Lessons of Cyprus and Depositor Liability in Islamic Banks

There is a common explanation that Islamic banking can alleviate the European debt crisis, or could have prevented the financial crisis. Normally, these claims are not thought through enough to provide specific policy recommendations, and they instead just form the normal cheerleading heard at many Islamic finance conferences.

However, with the ‘bail-in’ of depositors in Cyprus, Islamic banking may have a specific recommendation for conventional banks based on the products used by Islamic banks. Rather than just lump creditors together an encourage complacency around the potential losses, make these explicit by dividing them into ‘safekeeping’ deposits and ‘profit-sharing and loss-absorbing’ deposits, and connect them with the specific pools of assets within the bank to provide increased transparency.

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What can we learn from a widow in Indonesia about equity-based Islamic banking products?

Bloomberg has an interesting article on the potential for the Islamic finance market in Indonesia that starts with the story of one woman who received financing for her small business from PT Bank Muamalat Indonesia:

Hanifah took out a Shariah-compliant loan from PT Bank Muamalat Indonesia after her husband’s death to help finance a store on the ground floor of a shophouse in Serang, two hours’ drive west of Jakarta. While she doesn’t pay any interest, borrowers like Hanifah typically must give the bank 40 percent of their profit plus part of the principal each month.

“When times are good, I pay more on my loan than most people,” said Hanifah, whose monthly take is about 50 million rupiah ($5,189). “But I won’t have to worry when times are bad. I don’t have to pay anything when I’m not turning a profit.”

Besides being a nice story about a widow who has been able to successfully build a store to provide her with income, it shows the potential benefit from the Islamic banking product she uses, which sounds like either a musharaka or mudaraba.  Without knowing for sure, I would guess it is a mudaraba, although the bank offers both forms of financing. 

In a mudaraba, the bank provides the capital (acting as rabb al-mal) and the woman runs her store (as mudarib), with a pre-agreed split of profits (in this case 40% for the bank, 60% for the woman running the store).  If it is a mudaraba, she does not bear any losses, except the loss of her labor running the store.  It is likely that if the business failed, the bank would be able to force the sale of the inventory of the store (and any fixed assets it has) to recoup its investment, but not giving the bank recourse on the woman's other assets. 

For small business owners, this is a form of insurance against the failure of the business, since there is not liability for losses on the part of the business owner.  As a consequence, the bank is going to require greater upside potential (in this case taking 40% of the businesses profits, "When times are good, I pay more on my loan than most people").  However, for this woman at least, this is an acceptable trade-off, "I won't have to worry when times are bad.  I don't have to pay anything when I'm not turning a profit". 

There are several criticisms of Islamic banks using the mudaraba (or musharaka) structure and its applicability as a banking product that are worth remembering:

1. Banks are in the business of credit risk, transforming short-term deposits into long-term financing and (in their banking business at least) are not skilled at making assessments of equity risk;
2. Banks are regulated in terms of acting as judges of credit risk and for the purpose of liquidity transformation (turning short-term assets, deposits, into long-term assets, loans) and providing equity financing does not fit within the standard regulation of banks;
3. Equity-based financing products create an incentive problem since the incentives of the bank and of the entrepreneur may differ, and monitoring is costly;
4. Equity investments are of longer duration (potentially infinite) than loans and it will be more difficult for banks to exit if they need to access liquidity.

 These objections have merit, so perhaps it is useful to look at how they can be overcome (to provide additional opportunities for equity products to be used in Islamic banking, where murabaha, ijara, istisna'a and salam (generally more similar to debt) dominate. 

1. Banks are not traditionally seen as evaluators of business prospects beyond the credit risk they pose to the bank when they take a loan.  This is probably one of the more difficult areas for incorporating equity (or quasi-equity products) into an Islamic bank's product portfolio.  However, where the payments are set up as a percentage of profits plus the gradual reduction in the bank's interest in the business, it is possible for the analysis to be performed more like a credit analysis since the bank is providing financing to generate some target yield (paid out as a share of profits) and to have its investment redeemed over time. 
   
   They do not necessarily have to assess the growth potential of the business, but will instead do more to analyze the probability of default (that the business will not be able to buy out the bank's share, and that the profits generated will be sufficient to pay profits up to the bank's targeted return).  A bank looking at the credit risk of the business will look at the same factors: will the business generate enough revenue to make payments of the interest on the loan (and still remain in business) and will it be able to pay off the loan when it comes due.  The factors that will be analyzed will be the business' historical profitability and the fixed assets (which can be sold if it defaults to recover some of the principal).
   
