The impact of a run on an Egyptian Islamic bank

Bloomberg reports:

"Egypt’s banks may risk a surge in customer withdrawals when they open for business, placing them among companies worst hit by the nationwide uprising against President Hosni Mubarak."
[...]
"Central Bank Governor Farouk El-Okdah said in a telephone interview Jan. 29 that his bank has $36 billion in reserves, enough to accommodate investors should they wish to withdraw funds. His deputy, Hisham Ramez, said interbank lending “will function properly” when banks are reopened. He said the security situation will determine when that is possible."

"Asked about the risk of a bank run, Mohamed Barakat, chairman of state-run Banque Misr and head of the country’s banking association, said in a telephone interview that Egyptian lenders are “very liquid,” with average loan-to-deposit ratios of 53 percent."
[...]
"The Egyptian interbank offered rate, the rate banks charge to lend to each other, is at a 16-month high of 8.5 percent."

Despite what I thought, there are several Islamic banks operating in Egypt: Faisal Islamic Bank, Al Baraka Egypt (Al Ahram Bank) and Abu Dhabi Islamic Bank NBD (formerly National Bank for Development). Al Watany Bank of Egypt also has an Islamic window. There may be others as well, but it is at least present in Egypt and the risks of a run on the bank should concern those interested in Islamic banking around the world because it could provide a test of how resilient Islamic banks really are to crisis.

What I mean is that the Egyptian situation, which could be a fantastic opportunity for the Egyptian people, could expose a weakness within the Islamic banking industry if it is problematic. The main risk to any bank is that there is a run and the bank cannot meet depositor withdrawals with the cash available on hand. This forces the bank to raise cash from other means. In most cases, it can either get an inter-bank loan from another bank overnight that allows it to handle withdrawals. If other banks are hesitant to lend to a given bank because of fears of asset quality, then the bank will usually have access to an overnight borrowing facility with the central bank, which operates as the lender of last resort.

If neither of these options are available, the bank will have to try to raise funds by selling its assets, most of which (loans) are illiquid in the short run. It will have to take a loss on the sale to realize the cash it needs to meet withdrawals. If this continues and the bank sells enough assets at a discount to the value they are held on the balance sheet, the bank's equity will be negative (the value of assets minus liabilities) and it will become insolvent (having earlier only been illiquid). This is the fundamental danger in banking from a financial stability perspective. If enough banks face runs and have to sell assets, the run could become self-sustaining and contagious. Even a healthy bank facing a run can become insolvent.

The key for Islamic banks is that they are not able to take advantage of the inter-bank lending market, nor are they able to borrow from (or lend to) the central bank because those loans are interest-bearing. The only alternative is to find other banks (mostly Islamic banks) willing to extend Shari'ah-compliant, bilateral loans often using commodity murabaha. In a country like Egypt where the Islamic banking industry is a small portion of the total banking system, it does not create a systemic risk if Islamic banks fail, but it does matter a lot to the depositors of other Islamic banks in the country and globally. If there is the potential that a run on an Islamic bank will not be stopped by someone; whether that is a foreign bank, a multi-lateral bank like the Islamic Development Bank or the central bank of Egypt (through emergency measures), then it could hurt confidence in Islamic banks.

The loss of confidence is more than just a reputational hit and a hit on the egos of Islamic bankers. It would make it more difficult for Islamic banks to attract and retain depositors and it could raise the cost at which it can attract depositors. This would make the bank, all other things equal, less profitable (it makes profit of the spread between the return on invested funds and the cost of funds borrowed from depositors). Lower profitability will lower the attractiveness of Islamic banks to equity investors limiting their ability to increase capital through equity offerings (or at least increasing the dilution to current shareholders). It will lower the amount available to supplement capital as well as pay dividends to its shareholders.

Therefore, it is important that the Islamic banks in Egypt make it through the 'run' that is predicted if it materializes, not just for those banks' shareholders, but also for the Islamic banking industry. I have laid out the negative case (the "worst case"). This scenario also has an opportunity for Islamic banks; if Egyptian Islamic banks make it through the crisis unscathed, it will lower the perception of risk associated with Islamic banks in terms of their ability to meet high volumes of depositor withdrawals in a crisis. However, it remains to be seen which outcome materializes in Egypt. I'm watching; you should too.