An empirical study of Islamic banks and the financial crisis

After reading the IFSB Secretary General's statements about Islamic finance not being immune to crisis, I ran across a paper released last winter (Abduh, Muhamad and Raditya Sukmana. 2011. "Deposit Behaviour in Indonesia Islamic Banking: Do Crisis and Fatwa Matter?", PDF) which examined the relationship between several economic variables and the deposits with Islamic banks in Indonesia.  The connection with the IFSB comments is that the authors of the paper suggested that their empirical analysis demonstrated that Islamic banks were more resilient in the face of the latest financial crisis than conventional banks in Indonesia.  I read the paper with a keen interest to see my own preconceptions about the stability of Islamic banks in the financial crisis challenged (particularly since the data in Indonesia could tell a different story than my anecdotal story from the GCC experience). 

Their method of capturing the effects of the crisis was to include a dummy variable (one that has the value of 1 when a condition is met, and 0 otherwise) for the periods during the financial crisis, which they define as April 2007 to December 2008.  This method is likely to be effective to capture the direct impact of the financial crisis (the financial contagion which spread around the world rapidly as the value of mortgage-related assets fell).  However, it will not capture the second wave effects from a shrinking or slowing global economy and the wealth destruction that occurs as a result of the crisis. 

The authors, in their literature review, provide a similar critique of a paper which investigated the performance of Islamic banks in Malaysia before and after the Asian financial crisis of the late 1990s using data from 1994-1999, which the authors note will not reflect the post-crisis period "since the impact of the 1997/1998 global financial crisis is felt until beyond the year of 1999".  I would offer a similar critique of their study's conclusions about the resiliency of Islamic banks to financial crises: their selection of the dates for the financial crisis will only pick up first round effects on Indonesian Islamic banks and cannot be generalized to support a thesis that: "whenever crisis comes, it seems
that Islamic bank depositors will not withdraw their money substantially in both the short run and the long run periods".  What their tests showed was that in the short-run, Islamic bank depositors did not withdraw in large amounts.  The longer-run effects, as well as the resiliency of Islamic banks to crisis has not been tested. 

The authors do explore other reasons for the lack of direct impact of the financial crisis on Islamic banks:

"Other explanations on why crisis is not a significant factor to influence deposit in Indonesia Islamic bank are as the following. First is that Islamic banks do not indulge with the derivative instruments. Secondly,  during the time of crisis, institutional investors which put the huge amount of investment in US were also affected. In turn, people dump their dollar to the market which resulted in dollar being significantly decrease in value. For those banks which provide loan/financing overseas, obviously, will be greatly affected. Fortunately, Islamic bank in indonesia has spreaded the financing to domestic market which certainly adopt the local currency of rupiah. The dynamic movement of US dollar will have no influence to the performance of islamic banks."

I would agree that Indonesian Islamic banks were less exposed due to their lack of exposure to derivatives.  The second explanation, of a dollar devaluation, is puzzling since when speaking about the crisis itself, since there was a surge of money into the US during the height of the crisis (as a result of a flight to safety into US Treasuries), which led to a dramatic appreciation of the US dollar (breaking a longer term trend of depreciation). The argument which follows, however, does make sense: Islamic banks in Indonesia, with more domestic exposure, and less international exposure, would be expected to take a smaller hit than if they had more international exposure.  However, without comparing the foreign-domestic split of assets between Islamic and conventional banks in Indonesia, it is hard to say whether this explanation makes sense. 

My conclusion remains relatively unchanged after reading this paper.  Islamic banks were not exposed to the first wave of asset implosion that was led in large part by the exposure of conventional banks to mortgage-related products, including derivatives, which sparked an institutional run on the bank (most countries have deposit insurance, which limited the retail bank runs).  Islamic banks have been developing more and more complex products, but at the time of the crisis, had not developed mortgage derivatives, so were spared from the direct impact of the crisis. 

However, as the crisis led to a worldwide recession, it begun to affect Islamic banks that saw American and European banks retrench somewhat from countries with a lot of Islamic banking, which led to slower growth in these countries (along with falling oil prices, which hurt GCC countries in particular).  The slowing economy and reduced inflows of oil money and global wealth destruction led to a reversal in asset prices (notably real estate prices in Dubai), which did not spare Islamic banks, and which continues in some corners of the Islamic finance industry (e.g. Arcapita and GFH).

