Since the global financial crisis started to unfold in 2008, there have been several reports suggesting that Islamic banks have been less affected by the crisis because they are not allowed for ethical reasons to invest in the pernicious derivatives such as CDOs (credit default obligations) that precipitated the worst crisis the world has seen since the Great Depression in the 1930s. Such reports have largely been based on oversimplified assumptions about Islamic finance and in a few instances on an emotional attachment based more on religiosity than on dispassionate non-descriptive empirical analysis.
Now the International Monetary Fund (IMF) this month published a working paper titled "The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study" in which the authors Maher Hasan and Jemma Dridi conclude and confirm that in general Islamic banks fared better than conventional banks during the global financial crisis, although they warn that such comparisons are subject to a motley of caveats and should not be over-simplified.
"Comparing the performance of Islamic banks to conventional banks globally," explained the authors, "would suggest that Islamic banks performed better, given the large losses incurred by conventional banks in Europe and the US as a result of the crisis. However, such a comparison would not lead to reliable conclusions about financial stability and the resilience of the Islamic banking sector because it would not allow for appropriate control for varying conditions across financial systems in countries where Islamic banks operate. For example, this comparison might not reflect the moderate impact of the crisis on the GCC, Jordan, and Malaysia."
Given that the impact of the crisis is still unfolding, the authors also stress that their conclusions should be considered provisional.
How accurate the paper is depends on the data collection methodology, the reliability of the sources, and the abstract assumptions. There are some shortcomings in this respect. For instance, the information would have been much more reliable to extract from official data from central banks, all of whose countries are members of the IMF, as opposed to commercial outlets such as Zawya, whose criteria and classification can sometimes fall short of expected standards, simply because it does not have privileged access to the sources of data and information.
There is also a strong case not to lump all regions as if Islamic finance were a global homogenous industry. It is not as the variations in practice suggests. The study could have been more useful had it being done on a regional basis, given the huge disparities in regulatory, supervisory and legal infrastructure and quality; in market size; Shariah governance processes and market education and awareness. Malaysia in this respect is light years ahead in terms of a holistic systemic approach. It could have been more meaningful to see how Malaysian Islamic banks fared with their conventional counterparts because the playing field is perhaps the most level compared to other markets in the GCC (Gulf Cooperation Council), Turkey etc. The Malaysian experience could have served as a microcosm for others to emulate or to learn from.
Nevertheless, Islamic finance is one of the fastest growing segments in global financial services and has become systemically important in many markets and too big to ignore in others. While conventional intermediation is largely debt-based and allows for risk transfer, Islamic intermediation, in contrast, is asset-based, and centers on risk sharing.
"In addition to providing Islamic banks with additional buffers," explains the paper, "these features make their activities more closely related to the real economy and tend to reduce their contribution to excesses and bubbles. Our analysis suggests that Islamic banks fared differently than did conventional banks during the global financial crisis. Factors related to Islamic banks' business model helped contain the adverse impact on profitability in 2008, while weaknesses in risk management practices in some Islamic banks led to a larger decline in profitability compared to conventional banks in 2009. In particular, adherence to Shariah principles precluded Islamic banks from financing or investing in the kind of instruments that have adversely affected their conventional competitors and triggered the global financial crisis."
So what was the actual impact of the crisis as shown by the data and the analysis? In terms of four key indicators, namely, profitability; bank lending; bank assets; and bank ratings, the conclusions were interesting rather than dramatic.
In terms of profitability, in 2008, Islamic banks fared better than their conventional counterparts in all countries, except Qatar, the UAE, and Malaysia. In Saudi Arabia, offshore Bahrain, Jordan, and Turkey, the change in profitability was significantly more favorable for Islamic banks (the difference in the weighted average change in profitability was statistically significant).
The picture, however, was reversed in 2009, with Islamic banks faring clearly worse in three countries especially Bahrain and the UAE, where the profitability of such banks declined significantly more than those of conventional counterparts, while in Qatar the increase in Islamic banks' profitability was significantly lower than that of conventional banks.