2. The regulation of banks is predicated primarily on their business as being making interest-based loans to individuals and businesses and may not be flexible enough to allow equity products.  For example, banks in the US are not able to provide equity investment (the reason why Islamic mortgages using equity structures are only offered by non-bank financial institutions). 
   
   In some cases, this is addressed by making changes to the bank regulatory system, while other countries opt to create a separate regulation for Islamic banks (with separate licensing requirements).  The problems of broadening the regulations to allow for more equity products from Islamic banks (particularly if it is not allowed for conventional banks) is that it creates the potential for regulatory arbitrage where conventional banks set up separate Islamic banking subsidiaries or Islamic windows where they conduct the possibly more risky equity financing, while retaining the traditional financing activity in their conventional banking units.  It is always difficult to design banking regulations to neither favor or obstruct Islamic or conventional banks, while not allowing for any differences in the regulation to be used for purposes different from what they were intended. 
   
   
3. The principal-agent problem that occurs makes it harder for a bank to work with equity products than in other areas.  The bank, as principal, wants the business owner to maximize profits while avoiding losses and fully report all the profits when the profit split occurs.  The business owner wants to maximize the profits, because that will increase her income, but is not directly incentivized to avoid losses to the extent that she would if she were fully liable for them (since the bank will take losses under the mudaraba).  There is also an incentive for the business owner to minimize the reported profitability to lower the amount paid out to the bank. 
   
   The second problem--of reporting profits accurately--is the easier to deal with since the bank can require access to information about the inventory, sales, and expenses to check to see if the reported profits are likely to reflect reality (with the assistance of an external auditor).  The bank can require the business prepare financial statements when announcing the profit that is available to split, which can be compared to the other information (inventory, expense invoices, etc) to ensure the profits and losses are accurately measured. 
   
   It is harder to align the incentives between the business owner and the bank in how the business owner manages the business.  No business owner wants to see their business fail, and that provides some discipline, but if the financial losses of the business are absorbed by another party (and the owner loses just her share of future profits) than it may lead to more risky behavior on the part of the business owner, particularly if the business is having difficulties. 
   
   The way banks can mitigate this risk is by again ensuring accurate reporting of the business' revenues, expenses and profits, with the assistance of an external auditor to find signs in advance if a business is having problems, before it becomes more likely that the business owner will pursue more risky business strategies or start shifting revenues out of the business by engaging in business off of the books (to get what income she can while pushing more losses onto the bank).  This is not easy, but there are similar challenges for banks making interest-based loans to businesses, so banks are not necessarily starting from scratch. 
   
4. The equity product described in the Bloomberg article uses the profit-sharing structure, but makes a key modification.  Instead of having an equity investor relationship last forever, the mudaraba is structured to have profit payments be made with a buy-out of the bank's share in the mudaraba [1].  This diminishes the bank's share according to a planned schedule with a targeted end date, similar to a loan.  The end date for the financing is likely to be contingent upon the profits of the business (where the buy out amount is done only where there are profits from the business, although it may be possible to separate out the two components and have the buy-out transaction done every period, but profit payments only made where there are profits.

These are just a few thoughts that came to mind when reading about the widow in Indonesia who uses Islamic banking products to mitigate her risks from her business not generating profits.  There are many more aspects that are involved in looking at how Islamic banks can incorporate equity products into their financing offering.  I hope this will provide a starting point for thinking about how Islamic banks can use equity products alongside their other products, and how it can benefit their customers.  

[1] I am assuming it is a mudaraba contract, it may have been a musharaka, where there was a contribution made either in cash or in kind at the outset.  Then it would be a diminishing musharaka, which is more commonly used.  There are Shari'ah issues with a diminishing mudaraba (as noted in the Vogel & Hayes book section on mudaraba).  The issues are 1) if the principal payments are accumulated to buy out the mudaraba at maturity, it may not be Shari'ah-compliant to specify this purchase in advance; 2) If each payment goes to buy out a share of the mudaraba, it is not clear how the price can be determined at each time; and 3) if the principal payments are used to buy out a share of the mudaraba which is reconstituted each period, it may not be possible to specify that the mudaraba shall be reconstituted in advance. 

World Council on Credit Unions may take lessons from Afghanistan to Libya

The World Council of Credit Unions has spent the past 8 years building 34 Islamic Investment and Finance Cooperatives across Afghanistan providing murabaha, ijara and a murabaha-ijara hybrid product to its 92,456 member-owned cooperatives (here's the WOCCU's page on the IIFCs).  Now it is shifting its attention to Libya where there CEO of San Francisco Federal Credit Union said "As the country reconstructs, it is an opportunity for credit unions to participate in rebuilding the economy."