The "Immunity" Myth, debunked by the IFSB

"At the IFSB, we share in the general assessment that Islamic finance has been resilient to the global crisis, but Islamic finance has not escaped the crisis and it is certainly not immune to it." - IFSB Secretary General Jaseem Ahmed

The IFSB held its 9th summit in Istanbul and Secretary General Ahmed laid out a few goals in his speech, but I think most critically for the industry gave the above quote that effectively renounces the widely parroted view that Islamic finance is somehow immune from crisis.  This is important because the view that Islamic finance is immune from crisis (or even from the most recent financial crisis) is one of the damaging viewpoints for the industry's development.  It is critical that the Islamic finance industry recognize that it is connected intimately with the global economy (including the conventional financial industry). 

Islamic finance must learn from the failures of the conventional finance industry lest it repeat the failures, especially since it already has been swept into the crisis with the massive real estate boom in Dubai that became speculative and led to its own crisis.  It is true that the Dubai property boom was fueled in large part by conventional financial institutions, but Islamic finance was not immune from the greed-fueled run-up. 

One need only to remember that the trigger for the entire Dubai debt crisis was the likely inability of Nakheel to repay a massive sukuk that came due in December 2009.  I wrote about the prospects for the holders of that sukuk at the time and noted that, although it was guaranteed by Dubai World (unlike the other Nakheel sukuk) there was no direct sovereign recourse, making repayment unlikely without a bailout. 

That bailout of course did come, from Abu Dhabi, which loaned Dubai $10 billion to repay, in part, the $3.52 billion Nakheel sukuk. The important point in rehashing the Nakheel sukuk bailout is to remember what the sukuk was financing (or at least the asset underlying the sukuk).  It was a strip of desert that was envisaged to become a huge development (and the value of its appraisal was based on these plans).  After the near-default, Nakheel struggled to craft a resolution for its creditors, a high point in the crisis in my mind since most of the claims were adjudicated by a tribunal made up of foreign judges under the laws of the DIFC (which are based on English law). 

However, for trade creditors, the situation was not quite as predictable since they were paid partly in cash but partly with a sukuk backed by land under the Persian Gulf.  Essentially they were given a back-door version of a (now) common 'extend-and-pretend' refinancing which gives some remedy (you might get some repayment, just not now), but also avoids the type of public restructuring that Arcapita is now engaged in (I personally favor the route forced on Arcapita since it gives more transparency).

Circling back from a rather long digression, the next step from the admission by the Secretary General of IFSB that Islamic finance is not immune from crisis is to develop a reaction to the next crisis, whether that crisis hits just one institution or the global economy.  The first order of business is to consider the idea of how bankruptcy or other resolution for failed institutions could work (a primer on the implications of bankruptcy of a Shari'ah-compliant financial institution are described in a paper by Michael McMillen). 

The next is to continue the focus of developing tools for Islamic finance institutions to avoid reaching a Lehman moment, since bankruptcy for financial institutions outside of a formal resolution process can turn messy and lead to contagion.  The keys for avoiding cascading failures is to have short-term liquidity management tools that are not tied up in the perceptions of solvency of a counterparty that doomed Lehman when times turned bad. 

The best solution for Islamic financial institutions would be to have a robust liquidity management system that offered both nearly risk-free assets like those that will eventually be issued by the International Islamic Liquidity Management Corporation (backed by many counties' central banks) and repurchase (repo) facilities in each country that will allow Islamic financial institutions to borrow against the IILM-issued assets.  Let's all thank the IFSB Secretary General for stating a point which is clear to all of us who paid attention to the financial crisis, but which was ignored by people who continued to describe Islamic finance as 'immune' from crisis, and get to work on making Islamic finance as robust as possible against future crises. 

Would national Shari'ah boards help Islamic finance?

According to Saif al-Samshi, the assistant governor for monetary policy and financial stability is that the "Despite the advanced state of the UAE in issuing Islamic sukuk, we believe that we still need to do more [including] finding a unified body for the main fatwas (decrees) in the Islamic financial services domain, as is the case in Malaysia".

