have analysed two case studies of housing loan transactions of Bank Muscat in order to find the benefits derived by the consumers and benefits for the bank under Islamic Banking Finance than in Conventional Banking.
In the first case study, we have calculated the interest payment by the customer on his housing loan and then compared with a hypothetical situation of the same loan being offered under Islamic Banking.
In the second case study we have calculated the total return to bank under one of its housing loan and then compared the return which could have been earned by the bank, if the same loan had been issued under Islamic Banking.
Bank Muscat, being one of the largest banks in Oman is also susceptible to competition. Hence, to maintain and grow their market share, they should also focus on their competitor's actions. A competitive analysis of Bank Muscat with one of its competitor is produced below. The competitor chosen for the analysis is Oman International bank. Oman international Bank with a branch network of more than 80 branches is one of the largest banks in Oman and is a major competitor of Bank Muscat. The competitive analysis of these two banks has been done by taking the financial statements for the year 2009 to 2011 and analysing them on a standalone basis as well as on a competitive basis for these two banks.
An extensive qualitative methodology has been used to find out the decline in the housing loans offered by the bank over a period of time, the reasons behind it and have also compared the portfolios of housing loans offered under Islamic banking to identify the reasons why Islamic mortgage model works better even under the situations of financial crisis.
Chapter 5: Findings
There is a difference in the mechanism of the whole lending process; the amount of interest/ profit made by the lender and the amount incurred by the borrower differ under both the option. This can be illustrated with the help of an actual cast study of an individual mortgage transaction of Bank Muscat.
The customer ABC wishes to buy a home that was valued at USD 200,000 (for the purpose of generalization, all figures has been converted into US$, where 1 Omani riyal = 2.6 US$). The rate of interest is 8%. The customer wishes to take a loan of up-to 90% for buying the property, keeping the remaining 10% as security. The loan will be a 30 year loan where it will be paid in 360 equal monthly instalments. Hence the loan amount comes to $180,000 and the monthly figure comes to $1,320.78. The schedule of repayment will be as follows:
Period
Monthly Payment
Interest
Principal
Balance after payment
1
$1,320.78
$1,200.00
$120.78
$179,879.22
2
$1,320.78
$1,199.19
$121.58
$179,757.64
3
$1,320.78
$1,198.38
$122.39
$179,635.25
4
$1,320.78
$1,197.57
$123.21
$179,512.04
….
120
$1,320.78
$1,054.47
$266.30
$157,904.47
…
180
$1,320.78
$924.02
$396.75
$138,206.81
…
240
$1,320.78
$729.68
$591.10
$108,860.33
…
358
$1,320.78
$26.07
$1,294.71
$2,615.37
359
$1,320.78
$17.44
$1,303.34
$1,312.03
360
$1,320.78
$8.75
$1,312.03
$0.00
Total
$475,479.44
$295,479.44
$180,000.00
Table 1: Amortisation schedule under conventional mortgage
From the above amortisation schedule, it can be seen that the total payment made by the borrower is $475,479.44, out of which the interest amounts to $295,479.44 and the principal repayment to the bank is the initial loan amount of $180,000.
Now, if we assume the same data for an Islamic mortgage lending system, where $20,000 is contributed by the customer and $180,000 is contributed by the bank for a $200,000 home. The rent is assumed to be the same as equal monthly instalment for a conventional loan i.e. $1320.78. Hence, in that case, 10% of the rent will belong to the customer and 90% will be part of the bank's remuneration. However, instead of taking the 10% portion, the customer will pay it to bank to buy the bank's share in the loan. Hence, the share of the customer will increase with each payment.