A comparison of the cumulative impact of the average profitability in 2008 and 2009 to its 2007 level, says the IMF paper, shows that Islamic banks did fare better in all countries, except Bahrain, Qatar, and the UAE. In offshore Bahrain, Jordan, Saudi Arabia, and Turkey, Islamic banks outperformed their conventional counterparts significantly in terms of profitability.
The reasons are that in 2008 Islamic banks' profitability was affected to a limited extent by the impact of the crisis, but as it started to affect the real economy in 2009, Islamic banks in some countries faced larger losses compared to their conventional peers because of the very nature of their business which involves greater risk taking.
The allied impact of the crisis was the credit crunch with banks in general starving households and businesses of lending. To their credit, Islamic banks have maintained stronger credit growth compared to conventional banks in almost in all countries in all years, thus according to the IMF paper, suggesting the market share of Islamic banks is likely to continue to increase going forward and that they contributed more to macro stability by making more credit available.
"While international experience shows that strong credit growth was usually followed by a large decline in credit, this was not the case for Islamic banks. However, very high credit growth rate could be at the expense of strong underwriting standards. Hence, supervisors should monitor very high credit growth in Islamic banks as well as in conventional banks," it urged.
Similarly, Islamic banks maintained stronger asset growth compared to conventional banks in almost all countries, growing on average more than twice that of conventional banks during 2007-09. This strong asset growth once again indicates that the market share of Islamic banks is likely to continue to increase going forward, and that they were less affected by deleveraging. In general, although the deceleration of Islamic banks' asset growth in some countries such as Bahrain has been faster due to their weaker performance in 2009, and the fact that liquidity support in the form of government deposits is easier to be directed to conventional banks given the easiness of auctioning government deposits to such banks.
Islamic banks, with the exception of those in the UAE, were assigned more favorable or similar ratings to that of conventional banks over the last two years. "In Qatar and Saudi Arabia," added the IMF paper, "the financial crisis did not change rating agencies' views about the capacity of banks to meet their long-term obligations. This in part reflects the support that banks could receive from the public sector. The fact that almost all Islamic banks in Malaysia are subsidiaries of conventional banks explains the absence of an independent rating for Islamic banks in this case."
Of course the authors did not consider the criteria whereby rating agencies assign ratings to Islamic banks compared with conventional banks. This, despite the fact, that Islamic banks have specificities and characteristics which are unique to them. Indeed the role and reporting failure of rating agencies in the subprime crisis is just as significant as a contributory factor as the behavior and mindset of some of the bankers.
The crisis, according to the IMF paper, also highlighted a number of sector-specific challenges that need to be addressed in order for Islamic banks to continue growing at a sustainable pace. They include the infrastructure and tools for liquidity risk management, which remains underdeveloped in many jurisdictions and which relate to a shallow money market due to the small number of participants and the absence of instruments that could be used as collateral for borrowing or could be discounted (sold) at the central bank discount window.
Indeed, the authors warn that the strengthening of liquidity management as a key part of the global reform agenda in Islamic finance is paramount.
The other challenges in clued a legal framework, which is incomplete or untested; the lack of harmonized contracts; and insufficient expertise (at the supervisory and industry levels) relative to the industry.
The impact of the proposed Basel III requirement to maintain sufficient cushion of high quality liquid assets, say the authors, needs to be carefully considered, as the infrastructure and tools for liquidity risk management by Islamic banks is still in its infancy in many jurisdictions.
The crisis also underscored the importance of appropriate institutional arrangements for the resolution of troubled financial institutions. This is even more relevant for Islamic banks, given the absence of precedents.
The previous challenges serve as a reminder that expertise in Islamic finance has not kept pace with the rapid growth of the industry. The human capital challenge is dire given that Islamic bankers need to be familiar with conventional finance and be versed on the different aspects of Shariah, particularly on the Islamic law of transactions.
