Friday, April 30, 2010

The Myth of Immunity in Islamic Finance

A book review in the Asia Times describes how the book being reviewed contains insights on the Islamic financial system and its inherent stability. While I cannot dispute that the authors have great credibility, I do believe that the book review's claims are not accurate in describing the Islamic financial system. I would welcome if the publisher sent me a copy of the book to review and post my own review. Because I have not read the book, I will limit my criticism specifically to the review.

I will present my comments after short quotes from the book review:
"Certainly Islamic finance and banking institutions are thriving relative to conventional finance. The Banker's 2009 survey of Islamic finance found the volume of sharia-compliant assets of the Top 500 grew by an extremely healthy 28.6%, rising to US$822 billion from $639 billion, in 2008 (forecasts are that this figure will top $1 trillion in 2010)."

I don't know whether the statistics on the size of the industry are accurate and I would not be comfortable myself relying on statistics of growth down to the tenth of a percent when the industry has been described often has having a size of $750 billion or $1 trillion for several years with growth rates usually quoted at 15% to 20%. The vagaries of the statistics, in my opinion, mean that there is really no data on the true size of the industry globally.
"Advocates claim Islamic finance has been immune because sharia-compliant institutions are focused on the fundamentals, with simple products bearing robust mechanisms for risk mitigation. Market analysts have stressed the correlation between asset quality in Islamic institutions and their conservative approach to risk as an insulating factor."

While I consider myself an advocate for Islamic finance, the idea that Islamic finance is immune from anything related to economic downturns is flatly wrong. It would contradict even the theoretical claims that the industry for it to be immune from economic downturn affecting its customers. If the industry were 100% profit-and-loss sharing, it would suffer a downturn comparable to the rest of the economy, depending upon the underlying leverage of the financial institutions. Even with ijara and murabaha making up most of the financing available, Islamic finance will still be susceptible to downturns through rising default rates and asset value depreciation.
"Many conventional bankers contend the success of Islamic finance in riding out the financial storm can be attributed to the fact it is underpinned by tangible assets such as real estate."

This, in my mind, has been completely disproven by the near-deafult of Nakheel, which relied almost entirely upon rising property values for its solvency and used sukuk to fund a large portion of its projects (and to add leverage). Besides Nakheel, many Islamic financial institutions suffered greatly when the Dubai real estate boom turned to a bust, whether they were conventional or Islamic.
"First, credit losses from debt default to the depreciation of assets may create a large divergence in relation to the liabilities that remain fixed in nominal value."
This is true in Islamic finance as in conventional finance. Even institutions that use Shari'ah-compliant debt financing retain the same economic characteristics as conventional finance. Those that use profit-and-loss sharing financing may be somewhat insulated from the fixed liabilities side, but the sukuk are typically structured to protect the creditors from a decline in the assets on which the sukuk is based or backed.
"Second, bank credit has no fixed relation to real capital in the economy and bears no direct relation to the real rate of return."

The rate of return in LIBOR or other interest rate benchmarks are affected by changes in the economy and Islamic financial products typically use these benchmarks to price Islamic financial products because the benchmarks provide guidance on the risk-return trade-off as viewed by creditors in the market.
"Third, banks caught in a credit freeze, with a drying up of liquidity. may default on their payments."

With fewer methods of liquidity management and no lender of last resort, Islamic financial institutions are more--not less--vulnerable to liquidity-driven crises.
"Fourth, banks are fully interconnected with each other through a complex debt structure; in particular, the assets of one bank instantaneously become liabilities of another, leading to fast credit multiplication. A credit crash causes a dramatic contagion and a domino effect that may impair even the soundest banks. "

With fewer Islamic banks offering the large majority of sukuk (at least prior to the AAOIFI ruling which restricted the issuance of mudaraba and musharaka sukuk), there is more counterparty risk to Islamic financial institutions. There are fewer issuers which leads to each issuer having a greater spillover effect on other banks' balance sheets if they were to fail or have their solvency questioned.
"In an economy governed by the principles of Islamic finance, the rate of return on equities is determined by the marginal efficiency of capital and time preference, and is positive in a growing economy. This implies that Islamic banks are always profitable provided that real economic growth is positive. "

As I mentioned above, interest rates are determined so that they represent the balance between the needs of recipients of capital and the providers of capital, incorporating the rate of return of the funds used (which affects the probability of repayment), as well as the risk-return ratio on the debt itself (the return balanced against the probability of default). Islamic financial institutions can make bad investments just like conventional financial institutions and can lose money even when economic growth is positive.
"A critical feature noted by the authors, and one consistent with the Austrian ideal for banking, is the fact that the Islamic system operates on a 100% reserve requirement. In this system, investment banking operates on a risk/profit sharing basis, with an overall rate of return that is positive and determined by the real economic growth rate."

Islamic finance is not based on 100% reserve requirements. An increase of $1 in equity or deposits is met with a larger expansion of assets by an Islamic bank through the use of debt-financing through sukuk issue. Also, nothing guarantees that any investment, whether financed using a risk/profit sharing method or not, will be profitable. The closer the asset side of an Islamic financial institution is to risk-sharing, the closer its profitability will be to an equity investment. The return on these investments--and stock markets or economic growth can be used as a proxy for the rate of return--can and often are negative.