The payment schedule for the arrangement will be as follows:
Period
Payment Amount
Client's share
Bank's share
Client's Equity
Client's Equity
(%)
Bank's Equity
Bank's Equity
(%)
1
$1,320.78
$132.08
$1,188.70
$20,132.08
10.07%
$179,867.92
89.93%
2
$1,320.78
$132.95
$1,187.83
$20,265.03
10.13%
$179,734.97
89.87%
3
$1,320.78
$133.83
$1,186.95
$20,398.86
10.20%
$179,601.14
89.80%
4
$1,320.78
$134.71
$1,186.06
$20,533.57
10.27%
$179,466.43
89.73%
….
120
$1,320.78
$289.07
$1,031.71
$44,061.78
22.03%
$155,938.22
77.97%
…
180
$1,320.78
$429.06
$891.72
$65,400.05
32.70%
$134,599.95
67.30%
…
240
$1,320.78
$636.85
$683.93
$97,072.03
48.54%
$102,927.97
51.46%
…
349
$1,320.78
$1,305.04
$15.74
$198,921.44
99.46%
$1,078.56
0.54%
350
$1,084.41
$1,078.56
$5.85
$200,000.00
100.00%
$0.00
0.00%
Total
$462,035.32
Table 2: Amortisation schedule under Islamic mortgage
From the above table, it can be seen that the customer becomes the owner of the property in less than 350 months, instead of the 360 months that was being taken in case of conventional mortgage lending system. The customer also had to pay on $462,035.32 under the Islamic lending which is less than the payment of $475,479.44 which was being made under the conventional mortgage lending system resulting in a saving of $13,444.13 for the customer as compared to the conventional mortgage lending.
The difference between the two lending system magnifies when we change the rate of interest being charged on the loan. Keeping all the other factors (viz. principal, borrower contribution, term of the mortgage etc.), the total interest payments and total payment for different rate of interest will be as follows:
Interest Rate
Monthly Payment
Total Payback
Total Interest
Total Principal
6%
$1,079.19
$388,508.74
$298,508.74
$90,000.00
8%
$1,320.78
$475,479.44
$385,479.44
$90,000.00
10%
$1,579.63
$568,666.38
$478,666.38
$90,000.00
12%
$1,851.50
$666,540.96
$576,540.96
$90,000.00
Table 3: Total interest and principal under conventional mortgage for various interest rates
Hence, at 6% interest rate, total interest will be $298,508.74 which increases to $576,540.96 in case the rate of interest is increased to 12%.
On the other hand, if we consider Islamic lending and keep the other variables same (viz. principal, borrower contribution, term of the mortgage etc.) and just change the rent amount to adjust for the change in interest rate, the amount for acquiring the property and the time to be taken for the same will be as follows:
Monthly Rent
Total Payout
Bank's share of rent
Principal
Payment required to complete buyout
Years required to complete buyout
$1,079.19
$4,61,758.05
$3,71,758.05
$90,000.00
428
35.67
$1,320.78
$4,62,035.32
$3,72,035.32
$90,000.00
350
29.17
$1,579.63
$4,62,326.11
$3,72,326.11
$90,000.00
293
24.42
$1,851.50
$4,62,644.44
$3,72,644.44
$90,000.00
250
20.84
Table 4: Total interest and principal under Islamic mortgage for various interest rates
From the above table, it can be seen that when the monthly rent is $1,079.19, then the total number of payments required for the borrower to become the owner of the property. The number of payment required gradually reduces when the amount of monthly rent increases. The years required for the complete buyout by the borrower also decreases as the amount of monthly rate increases.
