Friday, November 25, 2011

Islamic finance complexity (Part IIe)

After thinking a lot about how products are structured, I am moving onto some real-world breakdown in the actual balance sheet balances of some Islamic banks to translate the ideas of how they design their products into how they are actually represented in terms of the bank's liquidity profile.  To do so, I picked one country (the UAE) to limit the differences between banks caused by different countries, different regulatory environments, etc, and focused just on the "Liabilities" items in the balance sheet at one point in time (December 31, 2010 for all except for Ajman Bank, which only had annual financial statements through the end of 2009).

The liabilities section is, in rough form, broken into three categories of liabilities: deposits, inter-bank borrowings and other liabilities (e.g. longer term liabilities like sukuk).  In general, deposits made up the vast majority of the Islamic banks' liabilities that I looked at, ranging from 76% to 85%.  Within the deposits, there were a few main types (current accounts, savings accounts and investment accounts).  Most of the banks had just one type of investment account, which I am guessing is almost universally mudaraba-based profit-sharing accounts.  Two banks (Al Hilal Bank and Emirates Islamic Bank) which had another category of deposits, wakala.  The banks in general used "investment accounts" as their primary funding source, representing around 60% of total liabilities (three-quarters of the deposits), although this wasn't universal.

The real difference between the banks (only two banks offered this detailed breakdown, unfortunately) came with the maturity of the deposits.  Dubai Islamic Bank had more (about two-thirds) of deposits in short-maturity or demand deposits, while Al Hilal Bank had more mid-range (3-6 month) deposits (about one-half) compared with the remainder split between longer-term (>1 year) and short-term funding (<3 months).  The split between short- and longer-term deposits is more of a business decision, than it is something that goes to the heart of how Islamic banking differentiates itself .

However, with the limitations on Islamic deposit insurance, the maturity of deposits can be a factor in how resilient an Islamic bank is to future banking system problems (longer maturity giving more protection against runs on the bank becoming destabilizing). The offsetting factor (for the bank) is that longer-term deposits are more expensive than short-term deposits, and that will be true whether the bank is Islamic or not because in practice, deposit accounts are not entirely pass-through, and also must offer rates of return that are competitive with conventional banks.

The other two areas of liabilities on Islamic banks' balance sheets varied bank to bank to fill the remaining 15-25% of the liabilities with some having more in inter-bank financing while others had longer-term liabilities like sukuk or the Central Bank wakala financing that was provided to banks during the Dubai debt crisis.  However, in general, the larger the bank the less reliant on inter-bank financing, although the three largest banks (DIB, ADIB and Emirates Islamic Bank) all had wakala financing from the UAE Central Bank, which skews the relative shares.

Removing the wakala financing from the Central Bank (assuming it was replaced with inter-bank financing) removes the previous relationship between longer- and shorter-term other (non-deposit) liabilities between larger and smaller banks (the smaller banks being Sharjah Islamic Bank, Al Hilal Bank and Ajman Bank; Noor Islamic Bank does not put financial statements on its website).  The ratio of short term to the sum of short- and long-term non-deposit liabilities is the metric I looked at (moving wakala financing from long- to short-term) ranged from a low of 29% to a high of 87%.

The sample I chose was purposefully non-representative to try and limit the fluctuations due to country-specific factors, but a few trends emerge.  First, most banks have deposits as the largest source of their funding, which is probably good because it is lower cost than sukuk and less volatile than inter-bank financing.  The one exception to the stability of bank deposits is in a banking crisis and the UAE Central Bank did what central banks are supposed to do in a crisis: they lent freely on more costly terms than they normally would (the wakala is convertible into equity).

In the non-deposit liabilities, the wide range of splits between inter-bank financing (short-term) and longer-term financing like sukuk was mostly explained by the difference between banks that had sukuk outstanding and those that didn't.  The banks with sukuk outstanding had lower reliance on inter-bank financing than banks that did not issue sukuk.  This suggests that one way to mitigate the reliance of banks on short-term inter-bank financing is to further develop the sukuk market, especially finding structures that don't require physical assets, but can fund longer-term assets on the balance sheet with longer-term funding.

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