Tuesday, November 02, 2010

IMF working paper on Islamic banks in the financial crisis

The IMF released a working paper by Maher Hasan and Jemma Dridi, titled: "The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study (Working Paper 10/201) in September 2010. The article is an econometric study of whether Islamic banks performed better than conventional banks during the credit crisis. It is an important topic because the standard line after the crisis began was that Islamic banks were inherently stable than conventional banks and, in the mind of a few commentators, even 'immune' to crisis.

I have long expressed the view that Islamic banks are no less exposed to financial crisis--including the recent one--based on the features unique to Islamic banking. In fact, from the very features touted as providing the 'buffer' (e.g. profit-sharing in deposit accounts and in contracts), the Islamic financial industry is more exposed to crisis than conventional banks. If banks were placed in a more 'equity' position with respects to the financing they provide, a fall in the value of the businesses they finance (from which their repayment comes in an equity-type structure) will decline by more than if the banks are debt-holders, as they generally are in conventional finance. On the other side, if depositors are forced to bear the losses, then Islamic banks could be less stable than conventional banks because they would be more vulnerable to a 'run' on the bank by depositors worried they will lose their money when the bank reveals the first signs of trouble. The run by depositors (that thing that deposit insurance is designed to stop by guaranteeing depositor's money, at least to a certain limit) could force the bank to sell in a fire sale its assets, which would result in greater losses to depositors and the bank's creditors than if it were liquidated in a more orderly process.

However, the industry of course does not operate along the back-to-back mudaraba that is described above. Islamic banks have generally tried to structure themselves as closely to conventional banks (for a number of reasons). The primary reasons are that the people running the bank have backgrounds in conventional banking and therefore adapt their experience in conventional banking and want to move away from conventional-type products only incrementally. The secondary reason is that almost all Islamic banks globally are regulated the same way as conventional banks and it would be difficult (if not impossible) for them to diverge significantly from the activities associated with 'banks' in the conventional sense. In the real world sense of Islamic banking, it would be logical that Islamic banks outperformed conventional banks primarily by not losing as much money as the conventional banks with exposure to the worst performing investments at the heart of the credit crisis.

The first set of results (looking at the change in bank profitability) did indeed find this. Islamic banks outperformed their conventional counterparts (accounting for country-level differences), particularly in 2008 compared with 2007 (the results were not as strong when comparing 2009 with 2007). The authors attribute this result to "the impact of the crisis [moved] to the real economy, [Islamic banks] in some countries faced larger losses compared to their conventional peers" (p. 17). For me, the reading of this is correct; conventional banks were more exposed to the investments that soured in the first year, while Islamic banks were less directly exposed, but saw their profitability dip by more during 2009, once the impact of the crisis spread to the real economy.

The alternative explanation is that their geographical exposure was more highly concentrated in the GCC than their conventional peers within the GCC and therefore the performance lag in 2009 compared to 2008 (both measured against 2007 levels was more of a factor of the lag between the crisis in the U.S. and Europe and its impacts on the GCC. In particular, the effect of the price of oil (which another paper found evidence was the driving force for the Islamic finance industry) may have had a greater impact on Islamic (versus conventional) bank performance. Because the price of oil did not peak until mid-2008, the effect of the price collapse would be less strong in 2008 with the background of collapsing prices of assets held only by conventional banks. In 2009, by contrast, the decline in asset prices held only by conventional banks had slowed or reversed, while oil prices remained low.

The authors run several other regressions using different variables with differing results (including the finding that larger Islamic banks performed better than smaller Islamic banks, in contrast to the findings of Cihak and Hesse (2009)). The findings of the paper were summarized by the authors: "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 weakness in risk management practices in some [Islamic banks] led to larger decline in profitability compared to [conventional banks] in 2009." (p. 33).

The conclusions of the empirical analysis are followed with an overview of the areas that Islamic finance can improve to increase its stability in future crises. These include "adherence to Shariah principles [precluding Islamic banks] from financing or investing in the kind of instruments that have adversely affected their conventional competitors", "the importance of neutral regulatory framework for [Islamic and conventional banks]", "strengthening risk management", "establishing large and well managed [Islamic banks] that can compete with existing banks", "higher solvency", "lending to the less affected consumer sector", "the importance of liquidity risks, and the need for efficient bank resolution framework", ensuring that "supervisory and legal infrastructure [...] remains relevant" and "greater convergence and harmonization of regulations and products".

All of these recommendations should be considered in the long-term development of an Islamic financial system that is as robust (if not more so) than the conventional system. There are some that are more relevant and more important than others. For example, liquidity management is a key area that is receiving some well deserved attention from the IFSB membership with the formation of the International Islamic Liquidity Management Corporation, as well as single-country initiatives. The efforts to make regulation of conventional and Islamic financial institutions equivalent is also the focus in several countries, including France and South Korea. The 'bigger is better' idea that is spreading through Islamic finance even as the 'too big to fail' problem is at the fore of the discussion in conventional banking may lead to an Islamic 'mega-bank' in Malaysia. This idea is of more debatable merit; there are certainly advantages to larger banks in some respects, but as Cihak and Hesse found, there may be greater challenges for Islamic banks to retain as high risk management standards as those institutions grow larger. Even in areas where I might question the recommendations by the authors, this is a valuable first step to apply rigorous econometric methods to the question of "Have Islamic Banks Outperformed Conventional Banks in the Crisis?" There should (and likely will) be more studies tackling this subject and refining the data and the methodology used.

No comments: