Islamic finance complexity (Part IIg)

I have covered the structure of the liabilities section of the Islamic bank's balance sheet in earlier posts, and I plan to return to the liabilities in the context of its interaction with the income statement and the maturity mismatch that is a function of banking.  However, that is best done with reference to the asset side of a bank's balance sheet because the income statement deals both with the income earned on assets and the costs of funding the assets.  Therefore, I am going to move onto the asset side to describe the 'stocks' of the asset (the maturity mismatch and the income/expense are included in the 'flows' arising from the 'stocks' of assets and liabilities).

Before going into the asset side of the balance sheet, I want to reiterate that this whole Islamic finance complexity series (maybe I should have come up with a better title for the series) of blog posts is a thought exercise to come up with interesting areas of how Islamic finacne works that are not always part of the day-to-day discussion of how Islamic finance works in practice.  Most of what is out there is either new products offered by Islamic finance institutions, the financial results of their activities or theoretical discussions of how Islamic finance should operate, or why it is 'superior' to conventional finance.  There is definitely a place for new developments and discussions of how the industry should operate, but I have found that the latter is done in generalities (including within a lot of my own writing).

Apologies in advance if my in depth discussion becomes dull or is too simplistic, but I think that if a discussion of the Islamic finance industry (and an analysis of how it has diverged from what it is 'supposed to be') is to be undertaken in a comprehensive way, it has to be a bit dull at points and include a simplistic analysis of the data that is put out about Islamic banks, which are largely contained in financial statements.  However, I hope that there is some value in the insights that come out of this analysis.  As always, I welcome comments on the blog posts or by email at blake@sharingrisk.org.

Moving into the balance sheet, there are a number of categories of assets held by Islamic banks and for a sampling, I delved into the balance sheet of a large UAE-based Islamic bank to provide a set of assets to go through.  It's not important which Islamic bank was selected, because the focus should be on the types of the assets on the balance sheet.

The assets can be divided into a few categories:

• Cash
• Inter-bank lending
• Islamic financing and investment
• Investments
• Receivables
• Property, plant & equipment
• Goodwill

Cash

Islamic banks, like all other financial institutions want to have a liquid supply of cash available to meet depositor withdrawals, payments to their vendors, money held with their central bank to meet reserve accounts, and any other needs that arise in the course of their business.  One thing that I have seen repeated widely (including in my blog) is that banks hold higher cash balances than conventional banks.  As a rough test of this idea, I compared the Islamic bank with one in the US that has similar total assets (I picked the US bank because it was easier for me to find a bank with comparable assets in the US).  

The US bank had 2.7% of its assets in cash (either in non-interest-bearing or interest-bearing instruments) while the Islamic bank held 6.4% of its assets in cash.  I accept that this is a highly unscientific analysis, but with a cash-to-assets ratio of the Islamic bank more than twice the conventional US bank, it seems probably that Islamic banks do hold more cash than conventional banks. 

The problem for Islamic banks when dealing with their cash balances is that it is harder for them to make a return on the balances sufficient to offset the cost associated with their funding and so higher cash balances should all other things equal lower the return on the bank's assets.  A mitigating factor is that the Islamic bank was able to place a large proportion of its cash balances in profit-paying instruments with the central bank (the UAE has an Islamic CD available starting in 2010 for Islamic banks in the country).  However, the remainder is either cash on hand, held in a current account at the central bank or held against the bank's reserve requirement with the central bank.  

The Islamic CD offered by the UAE Central Bank was significant for the bank I looked at.  Between the end of 2009 and the end of 2010 (i.e. before and after the Islamic CDs were offered), almost all of the drop in cash on hand and current account deposits with the Central Bank were offset by deposits in the Islamic CD (representing about 30% of the total cash balances of the bank).  Banks are responding to the opportunity to place funds with the central bank and generate a return on these assets, even if it is low.

I will return to the Islamic bank's assets in a future post.  See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html