It would be useful to see the development of more Islamic credit unions, particularly in countries where access to finance (of any kind, conventional or Islamic) is low because the credit union model has a seeming overlap with Islamic banking.  Depositors of the credit union are members (i.e. owners) of the credit union and the return they get on the use of their deposits are returned to them as profit.  While there are still aspects where the credit union will replicate how banks work (for example, losses are unlikely to be passed through to depositors unless the credit union fails), there are fewer areas where there are difficult contradictions inherent in the model.

For example, if an Islamic bank goes out and tries to attract deposits using the mudaraba structure, they would be theoretically at risk of loss if the investments made with the deposits lose money.  Yet, how is that different from the equity owners of the bank, who should in theory have the same risk-return profile.  One difference between the mudaraba depositors and the equity investors is that the investors would have the right to participate in some ways in the management of the bank where the depositors wouldn't. 

However, that would make the structure of an Islamic bank more beset with conflicts of interest than a credit union (where members provide deposits and also act as the owners of the bank, which is typically a non-profit).  The equity investors (musharaka partners, essentially, have a right to a portion of the bank's earnings, much of which is made using the funds provided by depositors (the mudarib fee in the mudaraba arrangement).  The depositors are liable for the loss of their deposits if the investments are poorly chosen, and are entitled to the share of the profits accruing to them as the rabb al-maal but have no rights to direct the management of the bank. 

In the actual operation of Islamic banks, depositors are treated as being senior to the equity holders (they will have their deposits paid first if the bank were wound up, with any residual accruing to the equity holders).  That introduces an additional potential conflict of interest where the bank's equity owners would benefit from gains but would not have as much at risk to loss if the bank failed (since they would be investing with their equity capital plus the deposits).  This conflict of interest, of course, is the reason why banks (including Islamic banks) are so highly regulated. 

However, from the perspective of choosing whether an Islamic banking entity would work better using musharaka equity investments alongside mudaraba deposits as a privately held bank or a member-owned credit union, I think there is a lot to be said that the credit union would be better because the potential conflict of interest between the depositors and the equity owners would be eliminated by making the depositors the owners of the credit union.  There remains still, of course, the governance challenge of aligning management and depositor/member interests in a credit union, but using a structure with fewer conflicts to manage seems like a better way to go. 

Dr. Zeti speaks on the shift towards equity-based Islamic financing

Dr. Zeti Akhtar Aziz, the governor of Bank Negara Malaysia, spoke today at the Islamic Development Bank's Regional Lecture Series in Indonesia, and while there was nothing groundbreaking contained in her speech, there were a few parts that I think are important to remember (and I would recommend again that when Dr. Zeti speaks it is wise to be listening). A few quotes:

The recent global financial crisis provides a distinct example of how excessive leverage and exponential growth in financial activities that are detached from the growth trajectory of the real economy can become a source of instability. Leverage increased sharply in the years leading to the crisis, buoyed by years of strong economic growth. In the advanced economies, bank balance sheets exploded, growing to multiples of annual GDP.
[...]

The sheer size, complexity and leverage in the banking system increased the fragility of financial institutions and limited their ability to absorb even small losses, thereby resulting in widespread and deep economic dislocations.

[...] 

There is also strong discouragement against excessive risk undertakings and a prohibition against speculative elements. These rulings also serve to insulate the Islamic financial system from excessive leverage, which in turn contributes towards promoting financial stability and its long-term sustainability. These fundamental elements resonate with the call for banking to focus on its core function of providing financial services that add value to the real economy.

[...]

Whilst Islamic finance has all the ingredients and the potential to meet the needs of the global economy, the channelling of funds to productive activities in Islamic finance today is still largely being carried out through non-participatory contracts, that includes the mark-up sale (Murabahah) and the lease-based (ijarah) structures, which continue to remain essential to cater for financing trade and the purchase of assets. Such contracts are similar to lending instruments which expose the Islamic financial institutions mostly to credit risk elements. Whilst non-risk-sharing contracts will continue to contribute to the future growth of Islamic finance, the wider use of risk-sharing transactions and undertakings under participatory finance models have significant scope in evolving a broader representation of Islamic financial products that will spur the next phase of industry growth and development. This includes participatory or equity-based contracts such as Mudarabah and Musharakah that support ventures involving entrepreneurship endeavours. Greater use of equity-based models in Islamic financial solutions has been observed in the more recent period. This has been most evident in the sukuk segment, with Shariah structures evolving from predominantly ijarah and murabahah structures to musharakah partnerships as well as convertible and exchangeable trusts. 

