Sunday, May 20, 2012

Could there be an Islamic whale?

I think of myself as one of the last people who would suggest that Islamic finance is inherently superior to conventional finance, because I think there is a lot more than just the Islamic label that will determine such a value judgment.  For example, is Islamic finance inherently superior if it is more expensive than conventional finance without offering anything different (e.g. without any change in the rights and responsibilities of the two parties which could offer a fairer deal that could offset the additional cost). 

However, since the news of the JP Morgan loss was announced, and the actual losses have piled up (potentially rising to $5 billion at last count), and reading through the excellent coverage on the FT Alphaville blog on how the trades might have actually been constructed, I came to the conclusion that Islamic finance might actually prevent some of these types of trades. 

Underlying the whole JP Morgan story is that the bank would turn into a massive liability on the government balance sheet if it were to fail, notwithstanding that the current losses are tiny relative to the bank's overall capital.  Then there is the issue of the Volcker Rule, which is more of a weakened form of Glass-Steagall, the Great Depression-era law that separated commercial banking, which would allow investment and commercial banks to operate within one corporate structure, but would limit their ability to speculate using their capital.  As it stands, with the size of JP Morgan, it is somewhat toothless since they could probably find something, somewhere on their massive balance sheet that would make all of the bits of the bad trades hedges of something. 

Most of this story (too-big-to-fail, combining investment and commercial banking and exposure to derivatives markets) could happen in Islamic finance, even if the potential today seems slim.  The relevant question, for Islamic finance then would be in the oversight process of the trading operations of the Chief Investment Office, the part of JP Morgan which seems to have shifted from risk management to just another profit center for the bank.  Here it is where an Islamic bank would have the trouble getting into the specific situation that people think the bank is in. 

JP Morgan's losses have come primarily as corporate credit markets deteriorate as the Euro crisis flares up again.  And, they are facing losses which seem outsized, even based on the description of the trader who entered the trades as the London Whale.  A bank, conventional or Islamic, would expect to take losses as the market for corporate credit hits a rough patch, but the losses should be coming from the banking operations, not from the risk management/hedging department.  Whether through mismanagement of a trade or just a bad call with a trade that was intentional, JP Morgan ran into a situation that would be difficult for an Islamic bank to replicate because:
  • The loss on the derivatives are moving in the same direction as the bulk of the bank's balance sheet; and, 
  • It appears the derivatives were designed to provide enhanced leverage to the bank on the trades.  
These two would be very hard for an Islamic bank to replicate because there would be (at least hypothetically) another layer of oversight from the internal Shari'ah audit department over the derivatives and one specific question they would ask would be for evidence that the derivatives transactions were entered into for hedging purposes (and not for speculation or to increase leverage).  Ex ante, it would be harder for the traders to enter into the trade.  In the JP Morgan example, the trade will make them a lot of money if it moves in one direction, and will cost the bank a lot of money in the other direction, but in a conventional bank, even with the Volcker Rule, the traders will be able to use the hedging excuse because it would come ex post, and they have a huge balance sheet to dig through to find the other side.  

An Islamic bank, if things work correctly, will have internal Shari'ah auditor whose job is to force the determination that the trades are hedges ex ante, which should limit these types of trades in the first place.


invest in bamboo said...

I suspect that Islamic banking would make a difference in preventing these kinds of things from occurring. Based on basic decency and morality alone, I cannot imagine an Islamic institution taking on these kinds of huge risks and being driven by this kind of greed. Somewhere along the line, investing turned into high frequency trading and gambling. Just as a Brit, if a trade like this had actually sunk JP Morgan, I wonder which country would have to clean up the mess, the US or UK (as the trades were in the UK)?

Blake Goud said...

I agree that it would be an interesting issue about who would be responsible if JPM failed. I suspect the US, becuase that is the country where it is primarily located in and regulated. And the government has more resources to bail them out than the UK which is still sitting on RBS.

As for the idea that Islamic finance could not have these types of huge risks, I would suggest looking at Gulf Finance House, or Arcapita, or the number of Islamic institutions that speculated on the real estate frenzy in the Gulf, especially in Dubai.