IMF Study Shows Larger Islamic Banks Need Prudential Eye

by Mary Swire, for LawAndTax-News.com, Hong Kong

21 May 2008

Institutions offering Islamic financial services constitute a significant and growing share of the financial system in several countries, the IMF announced in a statement on Tuesday.

It went on to reveal that since the inception of Islamic banking about three decades ago, the number and reach of Islamic financial institutions worldwide has risen from one institution in one country in 1975 to more than 300 institutions operating in more than 75 countries.

The entire banking systems of Sudan and Iran are based on Islamic finance principles. Although Islamic banks are concentrated in the Middle East and Southeast Asia, they are also niche players in Europe and the United States. According to McKinsey & Co., Islamic banking assets and assets under management reached $750bn in 2006, and the Islamic finance sector is expected to reach $1 trillion by 2010.

Islamic or Shariah-compliant banking provides and uses financial services and products that conform to Islamic religious practices and laws, which, in particular, prohibit the payment and receipt of interest at a fixed or predetermined rate.

In practice, this means that instead of loans, Islamic banks use profit-and-loss sharing arrangements (PLS), purchase and resale of goods and services, and the provision of services for fees form the basis of contracts.

In PLS modes, the rate of return on financial assets is not known or fixed prior to undertaking the transaction. In purchase-resale transactions, a markup is determined based on a benchmark rate of return, typically a return determined in international markets such as the London interbank offered rate (LIBOR).

Islamic banks also determine return on deposits differently. In a commercial bank, the rate of return is set contractually (fixed in advance or tied to a reference rate) and does not depend on the bank's lending performance.

In an Islamic bank, the rate of return on a deposit is directly dependent on the quality of the bank's investment decisions.

If the bank records losses as a result of bad investments, depositors may lose some (or all) of their deposits.

The contractual agreement between depositors and the Islamic banks does not predetermine any rates of return, it only sets the ratio according to which profits and losses are distributed between the parties to the deposit contract.

The IMF went on to reveal that there is a large body of descriptive literature about Islamic finance, but there has been relatively little empirical work on Islamic banking and financial stability, an area of increasing interest as Islamic banking grows.

In a new IMF working paper, the Fund has attempted to fill this gap in the literature, using data on 18 banking systems with a substantial presence of Islamic banks to provide a cross-country empirical analysis of the role of Islamic banks in financial stability.

Posing the question of whether Islamic banks are more or less stable than traditional banks, the IMF suggested that:

"A majority of the relevant literature suggests that the risks posed by Islamic banks to the financial system differ in many ways from those posed by conventional banks."

It continued: "Risks unique to Islamic banks arise from the specific features of Islamic contracts, and the overall legal, governance, and liquidity infrastructure of Islamic finance."

"For example, PLS financing shifts the direct credit risk from banks to their investment depositors. But it also increases the overall degree of risk of the asset side of banks' balance sheets, because it makes Islamic banks vulnerable to risks normally borne by equity investors rather than holders of debt."

"Also, because of their compliance with the Islamic law, Islamic banks can use fewer risk-hedging techniques and instruments (such as derivatives and swaps) than conventional banks."

"Moreover, most Islamic banks have operated in environments with less developed or nonexistent interbank and money markets and government securities, and with limited availability of and access to lender-of-last-resort facilities operated by central banks."

"These differences have been reduced somewhat because of recent developments in Islamic money market instruments and Islamic lender of last resort modes, and the implicit commitment to provide liquidity support to all banks during exceptional circumstances in most countries."

The IMF went on to observe that: "In some ways, Islamic banks could be less risky than conventional banks. For example, Islamic banks are able to pass through a negative shock from the asset side (such as a worsened economic situation that causes lower cash flow from PLS transactions) to the investment depositors."

"The risk-sharing arrangements on the deposit side thus arguably provide another layer of protection to the bank, in addition to its book capital."

"Also, it could be argued that the need to provide a stable and competitive return to investors, the shareholders' responsibility for negligence or misconduct (operational risk) and the more difficult access to liquidity put pressures on Islamic banks to be more conservative."

"Furthermore, because investors (depositors) share in the risks (and typically do not have deposit insurance), they have more incentive to exercise tight oversight over bank management."

"Finally, Islamic banks have traditionally held a larger proportion of their assets than commercial banks in reserve accounts with central banks or in correspondent accounts with other banks."

"So, even if Islamic investments are more risky than conventional investments, from a financial stability perspective the question is whether or not these higher risks are offset by bigger buffers."

"Whether Islamic banks are more or less stable than conventional banks depends on the relative sizes of the effects discussed above, and it may in principle differ from country to country and even bank from bank."

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