Anyone who reads my blog with regularity over the past several years, will probably remember times where I have expressed support for national Shari'ah boards, and other times when I have questioned whether the establishment of national boards would limit the potential of the industry to innovate beyond the current state of replicating conventional products.  So, to start the discussion, I will admit to not holding a consistent view on the issue because there are many different factors that would lead a national Shari'ah board to be successful or unsuccessful in providing consistency in Shari'ah rulings, with enough leeway for institutions to develop new products.

However, the question remains about whether developing a national Shari'ah board for the UAE to complement those that exist in Indonesia and Malaysia, with potentially more national Shari'ah boards popping up across the GCC, South Asia and Africa.  On the once hand, national Shari'ah boards could provide clearer guidance on what the base Shari'ah standards are for individual countries, which would provide some certainty to institutions considering whether to launch cross-border services or products.  But it would also risk crystallizing the status quo, and dividing the industry and limiting the ability of successful products to be adopted more widely, because they would likely have to be reviewed by the national Shari'ah board of every country, something which is unlikely to be as rapid as it could be if the Shari'ah-compliance decision were left to each institution (and its customers). 

A recent article on the difficulties of introducing more arbitration proceedings in the place of court hearings to adjudicate disagreements in Islamic finance contracts leans to some regard in favor of greater centralization of Shari'ah standards.  One difficulty, which the article convincingly argues could limit the use of arbitrations in Islamic finance, is that the Shari'ah standards applicable in the Islamic finance industry are determined more by individual Shari'ah boards, and not based on an industry-wide, or even country-wide set of standards.  From this perspective, the establishment of national Shari'ah board could set the ground rules (on Shari'ah issues) for an arbitration panel and in cross-border deals, the contracts could specify then a certain national set of Shari'ah rules in case of disputes. 

Perhaps a more specific plan for a national Shari'ah board in the UAE would give me more conviction on whether it would likely be a positive or negative development for the Islamic finance institution, because today I remain as conflicted as I was before on the issue.

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.

Islamic mega-bank redux

I am a bit tired of writing blog posts about an Islamic mega-bank because it has been so many years of talk with very little to show for it (I called it an 'elusive dream' in my annual predictions at the beginning of 2011).  Back in 2007, I presented a quote from an article where Sheikh Nizam Yaquby said that an Islamic mega-bank was needed because there was "no collective efforts are seen at the institutional or regulatory levels to formulate a strategy on developing liquidity management tools.  Well, we are still waiting for the IILM to issue the first global liquidity management sukuk it has planned later this year, and there are others out there, including Islamic repo in the UAE, which are attracting limited interest so far.  However, this collective effort seems to be the most likely to succeed so far and I have questions about whether another effort would do as well as one backed by a number of central banks. 

Even as late as last summer, there were questions about where an Islamic mega-bank would be headquartered.  The most likely location is Bahrain because that is where the headquarters of the Albaraka Banking Group reside.  Albaraka is headed by Adnan Yousif, who has been the most public face behind the Islamic mega-bank.  However, the civil unrest in that country continues and it is unclear whether it is the suitable location for what is supposed to be a global bank that would represent in some ways the Islamic finance industry.  There has also been a notable decline in talk of the mega-bank becoming an Islamic Goldman Sachs after that august investment bank ran into a PR buzzsaw, and its sukuk attracted significant controversy.  There was even a name for the Islamic Goldman Sachs, Istikhlaf which the Economist noted was "Arabic for “doing God’s work”.

The size of the Islamic mega-bank has also been adjusted over time as expectations for its founding have moderated.   As late as last summer, the bank was expected to start with $10 billion in capital, with plans to raise this to $100 billion in the first 10 years.  Recently, this has been paired back to $1 billion, with $600 million coming from Arab Islamic banks and the remaining $400 million being publicly raised. 

If the bank were successfully incorporated and raised a large amount of capital, how would it fare?  Would it be able to contribute to the Islamic finance industry in a way that other large banks like Al Rajhi Bank cannot?  Would it be able to compete effectively with global financial institutions that have Islamic windows or engage in Islamic investment banking?  Most importantly, if you have a $100 billion or larger Islamic bank with the Islamic finance industry where it is today (with at most $1.1 trillion in assets), does that institution not represent a systemic risk to the industry (something I pondered last August when the idea generated some media buzz? 