Islamic mortgage banking is more linked to sharing of profit/ loss on the property rather than the earning of interest which is the primary motive under the conventional mortgage banking. Hence, from the point of view of the bank, the return on amount lent will remain the same for the whole tenor of the loan as the amount earned is only the interest received on the lent money. However, in case of Islamic banking, the amount earned will be linked to the appreciation in the value of the property as well as the increase in the rental value of the property. This can be explained by giving another case study:
In this example, a customer of the bank purchased a property of USD 500,000 in 1986. The rental value of the property at that time was USD 50,000. The current value of the property as on 2012 has increased to USD 35,000,000 and the rental value has increased to USD 1,500,000. To purchase the flat, the customer contributed 50% and took the remaining 50% on loan from the bank. In case we assume that the customer does not repay the principal and the interest rate for the loan under conventional mortgage loan being 15%, the calculation of the return on investment for the bank under Islamic and conventional mortgage banking will be as follows:
Practically, the appreciation in the value of the property takes place in various phases, however, for the purpose of this calculation and understanding the working, we calculate the internal rate of return for the increase. The IRR of the property value comes to 17.04%. Similarly, the increase in the rental value from 1986 to 2012 comes to 13.98%.
The return on investment for the bank under the Islamic mortgage lending scheme and conventional mortgage lending scheme for various years can be shown as below:
Financing Scheme
1986
1991
1996
2001
2006
2011
2012
Total return on Property
85,204
1,87,130
4,10,986
902,635
1,982,426
4,353,935
5,095,876
return under Islamic mortgage
67,602
1,41,649
2,97,977
629,197
1,333,340
2,835,002
3,297,938
return under conventional mortgage
37,500
37,500
37,500
37,500
37,500
37,500
37,500
Table 5: Returns on property, conventional mortgage and Islamic Mortgage
From the above table, it is clearly evident that the return on conventional mortgage lending is fixed irrespective of the value of the property or the rental value of the property. However, under the Islamic mortgage lending scheme, the return on invested capital for the bank is much higher. In fact the return on capital under Islamic banking increases with each passing year. However, the same is less than the return on the total property. This is because of the fact that the bank only owned 50% of the property and balance was owned by the customer.
Moreover, if we look at the total return earned by the bank under both the options, the total return of the bank under the conventional banking was USD 1.01 million while under the Islamic banking, the return in the same period was USD 5.94 million in rentals and the cumulative share in appreciation of the property of USD 17.25 million. Hence, in such a case, Islamic banks would have earned 16.24 million more than the conventional banks. The same is justified as the value of the property had also risen from USD 500,000 to USD 35,000,000 from 1986 to 2012.
The return on property, Islamic mortgage and conventional mortgage can be depicted with the following graph over the years:
Figure 2: Graph depicting returns that bank earns on property, conventional mortgage and Islamic Mortgage
Hence, from the above table, we can see that the return under conventional mortgage is constant in all the years; however, the return on Islamic mortgage and the return on the property itself have increases substantially. In the above example, the return on property is somewhat higher than the return on Islamic mortgage, this is due to the fact that the appreciation in property was significant and only a part of that increase was passed on to the bank under the profit sharing scheme resulting in a lower return for the bank. However, it is quite clear that the return on Islamic mortgage is far superior to the return on return on conventional mortgage.
