Islamic finance complexity (Part IIf)

One of the ideas of Islamic banking that is most often repeated is that the Islamic banking system is based on profit-and-loss sharing products.  However, the theory and practice diverge significantly on this at least on the asset side of the balance sheet.  The liability side (e.g. deposits and equity) are done more along the lines of the theoretical model of mudaraba.  However, a recent working paper published by the IMF (pdf) found that the profit-and-loss sharing of Islamic banks did not translate into a significant difference in the profit rates paid on deposits.  

The study examined Malaysia and Turkey from 1997 to 2010, which included 2 crises (1997/98 for Malaysia, 2000/01 for Turkey, and 2008/09 for both).  This should provide some evidence that Islamic banks operate differently from conventional banks by not focusing exclusively on a smoother period, or a crisis period.  However, the results of the econometric tests showed that the deposit rates on Islamic and conventional deposits moved together and tests for causality showed a significant causality from conventional deposit rates to Islamic deposit rates, but did not find evidence of causality in the other direction.  The data used in the study were for 1-year deposits, although the authors indicate that tests using 1-month and 3-month deposit rates gave similar results. 

The authors of the study do not test to see why this relationship exists, but they do hypothesize on a few possible explanations.  One is that Islamic banks have to compete for deposits with conventional banks and therefore have to pay depositors competitive returns on their money in order to attract deposits.  This is accomplished in most Islamic banks by using Profit Equalization Reserve accounts that allow the bank to save up excess profits to cover shortfalls from the market rate of deposit interest/profits. 

Another explanation is that the profitability of an Islamic bank is determined, in large part, by the assets on its balance sheets.  Given that the products used by most Islamic banks are debt-based products like murabaha, ijara, and istisna’a, which generate returns that are benchmarked to LIBOR or another conventional interest rate benchmark, the profitability of the bank will be in large part based on interest rate movements.  

This explanation does make sense, but is less obvious an explanation because, while deposit rates do move in line with other interest rates, like LIBOR, there is not necessarily an automatic relationship between one and the other.  If the changes in Islamic bank deposit rates were driven by changes in rates on assets (e.g. LIBOR), the causality flowing from conventional  bank deposit interest rates to Islamic bank deposit profit rates would probably not be there.  Islamic banks as they work today should not have significant differences in the breakdown of their assets compared with conventional banks, so the transmission of changes in LIBOR to changes in deposit profit rates should not occur with a lag compared with conventional banks (there should not be causality from conventional rates to Islamic rates on deposits).  

The evidence, at least from this one study looking at just two countries, suggests that the more probable explanation is that Islamic banks manage their deposit profit rates using Profit Equalization Reserve accounts to follow conventional deposit interest rates.  The reason for this is relatively simple: if they offer lower rates, they will have trouble attracting deposits.  Alternatively, if the rates are highly variable, with some period where Islamic deposit account returns are significantly higher than conventional deposit rates, but also periods of significant underperformance, it will also discourage depositors from moving to Islamic banks because depositors are not likely concerned with the average deposit rate over a period of time alone, but want this return to be of lower variability.  

What are the lessons from this?  First, Islamic banks are not independent of conventional banks and (based on the data in this study) compete directly with conventional banks.  Second, Islamic banks do not operate based solely on the theoretical construct of profit-and-loss sharing, even on their liability side.  As long as this relationship continues to hold--and there are valid consumer demands that Islamic banks must meet, and regulatory environments which make Islamic banks look like "banks"--the idea that Islamic banks are more resilient or even somehow unique in their response to economic changes should be dismissed.  There may be areas where they could be, but even on the side of the balance sheet where profit-and-loss sharing is at least theoretically entrenched, the data shows a strong relationship between Islamic banks and their conventional competitors.  

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html