S&P report summary (part 2)

In an earlier post, I began a summary of the Standard & Poor's Islamic Finance Outlook 2009 and I want to continue the analysis with a more in depth look at one of the main liquidity risks that is particular to Islamic banks: the use of profit-sharing investment accounts. The idea of profit-sharing deposit accounts instead of traditional interest-bearing deposit accounts goes back to the early conceptions of Islamic banks where they operated raising funds from depositors under a mudaraba arrangement (acting as the mudarib, the manager of the funds). In this arrangement, deposits would be invested on behalf of depositors and profits would be shared between the Islamic bank and the depositors but losses would be borne exclusively by depositors (as the rabb ul-mal, the provider of capital).

This ran into two primary problems. First, there was an informational (and incentive) asymmetry causing a principal-agent problem between the depositors. The depositors prefer greater stability over higher returns because they bear any losses whereas the bank benefits from the sharing of any profits but are not on the hook for losses. Second, absent a solution to the principal-agent problem, Islamic banks have a competitive disadvantage vis-a-vis conventional banks who are more than willing to accept deposits from clients who refuse to accept any interest.

In order to be competitive with conventional banks while still adhering to the mudaraba style deposit, Islamic banks developed several safeguards to protect depositors against losses of principal. Standard & Poor's describes these:

• "Profit equalization reserves (PERs): These reserves constituted by IFIs can be used to smooth returns offered to PSIA holders in cases of reduced distributable cash flows. For instance, if an Islamic bank realizes an effective profit that is not sufficient to offer its PSIA holders a satisfactory return, it could use part or all of its PER to boost the return and maintain its deposit base. PERs are deducted from a bank’s gross profit before allocating the mudarib fee.
  
• "Mudarib fee: This is the remuneration of the bank for acting as a manager (mudarib) of PSIAs. The mudarib fee is not fixed and differs from one bank to another, but is typically between 20% and 40% of the distributable cash flows. This can provide a bank with some room for maneuver in case of unexpected profitability deterioration; it could simply decide to waive its fee, allowing a higher remuneration to PSIA holders.
  
• "Investment risk reserves: These are reserves constituted by IFIs in order to curb the risk of future unexpected losses and enable them to be in a position to support PSIA holders should such losses occur. IRRs are set aside by IFIs after allocating the mudarib fee.
  
• "Liquidity: IFIs offering PSIAs are in general more liquid than conventional banks as they are aware that their reliance on PSIAs could trigger liquidity stress. The average liquid-to-total assets ratio for GCC-based IFIs rated by Standard & Poor’s was 30% at midyear 2007, compared with 18.1% for GCC-based conventional peers. This extra liquidity has a negative impact on profitability, however. Some leading Islamic banks have a portfolio of assets that can be repoed with their central bank.
  

Profit equalization reserves. Profit equalization reserves offer the first cushion between an Islamic bank's asset performance (funded by deposits) and depositor returns. When returns are above the level needed to meet the competitive rate, additional profits are put aside into the PERs. If the bank's investments returns falls below the level needed to offer a competitive rate for depositors, the PER can be tapped to make up the shortfall.

Investment risk reserves: These are essentially an additional buffer for depositors that are set aside from depositor returns (e.g. after the mudarib fee is taken) out of profits that would otherwise flow to depositors. Their presence adds protection to depositors, but at the same time, because they are taken from the depositor share of profits, lower returns for depositors. This smoothing of paid-out returns to depositors is used to make the deposit base more stable. Without the smoothing, depositors could move their deposits between banks in search of the current highest return. If this happened, it would undermine all Islamic banks' returns because they would either face liquidity shortages (forcing them into sales of assets at fire sale prices) or more likely, they would hold additional assets in low- or no-yielding assets which would reduce their overall profitability and therefore limit their ability to generate returns for depositors.

Mudararib fee: In exchange for managing mudaraba deposit accounts, Islamic banks receive a share of any profits. In cases where the investment risk reserves and PERs are depleted or are in danger of being depleted, Islamic banks reduce the share of profits they take in order to preserve the other buffers. This functions the same way for depositors as the PERs and the investment risk reserves but the funds come from a different source. This helps Islamic banks maintain their deposit base but come at the expense of shareholders instead of out of depositors' retained profits in the investment risk reserves and PERs.

Liquidity: This is the most similar to conventional banking (especially in situations where deposit insurance is absent). In order to meet depositor withdrawals and stem any potential runs on the bank, all banks are required to hold liquid assets. However, because the mudaraba deposits are not insured and because there are limited sources of external liquidity for Islamic banks because they cannot turn to conventional inter-bank money markets, this liquidity buffer is significantly larger for Islamic banks than for conventional banks (30% versus 18% in the GCC).

Overall, the goal of all four buffers is to attract and retain depositors at competitive rates. Another way to think about it is in terms of the flows of money within a bank as it collects deposits, invests them and pays out profits to depositors and shareholders.

Depositor funds are invested by the bank and expect a return that is equal to the rate of return they could receive from a conventional bank. The bank takes the deposit and invests it in assets that have a higher average return than the market rate paid on depositor accounts, but this return can fluctuate. In the good times, the deposited money generates profits that exceed the return expected by depositors by more than the mudarib fee. Some of these profits are placed into the profit equalization reserve account. The remainder is divided between the depositors and the bank (through its mudarib fee). The expected return is paid to depositors and the remainder is placed into the investment risk reserve account. This happens every month (or year) while profits are healthy enough to afford it. If in one month or year, profits leftover for depositors fall short of the expected depositor return, the difference is made up from the investment risk reserve account (depositors' retained profits). If this is not sufficient, it is supplemented out of the PERs (retained profits, some of which is depositors', some is the bank's retained mudarib fee). If the PER is not sufficient, then mudarib fees are cut in order to make up the difference (shareholders' retained profits). If all sources of retained depositor investment profits are exhausted, the bank has run into trouble and depositors will receive less than their expected rate of return. If depositors remove their funds en masse, the bank will have to draw from its liquid assets to meet withdrawals to avoid selling assets at distressed prices. Without a sufficient liquidity buffer, the bank could be forced into distressed asset sales which would constitute a crisis and could, depending on the price at which they can sell assets, precipitate insolvency.