Thursday, October 06, 2011

Derivatives trading in Islamic banks

I was reading through an article from a few weeks ago from Reuters about Kuwaiti banks involvement in derivatives trade in a way that might put depositors' money at risk and which lies (as I read it) outside of the central bank's regulatory oversight.  The banks concerned are the National Bank of Kuwait and Kuwait Finance House. The former is a conventional bank that has an Islamic window, while the latter is an Islamic bank with a long track record in Islamic banking.  The statements from the banks were:
Bank 1: "[The bank] does not engage in any derivative trading at all and has no exposure whatsoever to these instruments"
Bank 2: "[The bank] is fully committed to the laws and regulations of the supervisory authorities and all the procedures governing banks, and has no dealings that violate or circumvent the supervision of the Central Bank of Kuwait"
Can you guess which bank is which?  I would imagine that most readers would pick Bank 1 as KFH because derivatives (in their conventional form) are not permissible, but most readers (and me to be perfectly honest) would be wrong.  Bank 1 is NBK.  The bank providing an evasively unspecific response was KFH. 

The Islamic finance industry has developed Shari'ah-compliant versions of derivative products, as they should, to deal with interest rate (profit rate) risk, currency fluctuations, commodity fluctuations, but the idea often given for why Islamic banks are better than conventional banks is that by the nature of the Shari'ah standards they adopt, they should be more transparent, and should adopt simpler products to perform their role as financial intermediaries. 

Regardless of whether KFH uses derivatives (they probably should be since they have operations in Kuwait, Turkey, Malaysia and elsewhere), statements like what KFH provided do nothing to provide outside observers such as this blog with any confidence that they are transparent in how they operate.  That more than anything is increasingly important when competing with a conventional financial industry that has lost the public's trust due to hidden liabilities. 

The well known financial commentator from the UK in the mid 1800s Walter Bagehot pointed out that when a bank is arguing over its solvency, it has already proven to the public that it is not solvent (and in the days before deposit insurance) this usually led to a run on the bank.  Today, while bank runs do happen, they are much less of a risk.  The issue at the heart of Bagehot's argument was that once a bank loses confidence of the market or its customers, it is impossible for it to convince people to restore that confidence.

In today's world of Islamic banking, the issue of confidence is much more concerned with the bank's reputation as an "ethical" institution.  There have been many examples of that confidence abused and punished (Gulf Finance House comes to mind).  KFH should not tread down the path where it cannot come out unequivocably and state that it either does not use derivatives (like NBK) or that, while it does use (Shari'ah-compliant) derivatives, these are done for the purpose of risk management and in full compliance with its regulatory requirements.  KFH took the third way of not acknowledging whether or not it uses derivatives but stating without clarification that it acts in compliance with regulatory requirements. 

This is the "trust us" path that asks for confidence without refuting the allegations against it.  In a climate where banks are suspect and Islamic banks try to keep above the fray by deferring to their "ethical" underpinnings, this is a risky strategy.  Evasion does not often win friends or confidence. 


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