While these criticisms are rather harsh, I do still believe Islamic finance can provide a positive example to the financial system. Limits on leverage will on their own make a financial system more stable because of the magnifying impact of leverage on returns, both positive and negative. There remain, however, many issues that Islamic finance as an industry needs to deal with to become fully mature so it has at least an equivalent risk management system including liquidity management and finding an Islamic way to provide lender of last resort financing, as well as Shari'ah-compliant hedging. The Islamic banking industry in particular has demonstrated the ability to be profitable and sustainable while adhering to Islamic ethics. Even as the financial system globally was on the verge of melting down, many Islamic financial institutions were able to weather the storms through a conservative approach to risk and high levels of liquidity (in part due to a lack of lender of last resort and adequate liquidity management tools). That is not to say that they remained profitable: many did not. However, they were able to remain in business and live another day even as banks that had been around for decades collapsed. As economies and financial systems recover, Islamic financial institutions will once again move in to the black, but they should not adopt the complacent attitude that by virtue of their Islamic nature they are immune from future downturns.


Anonymous said...


Great article. I have been an Islamic finance lawyer for the past 5 years. The continuous claim that Islamic banks are better isolated / more profitable than conventional banks might hold true when asset values are increasing (because of the equity type returns you point out) but definitely not in times of recession. One of the problems with Islamic finance (which is only now being dealt with) is that the industry's explosive growth coincided with one of the world's best growth periods i.e. between 2002 and 2008. Unfortunately many commentators still attribute Islamic finance with qualities it had during these halcyon days, rather than the more sober reality of where the industry is today. (The exception to the above is the fact that Islamic banks are prohibited from investing in conventional-type derivatives, such as the RMBS CDOs that initiated the credit crisis, and this is definitely one advantage to Islamic banking over conventional banking).

The book's claim that Islamic banking is based on 100% reserve requirement is wholly inaccurate. Islamic banking is fractional banking, just like conventional banking. (Interestingly, some conventional economists are advocating a return to the gold standard whereby fiat currencies would be "backed" by an "asset". Ignoring the fact that gold is the asset in question (which is not great from a Shariah perspective), was the gold standard actually closer to the ideals of Islamic banking than the current fiat system?)

On a slightly separate note, do you have a view on whether Islamic depositors should be protected by FDIC or equivalent bank deposit schemes? Not much has been written about this, but my take is that Islamic depositors are investing in mudaraba or wakala accounts where the return on their account is equity-based i.e. dependent on the underlying performance of their bank. Thus, if the banks' investments make a loss, under Shariah the depositors should lose their money. However, if I am not mistaken, I think that in the US and UK the central bank won't actually allow Islamic banks to be exempt from this regulatory requirement, irrespective of the Shariah beliefs of individual investors. (The exception to this is depositors who deposit on a wadia (i.e. "trust") basis, whose capital is in fact protected).

Blake Goud said...

I agree with your point that the reference period for Islamic banks' performance was during a period in which economies were growing and financial institutions (in particular) were very profitable.

The way Islamic finance operates, however, I don't know whether the Islamic banks were more profitable in these conditions. As I am sure you know, Islamic banks use ijara and murabaha more than the equity-based products (and that is a commercial decision by the banks that makes sense given the difficulty in managing excess liquidity without fearing a liquidity crunch that would be severely detrimental in the absense of a lender of last resort. There are also additional structuring costs that may lower profitability as well. Some of these costs may be passed on to consumers, but with Islamic banks trying to be cost competitive with conventional banks, some of these are likely to be absorbed by the banks, reducing their profitability.

The issue of deposit insurance (and more generally the issue of deposits being at risk) is difficult. On the one hand, the conventional deposit insurance is clearly not permissible (although it may be allowed in cases of necessity; banks in the US and UK have not been allowed to forego deposit insurance).

However, there are ways to make the deposit insurance unnecessary even if it is statutorily required or required by regulators. The bank will still have to pa y premiums into the deposit insurance fund, but except in cases where the institution fails, the customers will not be receiving any funds from the deposit insurance. Using a mudaraba or wakala deposit structure, most Islamic banks set up reserve accounts and essentially provide additional reserves to protect the depositors ahead of the shareholders to make a loss of principal unlikely except in cases where the bank fails. With no experience of an Islamic bank failing where the deposits were protected by deposit insurance, we can't know what the outcome would be. However, the presence of deposit insurance will make runs on banks much less likely, which will increase the financial system's stability, a great public benefit. As the FDIC will tell you, since it was established, not one dollar of depositors' money has been lost.

The FDIC insurance system where the FDIC holds premiums to make deposits whole is easily adaptable, I would think, to a takaful system so long as the premium income were contributed (and surplus owned) by the banks with an institution running it receiving a fee for managing the fund (the FDIC is invested in US Treasuries, so that would have to be changed as well). The other change would be any advances from the US Treasury to the FDIC would have to be restructured to not be interest-bearing loans.