The further development of participatory Islamic finance contracts on a broader scale offers particular potential in efforts to reinforce links between finance and the real economy. Several elements of risk- and profit-sharing participatory contracts support this. As profit-sharing and loss-bearing are clearly identified and agreed based on the contractual agreements between the financier and the entrepreneur, strong emphasis is placed on the value creation and economic viability of productive efforts that create new wealth. In equity-based contracts, the financial intermediation is thus also directed towards promoting entrepreneurship, in that the clearly defined risk- and profit-sharing characteristics of the Islamic financial transaction provides strong incentives for both parties to contribute to the success of the investment. This also provides the foundation for a long-term trust-based relationship, and a clear interest for the financial institutions to undertake the appropriate due diligence to ensure that the returns are commensurate with the risks being assumed. Aspects of governance and risk management thus strongly underpin these contracts. In particular, such contracts demand higher standards of disclosure and transparency to be observed, which in turn act to strengthen market discipline.

[...]

Business risks of equity positions and ownership risks of underlying assets are, for example, embedded in these arrangements arising from the contractual relationships between the investors and entrepreneurs as well as the Islamic banking institutions as the intermediary of funds. Further in-depth applied research is also needed to develop more innovative financial products using risk and profit sharing structures with the corresponding development of risk management techniques. This also needs to be reinforced by enhanced consumer protection and education initiatives to deepen the understanding and awareness of consumers on the associated risks and rewards in the Islamic financial contracts, in particular for equity-based instruments.

Equally important in ensuring the institutional soundness of Islamic financial institutions is the need for robust liquidity management. Today, Islamic financial institutions operating in the different jurisdictions are still confronted with the challenge of managing their liquidity positions effectively, given the limited supply of high quality Shariah-compliant liquid instruments being the reason most commonly cited. The lack of high quality liquidity instruments for Islamic finance is not only constraining effective liquidity management, but it is also affecting the efficient cross-border diversification of financial flows. It is therefore our hope that through the mandate of the International Islamic Liquidity Management Corporation (IILM) in issuing high-quality liquid sukuks, it will contribute to promoting more efficient cross-border liquidity management by Islamic financial institutions whilst facilitating Islamic financial institutions in meeting the international requirements on liquidity.

A theme during the speech is a focus on keeping the Islamic finance industry focused on a connection with underlying economic activity, avoiding excessive leverage and maintaining as much diligence in the underlying businesses being financed.  This is, again, not anything groundbreaking, but it is interesting how she ties it in with the contractual form used in Islamic finance products (ijara/murabaha versus mudaraba/musharaka). 

The primary criticism I would offer of the Islamic finance industry's structure is that it is not only focused on replicating the same contracts as are used in conventional finance, it is replicating to a degree the same business models, with a skew towards the more leveraged business models (investment banking and private equity) at the expense of some that would fit in well with the ideal of risk sharing that Islamic finance is often described as being focused on

There is of course a need for Islamic finance to offer products with similar economics as conventional products for some needs (trade finance using murabaha, for example, or ijara as a substitute for conventional financial leases) but the danger comes when these contracts are used within the context of institutions that accumulate significant degrees of leverage on their own balance sheets. 

In this regard, Islamic commercial banks receive good marks since they have higher levels of capital for the most part and are not heavily leveraged, even though their balance sheets do include some leverage.  Islamic investment banks and Islamic private equity companies, however, which were the main casualties of the financial crisis, on the other hand, used high degrees of leverage in their business and paid the price when financial markets turned and they were unable to roll over their debts as the value of their assets fell. 

In the case of many of these, the institutions themselves were leveraged and their investments were also leveraged, amplifying the effect of a fall in the value of the assets they owned.  To use one company as an example (Arcapita), it had a $1 billion murabaha syndicated loan that the parent company took out to fund part of the investments it made in portfolio companies.  These companies were acquired as leveraged buy-outs, and Arcapita's equity interest was sold to investors, with a portion of the equity retained by Arcapita. 

While Arcapita would argue that it was the actions of an agressive minority of murabaha holders that led to their bankruptcy, these holders acquired the debt at a steep discount to par value because there was a fall in the value of their portfolio companies (many of which were acquired near the peak in 2006 and 2007) and the effect on Arcapita's balance sheet was magnified by the leverage employed on each buy out deal, which led to doubts that Arcapita had sufficient assets to pay its inter-bank liabilities, balances to unrestricted investment account holders and the murabaha holders.  Had the structure been less leveraged, it would have had a greater chance of avoiding bankruptcy. 

And this brings me back to Dr. Zeti's conclusion that the use of risk sharing contracts will force greater connection to the prospects of the businesses the Islamic financial institutions are financing.  While it will force some greater diligence because the risk assumed is more than just credit risk, there will be an important caveat that the market discipline from equity-based contracts will only be effective if the Islamic financial institutions themselves are not leveraged up and thus susceptible to the same types of risks that ended up bringing down many conventional financial institutions.