Such a requirement is becoming essential given the increasing degree of sophistication of Islamic financial products. But as the IMF paper points out, professionals with this dual qualification are hard to find, although the number of newcomers in Islamic finance is steadily growing. Not surprisingly, the shortage of specialists also has an impact on product innovation, and could hinder the effective management of risks relevant to the industry, including the lack of instruments to hedge against the volatility in currency and commodity markets and the relatively higher liquidity, legal, and reputational risks.
By MUSHTAK PARKER | ARAB NEWS
Source : http://arabnews.com/economy/islamicfinance/article142384.ece - Sept 19, 2010
"Comparing the performance of Islamic banks to conventional banks globally," explained the authors, "would suggest that Islamic banks performed better, given the large losses incurred by conventional banks in Europe and the US as a result of the crisis. However, such a comparison would not lead to reliable conclusions about financial stability and the resilience of the Islamic banking sector because it would not allow for appropriate control for varying conditions across financial systems in countries where Islamic banks operate. For example, this comparison might not reflect the moderate impact of the crisis on the GCC, Jordan, and Malaysia."
Given that the impact of the crisis is still unfolding, the authors also stress that their conclusions should be considered provisional.
How accurate the paper is depends on the data collection methodology, the reliability of the sources, and the abstract assumptions. There are some shortcomings in this respect. For instance, the information would have been much more reliable to extract from official data from central banks, all of whose countries are members of the IMF, as opposed to commercial outlets such as Zawya, whose criteria and classification can sometimes fall short of expected standards, simply because it does not have privileged access to the sources of data and information.
There is also a strong case not to lump all regions as if Islamic finance were a global homogenous industry. It is not as the variations in practice suggests. The study could have been more useful had it being done on a regional basis, given the huge disparities in regulatory, supervisory and legal infrastructure and quality; in market size; Shariah governance processes and market education and awareness. Malaysia in this respect is light years ahead in terms of a holistic systemic approach. It could have been more meaningful to see how Malaysian Islamic banks fared with their conventional counterparts because the playing field is perhaps the most level compared to other markets in the GCC (Gulf Cooperation Council), Turkey etc. The Malaysian experience could have served as a microcosm for others to emulate or to learn from.
Nevertheless, Islamic finance is one of the fastest growing segments in global financial services and has become systemically important in many markets and too big to ignore in others. While conventional intermediation is largely debt-based and allows for risk transfer, Islamic intermediation, in contrast, is asset-based, and centers on risk sharing.
"In addition to providing Islamic banks with additional buffers," explains the paper, "these features make their activities more closely related to the real economy and tend to reduce their contribution to excesses and bubbles. Our analysis suggests that Islamic banks fared differently than did conventional banks during the global financial crisis. Factors related to Islamic banks' business model helped contain the adverse impact on profitability in 2008, while weaknesses in risk management practices in some Islamic banks led to a larger decline in profitability compared to conventional banks in 2009. In particular, adherence to Shariah principles precluded Islamic banks from financing or investing in the kind of instruments that have adversely affected their conventional competitors and triggered the global financial crisis."
So what was the actual impact of the crisis as shown by the data and the analysis? In terms of four key indicators, namely, profitability; bank lending; bank assets; and bank ratings, the conclusions were interesting rather than dramatic.
In terms of profitability, in 2008, Islamic banks fared better than their conventional counterparts in all countries, except Qatar, the UAE, and Malaysia. In Saudi Arabia, offshore Bahrain, Jordan, and Turkey, the change in profitability was significantly more favorable for Islamic banks (the difference in the weighted average change in profitability was statistically significant).
The picture, however, was reversed in 2009, with Islamic banks faring clearly worse in three countries especially Bahrain and the UAE, where the profitability of such banks declined significantly more than those of conventional counterparts, while in Qatar the increase in Islamic banks' profitability was significantly lower than that of conventional banks.
A comparison of the cumulative impact of the average profitability in 2008 and 2009 to its 2007 level, says the IMF paper, shows that Islamic banks did fare better in all countries, except Bahrain, Qatar, and the UAE. In offshore Bahrain, Jordan, Saudi Arabia, and Turkey, Islamic banks outperformed their conventional counterparts significantly in terms of profitability.
