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Monday, 26 May 2008

Islamic Banking makes headway in global finance—IMF

Since the inception of Islamic banking about three decades ago, the number and reach of Islamic financial institutions worldwide has risen from one institution in one country in 1975, to more than 300 institutions operating in more than 75 countries.

The entire banking systems of Sudan and Iran are based on Islamic finance principles. Although Islamic banks are concentrated in the Middle East and Southeast Asia, they are also niche players in Europe and the United States. According to McKinsey & Co., Islamic banking assets and assets under management reached $750 billion in 2006, and the Islamic finance sector is expected to reach $1 trillion by 2010.

Islamic or Shariah-compliant banking provides and uses financial services and products that conform to Islamic religious practices and laws, which, in particular, prohibit the payment and receipt of interest at a fixed or predetermined rate. In practice, this means that instead of loans, Islamic banks use profit-and-loss sharing arrangements (PLS), purchase and resale of goods and services, and the provision of services for fees form the basis of contracts.

Benchmark rate

In PLS modes, the rate of return on financial assets is not known or fixed prior to undertaking the transaction. In purchase-resale transactions, a markup is determined based on a benchmark rate of return, typically a return determined in international markets such as the London Interbank Offered Rate (LIBOR).

Islamic banks also determine return on deposits differently. In a commercial bank, the rate of return is set contractually (fixed in advance or tied to a reference rate) and does not depend on the bank’s lending performance. In an Islamic bank, the rate of return on a deposit is directly dependent on the quality of the bank’s investment decisions.

If the bank records losses as a result of bad investments, depositors may lose some (or all) of their deposits. The contractual agreement between depositors and the Islamic banks does not predetermine any rates of return, it only sets the ratio according to which profits and losses are distributed between the parties to the deposit contract.

There is a large body of descriptive literature about Islamic finance, but there has been relatively little empirical work on Islamic banking and financial stability, an area of increasing interest as Islamic banking grows. In a new IMF working paper, we attempt to fill this gap in the literature, using data on 18 banking systems with a substantial presence of Islamic banks to provide a cross-country empirical analysis of the role of Islamic banks in financial stability.

A prudential perspective

Are Islamic banks more or less stable than traditional banks? A majority of the relevant literature suggests that the risks posed by Islamic banks to the financial system differ in many ways from those posed by conventional banks. Risks unique to Islamic banks arise from the specific features of Islamic contracts, and the overall legal, governance, and liquidity infrastructure of Islamic finance.

For example, PLS financing shifts the direct credit risk from banks to their investment depositors. But it also increases the overall degree of risk of the asset side of banks’ balance sheets, because it makes Islamic banks vulnerable to risks normally borne by equity investors rather than holders of debt. Also, because of their compliance with the Islamic law, Islamic banks can use fewer risk-hedging techniques and instruments (such as derivatives and swaps) than conventional banks.

Moreover, most Islamic banks have operated in environments with less developed or non-existent interbank and money markets and government securities, and with limited availability of and access to lender-of-last-resort facilities operated by central banks. These differences have been reduced somewhat because of recent developments in Islamic money market instruments and Islamic lender-of-last-resort modes, and the implicit commitment to provide liquidity support to all banks during exceptional circumstances in most countries.

Less risky

In some ways, Islamic banks could be less risky than conventional banks. For example, Islamic banks are able to pass through a negative shock from the asset side (such as a worsened economic situation that causes lower cash flow from PLS transactions) to the investment depositors.

The risk-sharing arrangements on the deposit side thus arguably provide another layer of protection to the bank, in addition to its book capital. Also, it could be argued that the need to provide a stable and competitive return to investors, the shareholders’ responsibility for negligence or misconduct (operational risk) and the more difficult access to liquidity put pressures on Islamic banks to be more conservative.

Furthermore, because investors (depositors) share in the risks (and typically do not have deposit insurance), they have more incentive to exercise tight oversight over bank management. Finally, Islamic banks have traditionally held a larger proportion of their assets than commercial banks in reserve accounts with central banks or in correspondent accounts with other banks.

So, even if Islamic investments are more risky than conventional investments, from a financial stability perspective, the question is whether or not these higher risks are offset by bigger buffers.
Whether Islamic banks are more or less stable than conventional banks depends on the relative sizes of the effects discussed above, and it may in principle, differ from country to country and even bank to bank.

Islamic banks and financial stability

An increasingly popular way of assessing banks’ soundness is to analyze their so-called z-scores. The z-score combines a bank’s capitalisation, profitability, and a measure of risk faced by the bank into a single index. The interpretation of the Z-score is straightforward: the lower the score, the more likely it is that a bank will run out of capital.

Defining large banks as those with total assets of more than $1 billion and small banks as all others, the paper finds that:
• Small Islamic banks tend to be financially stronger (that is, have higher z-scores) than small and large commercial banks.

• Large commercial banks tend to be financially stronger than large Islamic banks, and
• Small Islamic banks tend to be financially stronger than large Islamic banks (see chart).
A plausible explanation for the contrast between the high stability in small Islamic banks and the relatively lower stability in larger entities is that it is significantly more complex for Islamic banks to adjust their credit risk monitoring system as they become bigger. For example, the PLS modes used by Islamic banks, are more diverse and more difficult to standardize than loans used by commercial banks.

As a result, as the scale of the banking operation grows, monitoring of credit risk becomes rapidly much more complex. That results in a greater prominence of problems relating to adverse selection and moral hazard. Another explanation is that small banks concentrate on low-risk investments and fee income, while large banks do more PLS business.

We also found that as the presence of Islamic banks grows in a country’s financial system, there is no significant impact on the soundness of other banks. This suggests that Islamic and commercial banks can coexist in the same system without substantial “crowding out” effects through competition and deteriorating soundness.

Sensitivity tests

These findings are subject to several caveats relating to the cross-country data. Databases often are incomplete in coverage of Islamic and commercial banks. Moreover, we focused only on full-fledged Islamic banks and did not cover Islamic branches operated by some commercial banks.

Data limitations also prevented the study from fully taking into account all aspects of Islamic financial contracts, for example, by distinguishing between PLS and other investments. Nonetheless, the main results are encouragingly robust with respect to a range of sensitivity tests, such as using different measures of financial soundness and different estimation methods.

Our findings underscore the importance of regulators paying attention to the prudential risks of Islamic banks, in particular those that are large. In addition, with the continuing above-average growth rates of Islamic finance, Islamic banks should invest into their credit risk management capabilities, as they are entering into more complex and larger projects.

(Vanguard, 26 May 08)

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