The overall calculation of the returns over the years for the property, under Islamic mortgage and under the conventional mortgage is reproduced below:
Year
Value
Increase
rentals
Return on property
Share in rent
Share in capital
return under Islamic mortgage
return under conventional mortgage
1985
500,000
1986
585,204
85,204
50,000
135,204
25,000
42,602
67,602
37,500
1987
684,926
99,723
56,988
156,711
28,494
49,861
78,355
37,500
1988
801,643
116,716
64,952
181,669
32,476
58,358
90,834
37,500
1989
938,248
136,606
74,030
210,636
37,015
68,303
105,318
37,500
1990
1,098,133
159,884
84,376
244,260
42,188
79,942
122,130
37,500
1991
1,285,262
187,130
96,168
283,298
48,084
93,565
141,649
37,500
1992
1,504,280
219,018
109,608
328,626
54,804
109,509
164,313
37,500
1993
1,760,620
256,340
124,927
381,267
62,464
128,170
190,634
37,500
1994
2,060,643
300,022
142,387
442,409
71,193
150,011
221,204
37,500
1995
2,411,791
351,148
162,286
513,434
81,143
175,574
256,717
37,500
1996
2,822,777
410,986
184,967
595,953
92,483
205,493
297,977
37,500
1997
3,303,799
481,021
210,817
691,839
105,409
240,511
345,919
37,500
1998
3,866,790
562,991
240,280
803,271
120,140
281,495
401,636
37,500
1999
4,525,718
658,929
273,861
932,790
136,931
329,464
466,395
37,500
2000
5,296,933
771,215
312,135
1,083,350
156,068
385,607
541,675
37,500
2001
6,199,568
902,635
355,759
1,258,394
177,879
451,318
629,197
37,500
2002
7,256,019
1,056,451
405,478
1,461,929
202,739
528,225
730,965
37,500
2003
8,492,496
1,236,477
462,147
1,698,624
231,073
618,239
849,312
37,500
2004
9,939,678
1,447,182
526,735
1,973,917
263,368
723,591
986,959
37,500
2005
11,633,471
1,693,792
600,350
2,294,143
300,175
846,896
1,147,071
37,500
2006
13,615,897
1,982,426
684,254
2,666,680
342,127
991,213
1,333,340
37,500
2007
15,936,143
2,320,246
779,883
3,100,129
389,942
1,160,123
1,550,065
37,500
2008
18,651,776
2,715,633
888,877
3,604,510
444,439
1,357,816
1,802,255
37,500
2009
21,830,172
3,178,396
1,013,104
4,191,500
506,552
1,589,198
2,095,750
37,500
2010
25,550,189
3,720,017
1,154,693
4,874,710
577,347
1,860,009
2,437,355
37,500
2011
29,904,124
4,353,935
1,316,070
5,670,004
658,035
2,176,967
2,835,002
37,500
2012
35,000,000
5,095,876
1,500,000
6,595,876
750,000
2,547,938
3,297,938
37,500
Total
34,500,000
1,18,75,134
46,375,134
5,937,567
17,250,000
23,187,567
1,012,500
Table 6: Schedule of payment and returns under conventional and Islamic mortgage
On the basis of Analysis of Financial Ratios (Appendix) of Bank Muscat and Oman International Bank, the following points have been noted:
The deposit base of both the banks is improving considerably year-on-year basis.
The Oman International Bank is comparatively less leveraged as compared to Bank Muscat which is evident from the lower liability to owner's equity ratio.
Profitability of both the banks has come under pressure in 2011 as compared to 2010 and 2009 levels. However, the profitability of Oman International Bank has suffered more than that of Bank Muscat.
The profit to total equity ratio for Bank Muscat is more attractive both on pre-tax and post-tax basis.
Though the total capital ratio of Bank Muscat is better than Oman International Bank, the Tier 1 Capital Ratio of Oman International Bank is much better than Bank Muscat's Tier 1 capital ratio.
EPS of Bank Muscat for all the three years was better than that of Oman International Bank.
On careful qualitative analysis of Bank Muscat's Housing Loan Portfolio and database, it can be seen that the disbursement under these products were very large during the pre 2008 crisis. The yearly made disbursements under these products were in the range of USD 50 million to USD 70 million in 2007-2008. A yearly break-up of the volume of Baituna loans for last 6 years is given below:
Year
Amount of loans disbursed
Number of loans disbursed
2006
16,294,912
366
2007
50,593,783
1,070
2008
69,080,813
1,368
2009
23,216,493
439
2010
25,134,243
470
2011
21,516,365
384
Table 7: Volumes of Baituna, mortgage product of Bank Muscat from 2006 to 2011
A graphical representation of the data is given below:
Figure 3: Volumes of Baituna loan of Bank Muscat from 2006 to 2011
From the above table, it can be seen that the volume of Baituna Home loans increased significantly in 2007 and 2008 as the product was newly launched and the Bank was aggressive regarding this product. However, due to the global financial crisis in late 2008, the Bank took an informed approach to scale down the product and due to this reason, the volume dropped from USD 69 million in 2008 to USD 23 million in 2009. The number of loans disbursed also witnessed the same trend. They were at their peak during 2007 and 2008 when the Bank was aggressive in its stance. However, the number of loans disbursed fell by around 67% from 2008 to 2009 (1,368 loans to 439 loans disbursed).