The reasons are that in 2008 Islamic banks' profitability was affected to a limited extent by the impact of the crisis, but as it started to affect the real economy in 2009, Islamic banks in some countries faced larger losses compared to their conventional peers because of the very nature of their business which involves greater risk taking.
The allied impact of the crisis was the credit crunch with banks in general starving households and businesses of lending. To their credit, Islamic banks have maintained stronger credit growth compared to conventional banks in almost in all countries in all years, thus according to the IMF paper, suggesting the market share of Islamic banks is likely to continue to increase going forward and that they contributed more to macro stability by making more credit available.
"While international experience shows that strong credit growth was usually followed by a large decline in credit, this was not the case for Islamic banks. However, very high credit growth rate could be at the expense of strong underwriting standards. Hence, supervisors should monitor very high credit growth in Islamic banks as well as in conventional banks," it urged.
Similarly, Islamic banks maintained stronger asset growth compared to conventional banks in almost all countries, growing on average more than twice that of conventional banks during 2007-09. This strong asset growth once again indicates that the market share of Islamic banks is likely to continue to increase going forward, and that they were less affected by deleveraging. In general, although the deceleration of Islamic banks' asset growth in some countries such as Bahrain has been faster due to their weaker performance in 2009, and the fact that liquidity support in the form of government deposits is easier to be directed to conventional banks given the easiness of auctioning government deposits to such banks.
Islamic banks, with the exception of those in the UAE, were assigned more favorable or similar ratings to that of conventional banks over the last two years. "In Qatar and Saudi Arabia," added the IMF paper, "the financial crisis did not change rating agencies' views about the capacity of banks to meet their long-term obligations. This in part reflects the support that banks could receive from the public sector. The fact that almost all Islamic banks in Malaysia are subsidiaries of conventional banks explains the absence of an independent rating for Islamic banks in this case."
Of course the authors did not consider the criteria whereby rating agencies assign ratings to Islamic banks compared with conventional banks. This, despite the fact, that Islamic banks have specificities and characteristics which are unique to them. Indeed the role and reporting failure of rating agencies in the subprime crisis is just as significant as a contributory factor as the behavior and mindset of some of the bankers.
The crisis, according to the IMF paper, also highlighted a number of sector-specific challenges that need to be addressed in order for Islamic banks to continue growing at a sustainable pace. They include the infrastructure and tools for liquidity risk management, which remains underdeveloped in many jurisdictions and which relate to a shallow money market due to the small number of participants and the absence of instruments that could be used as collateral for borrowing or could be discounted (sold) at the central bank discount window.
Indeed, the authors warn that the strengthening of liquidity management as a key part of the global reform agenda in Islamic finance is paramount.
The other challenges in clued a legal framework, which is incomplete or untested; the lack of harmonized contracts; and insufficient expertise (at the supervisory and industry levels) relative to the industry.
The impact of the proposed Basel III requirement to maintain sufficient cushion of high quality liquid assets, say the authors, needs to be carefully considered, as the infrastructure and tools for liquidity risk management by Islamic banks is still in its infancy in many jurisdictions.
The crisis also underscored the importance of appropriate institutional arrangements for the resolution of troubled financial institutions. This is even more relevant for Islamic banks, given the absence of precedents.
The previous challenges serve as a reminder that expertise in Islamic finance has not kept pace with the rapid growth of the industry. The human capital challenge is dire given that Islamic bankers need to be familiar with conventional finance and be versed on the different aspects of Shariah, particularly on the Islamic law of transactions.
Such a requirement is becoming essential given the increasing degree of sophistication of Islamic financial products. But as the IMF paper points out, professionals with this dual qualification are hard to find, although the number of newcomers in Islamic finance is steadily growing. Not surprisingly, the shortage of specialists also has an impact on product innovation, and could hinder the effective management of risks relevant to the industry, including the lack of instruments to hedge against the volatility in currency and commodity markets and the relatively higher liquidity, legal, and reputational risks.
By MUSHTAK PARKER | ARAB NEWS
Source : http://arabnews.com/economy/islamicfinance/article142384.ece - Sept 19, 2010