I hope to avoid the idea of an Islamic mega-bank until one is actually launched (and to be a mega-bank worthy of my attention, it would have to have a serious likelihood of substantially exceeding the roughly $50 billion in assets of Al Rajhi Bank).

Shari'ah risks are not the only risks to Islamic repo

Repurchase agreements, also called repos, are a common way for conventional banks to manage liquidity needs or to lend out surplus liquidity.  By doing so, the banking industry is able to manage its liquidity in a way that, at least in theory, does not create systemic risks.  This is because a repo transaction is a form of secured lending so that even if the counterparty in the repo transaction goes out of business, the lender can recover the amount lent by liquidating the securities provided as collateral.

The International Islamic Financial Market released a paper exploring the different options for a Shari'ah-compliant version of the repo transaction used by conventional banks.  The paper, which I discussed in a newsletter and in a blog post, had several possible methods for an Islamic repo, but the most likely to be used in practice is likely the collateralized murabaha structure.  A few using the collateralized murabaha have been executed in the market, but there is still not nearly enough agreement on the structure for it to become as commonplace as repos are in the conventional banking industry. 

The National Bank of Abu Dhabi seems to be leading the charge into using the collateralized murabaha structure, since it first executed a one-week $20 million Islamic repo with Abu Dhabi Islamic Bank.  However, moving forward in $20 million or even $100 million increments will not put the Islamic repo into common usage anywhere close to the levels of conventional repos (even when viewed in terms of relative size compared with total assets  in the Islamic banking system). 

Part of that is that it is new, and any new product will start out being used by one institution and other banks will only adopt it gradually.  However, based on the Reuters article describing the discussions at the AAOIFI conference, the entire structure is still facing an uphill climb to gain industry-wide approval from various Shari'ah boards regarding some of the issues associated with the transactions (for example, margin interest and netting exposures by setting off positions against other transactions in similar amounts in the opposite directions).

These are thorny issues, but as the idea of an Islamic repo gains market acceptance, there will be other weightier issues around the systemic risks from repos that will arise outside of the current discussion over Shari'ah issues with repos.  Specifically, if you return to remembering why a collateralized murabaha repo would be an improvement for the industry, it is because the collateralization protects the lenders in the transactions from default by the counterparty since in the case of default they can always sell off the collateral to recover the amount lent. 

The collateralized murabaha repo would presumably give the lender the same right, which would improve on the current commodity murabaha inter-bank lending (which is unsecured).  In the current state, lenders are likely to be more attuned to the risks that their counterparties default since their loans are backed only by the full faith and credit of the counterparty to repay the principal plus profit.  There is no asset they could take ownership of and liquidate so Islamic banks would or should be more hesitant to engage in inter-bank lending with institutions at risk of failing. 

They will be much faster at denying interbank credit to the very banks that need the funding the most to stay solvent and avoid a liquidation of their assets in a fire sale, which could turn a liquidity crunch into insolvency for the bank (which is where the systemic issues begin if the panic spreads to the banks who had been lending to the troubled one).  A secured inter-bank financing market based on collateralized murabaha repos will make Islamic banks more likely to continue to lending to one another even if one becomes troubled since the lender will have the collateral to protect its financing interest in the counterparty. 

The point where a risk remains is "what is the collateral?".  Most conventional repos are backed by government or quasi-government debt and so in most times banks can be assured that there will be a stable market with a ready bid if it ever needed to seize and liquidate the collateral.  The same cannot be said for most sukuk.  There is, in the best of times, a thin market for sukuk and any troubles for the issuers of sukuk lead to sharp sell-offs. 

When sukuk are used as collateral, the lending bank will require a haircut based on the strength of the sukuk issuer and the liquidity of the market for that sukuk, which introduces an inefficiency that, by requiring a higher degree of overcollateralization, will limit the potential for Islamic repos to replace unsecured commodity murabaha inter-bank lending.  Or else, participants in the Islamic repo market will ignore the risks that the collateral itself can play in the repo transaction as a whole, which is perhaps a worse outcome.