After doing an extensive research between the portfolios of conventional housing loan schemes and housing loans offered under Islamic banking, we can conclude that because of recent global financial crisis conventional banks badly affected everywhere in the world. Although Islamic bank also affected by the global financial crisis but performance of Islamic banks during global financial crisis is better than conventional banks. It has been further studied that Islamic banks suffer in term of leverage, capital ratio and return on equity and despite this, the performance of Islamic banks during 2006-2009 was better than conventional banks (Parashar and Venkatesh, 2010). Report of World Bank by (Beck, Asli., Kent, and Quarda, 2010) compared the performances of Islamic and Conventional banks during recent financial crisis and found that although both Islamic and Conventional banks were affected by the crisis, Islamic banks ranked superior in terms of liquidity reserves and credit risk. Performance of Islamic banks is better in financial crisis as compared to conventional banks.
Islamic mortgage banking is based on the principal of justice where in the financial contracts are made to ensure that none of the parties are exploited. Hence, under the Islamic mortgage banking the bank advances the client an interest free loan to the customer to enable them to continue their payments during the recession in anticipation that they will pay in full when the economy rebounds. The basic principal is that "Riba" (interest or usury) is a source of exploitation, and hence not allowed under the Islamic mortgage lending. Specially, under the sub-prime lending, the highest rates were charged to the lowest earners.
According to many Islamic scholars, the main reasons for the current crises are the result of the failed morality (Bernanke, 2007). In turn, the failed morality is the cause of corruption and greed and as a result of this greed there is failure of relationship between investment originator and investors (Chapra, 2008). This failure is due to the poor working of the financial institutions which have granted loans while ignoring the risks associated with such investments. Through effective regulation the excessive risk taking should be reduced, and there should be detailed focus on the disclosure of information regarding assets by financial institutions (Mirakhor & Krichene, 2009).
McNamara, (2009), the co-founder of Yasaar Media, expresses the same argument. "Sharia principle prevents Islamic banks from engaging in excessive speculative activities and because all transactions must be backed by physical assets, the use of derivative collateralized instruments is not permitted. This has shielded the Islamic banking industry from direct exposure to the toxic assets that have caused the major losses throughout the global financial crisis of the banking industry". He argues that Islamic banking is not entirely immune of the effect of the financial crisis. Because the interconnectedness of the international financial system, no country has direct immunity from the crisis and thus Islamic financial system is affected by the crisis of the confidence amongst investors.
Also according to (Ozturk, 2008) implementation of profit and loss sharing transactions results in full disclosure and transparency as a result market discipline can be well understand and as a result there appears a judicious control over unnecessary lending that improves the Islamic mortgage system.
Under the credit crunch and global financial crisis, the borrowing and the wholesale market came under stress; however, the Islamic banks were not at all exposed. As compared to conventional banks, no Islamic bank failed in the back drop of the financial crisis. No Islamic bank needed governmental recapitalization which ultimately was a burden on the tax payer's hard earned money. The most important reason for this strength and resilience was that the Islamic mortgage uses classical banking model and the fact that majority of financing were derived from retails and corporate deposits rather than being funded by the borrowings from the wholesale borrowings (Ariss, 2010).
Another reason for the resiliency of the Islamic bank in the sub-prime crisis is that the shariah compliance investors normally preferred portfolios which were heavily weighted viz. Sectors like utilities and healthcare which were comparatively immune to economic downturns. Hence, in cases of economic downturn, when the profitability declines, the depositor receives lower return; however, in case of economic upturn, higher returns are generated. This
