The Islamic banking model put to the test

The Islamic banking model put to the test, IMF research

Available at: http://www.islamonline.net/eng/article/1304970906068

The recent global crisis has renewed interest in the relationship between Islamic banking and financial stability—and, more specifically, the resilience of the Islamic banking industry during crises.
An IMF study looks at the actual performance of Islamic banks and conventional banks in countries where both have significant market shares, and address three broad questions. Did Islamic banks fare differently from conventional banks during the financial crisis, if so, why? And what challenges for Islamic banks has the crisis highlighted?

Using bank-level data covering 2007–10 for about 120 Islamic and conventional banks in eight countries—Bahrain, Jordan, Kuwait, Malaysia, Qatar, Saudi Arabia, Turkey, and the United Arab Emirates (UAE)— the study focused on changes in four key indicators: profitability, bank lending, bank assets, and external bank ratings.

Central concept

The central concept in Islamic finance is justice, which is achieved mainly through the sharing of risk. Stakeholders are supposed to share profits and losses. Hence, charging interest is prohibited.
While conventional intermediation is largely debt based and allows for risk transfer, Islamic intermediation, in contrast, is asset based and centers on risk sharing. “Asset based” means that an investment is structured on exchange or ownership of assets, placing Islamic banks closer to the real economy than conventional banks, which can create products that are mainly notional or virtual.
During the boom period of 2005 to 2007, Islamic banks’ profitability was significantly higher than that of conventional banks. During this period, real GDP growth for countries in the studysample averaged 7.5 percent a year before decelerating to 1.5 percent during 2008–09. If this profitability was the result of greater risk taking, one would then expect a larger decline in profitability for Islamic banks during the crisis.

The study found that factors related to Islamic banks’ business model helped contain the adverse impact on this group’s profitability in 2008. In particular, smaller investment portfolios, lower leverage, and adherence to principles of Shariah (Islamic law)—which precluded Islamic banks from financing or investing in the kind of instruments that adversely affected their conventional competitors—all contributed to better results for Islamic banks than conventional banks that year.

Contributor to stability

Islamic banks maintained stronger credit growth than conventional banks in almost all countries in the period studied—on average, twice that of conventional banks. This suggests that Islamic banks’ market share is likely to continue to increase—but also that Islamic banks made a greater contribution to macroeconomic and financial stability by making more credit available.

Interestingly, while for most banks internationally, strong credit growth was followed by a sharp decline in credit once the crisis hit, this was not the case for Islamic banks. Because high credit growth is sometimes achieved at the expense of strong underwriting standards, the study identified this as an area for supervisors to monitor.

The growth of Islamic banks’ assets likewise proved strong. The research found that, on average, their asset growth was more than twice that of conventional banks during 2007–09, but it started decelerating in 2009, indicating that Islamic banks were less affected than conventional banks by deleveraging.

Challenges must be addressed

While the global crisis gave Islamic banks an opportunity to show their resilience, it also brought to light some important issues that will have to be addressed if Islamic banks are to continue growing at a sustainable pace.

While Islamic banks rely more on retail deposits than conventional banks and hence have more stable sources of funds, they face fundamental difficulties when it comes to liquidity management, including a shallow money market due to the small number of participants; and the lack of instruments that could be used as collateral for borrowing or discounted (sold) at the central bank discount window.

Some Islamic banks have responded by running an overly liquid balance sheet (that is, having more cash-like assets that generate a lower rate of return than loans and many types of securities), thereby sacrificing profitability.

The establishment of the International Islamic Liquidity Corporation in October 2010 was a step toward enhancing Islamic banks’ ability to manage international liquidity. But such efforts need to continue.
More generally, monetary and regulatory authorities should ensure that the liquidity infrastructure is neutral to the type of bank and strong enough to address the problems highlighted during the global crisis.

In the recent global crisis, Islamic banks proved their mettle. But the crisis has led to greater recognition of the ways in which they still need to develop. As financial regulatory reform presses ahead on a global level, now is the time for the Islamic banking regulators to address the industry’s challenges.

Regards
ZULKIFLI HASAN

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