The Shari'ah issues probably will be resolved to provide an Islamic repo structure that is accepted widely, mostly out of the need for such a product.  However, the systemic issues underlying the growth in Islamic repo that uses risky collateral will not be addressed as easily.  However, it is incumbent on the industry to recognize these risks, and while the adoption of international financial and accounting standards like the Basel standards should force this issue to the forefront for each institution, it should be another reminder of the importance of ensuring a large supply of high-grade sukuk with a liquid secondary market behind it.

Islamic Development Bank sukuk size up-sized from expectations

The Islamic Development Bank is looking to tap the capital markets for $750 million to $1 billion when it issues its next sukuk later this year. The Bank, which holds a AAA rating from Standard & Poor's funds, should find it relatively easy to issue sukuk, given the demand for high-grade investments, and a general shortage of sukuk worldwide. 

Last year, after nearly reaching the limit of its $3.5 billion sukuk program, the VP of the Islamic Development Bank Abdul Aziz Al-Hinai said it would be raised to at least $5 billion and possibly to as high as $8 billion. Zawya's Sukuk database indicates that the remaining $600 million in unissued sukuk are due to be issued this year, so if the sukuk is larger than this, the Bank would have to raise its sukuk program size.  The IDB uses the sukuk to finance projects in OIC countries.

Malaysia explores exchange-trading of sukuk

Bursa Malaysia released a consultation paper for comment that would facilitate exchange trading of bonds and sukuk on the Malaysian exchange.   While there are many exchanges where sukuk are listed, there are few if any where they are traded (usually trades are conducted over-the-counter).  This is a big development for the secondary markets because it would significantly increase the transparency of sukuk pricing, although absent greater supply of sukuk, the transparency would likely not make as great an impact. 

The proposal from Bursa Malaysia would apply to domestic and global sukuk, but would only include investment-grade sukuk (those with higher than a BBB or equivalent global rating or an AA or AAA local rating) with maturities of greater than one year.  Given the focus on the retail market, this makes sense because retail investors are likely to be less able to discern the risks between different non-investment-grade sukuk. 

If the market becomes active and proves to be as transparent as expected, it could further attract issuers from other parts of the world including the GCC, because the liquid market and greater pricing transparency could lead to issuers being able to access lower-cost funding.  However, as I have mentioned before, most GCC-issuers would not be well-served issuing ringgit-denominated sukuk unless they hedged their exposure to currency fluctuations, something which is more difficult to do for Islamic issuers. 

Takaful provider looks to microtakaful for growth

"Ghassan Marrouche, chief executive of Takaful Emarat in the United Arab Emirates, said his company was expecting double-digit growth rates in coming years, supported by the launch of several new products including a capital-protected instrument and a “microtakaful” product focused on low-income earners." 

The quote above is one of the most encouraging I have seen for the development of Islamic finance, if it is sincere.  It represents a relatively unique statement by an Islamic finance company that they can profitably move down the economic ladder as a way to expand their business.  It makes sense that this would occur with a takaful provider because there are fewer opportunities to grow their business quite as far as with Islamic banks or wealth management companies (you only need so much insurance, but you can be sold a much wider number of other financial products).  

In order to continue their rapid growth takaful providers should realize (and may be realizing) that they need to develop products to offer to lower-income people.  However, when these products are developed, they should be done in a way that offers a useful product, not just another high fee product to pad the income statement of the takaful provider.  

But the important point in the discussion is that Islamic financial institutions need to assist microfinance institutions (including those providing micro-takaful).  It will provide a much larger market to support decades of growth into the future. 

Islamic REITs in Indonesia? Not yet.

Malaysia's oldest Islamic REIT may be looking to Indonesia for growth, which makes sense, although real estate prices have risen quickly recently and regulatory impediments remain relating to the tax treatment of REITs and rules about foreign ownership of land.  Islamic REITs may offer similar returns (i.e. regular dividends) to sukuk, and should provide an investment that pass through the risks and rewards from the underlying assets directly to investors (which most sukuk are structured to avoid). 

One area of caution around comparing REITs to sukuk is that many REITs invest in buildings using debt (presumably Shari'ah-compliant debt in an Islamic REIT) to generate leverage, which in the case of a market that has risen substantially ("The average value of industrial land in greater Jakarta surged 76 percent last year, while the cost of apartments increased 11 percent, according to a Bank Indonesia survey. "), poses greater risk than an asset-based sukuk where the return is not primarily dependent on the value of that underlying asset (and where leverage is absent for the investor, and more explicitly reported for the company issuing the sukuk in their financials).

Another potential area to keep an eye on with Islamic REITs is whether they are being used by investors as an explicit substitute for sukuk (e.g. by takaful or pension funds) given the shortage of the latter.  The fall-out from the global financial crisis was that it led to a subsequent debt crisis in Dubai, which also had a highly leveraged real estate sector that had moved into bubble terms.  The financial institutions which fared the worst in this crisis were those with too much exposure to real estate and those that were most leveraged.  Islamic financial institutions are in particular susceptible to this bias towards real estate since it provides a tangible asset that is the easiest to incorporate into a Shari'ah-compliant structure. 

Has the QCB directive had an impact on Islamic banks?

A Reuters article describes the seemingly limited benefit for Islamic banks from the country's central bank decision to force conventional banks to close their Islamic window.  The country saw: 

There was little sign of the expected flow of money into Qatar's Islamic banks last year; their total assets grew 35 percent, according to central bank data, but that marked a slowdown from 39 percent expansion in the previous year. [...] Meanwhile the performance of Qatar's conventional banks improved; their assets grew 23 percent in 2011, up from a 16 percent rise in 2010. The biggest negative impact, Moody's predicted, would be felt by the country's largest lender, Qatar National Bank. But assets at QNB jumped 35 percent last year and its return on assets actually improved slightly.

There are far too many different factors in play to definitively conclude that the QCB central bank ruling either had no effect or perversely helped conventional banks, but there is also no conclusive data suggesting that Islamic banks saw a huge growth in Islamic banking business.  

The ex ante goal of moving Islamic finance business was premised on the potential leakage between Islamic and conventional assets, an important question for regulators of conventional lenders which operate Islamic windows.  However, the way it was implemented was not ideal and could be viewed as being a regulatory hand out to the domestic Islamic banking system, whether or not this was the original intent.  

The directive forced conventional banks to fully divest their Islamic windows, but was later loosened to allow the banks to continue to service Shari'ah-compliant loans, as long as no new loans were extended.  As a result, there were few sales of Islamic windows to Islamic banks, which would have resulted in more transfer of depositor accounts (an important source of funding for expanding the assets of Islamic banks).  It is likely that many customers at Islamic windows were given a choice: move your account to an Islamic bank, or have it automatically converted into a conventional bank account (any first-hand experience about whether or not this is the case would be appreciated, email me at blake@sharingrisk.org).  

Many Islamic banking customers may prefer Islamic banks, but will not go to any length to avoid conventional banks, so an easier conversion from an Islamic account to a conventional account (compared to the time-consuming process of opening a new account and closing the old one, with the time needed to change automatic deposits and withdrawals) led to their money not moving to the Islamic banks (which would be reflected in Islamic banks' growth rates holding steady with previous years, which the high level data show). 

Perhaps undertaking the central bank directive in a different way could have encouraged greater adoption of Islamic finance.  An alternative way that the split between conventional banks and Islamic windows could have been accomplished would be to require the Islamic window to be completely separated into a subsidiary of the conventional bank, with its own banking license (as a full fledged Islamic bank).  This would have allowed the conventional banks to retain the Islamic banking business, while providing regulatory separation  between the two units.  This would retain continuity for customers, while also giving the conventional banks an 'out' if they decide the separate entity is not worth keeping.  They can always sell it and do so much easier than with an Islamic window that is still regulated with the conventional parent. 

There are many lessons that we can learn from the experience of the QCB and their directive to separate conventional and Islamic banking.  Key to learning more will be more detailed analysis of the impact of the directive itself on the trajectory of the Islamic banking industry in Qatar. 

Below are links to my previous posts on the QCB directive:

• QCB announces directive
• Additional commentary on QCB announcing directive
• QCB directive leads banks with Islamic windows to sell retail banking units
• Unintended consequences of the QCB directive
• IMF Article IV report on Qatar addresses the QCB directive