Islamic banks versus conventional banks financial stability

Islamic Finance Conference Series I “Implications of Participation Model in Finance”

3-4th, March 2014

Mahmoud Sami NabiAssociate Professor of Economics

Tunisia Polytechnic School ERF & IRTI

OUTLINE

1. What is financial stability for a bank ?

2. First experiences of Islamic banks

3. Specificity of the Islamic banks’ business model

4. The practice of Islamic banks

5. Are Islamic banks more stable than conventional banks ?

6. Conclusion

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1. What is financial stability for a bank ?

• Financial stability of a given bank reflects its capacity to be solvent andremain so under difficult economic conditions by means of its capitaland reserve accounts.

• The IMF developed financial soundness indicators (FSIs) includingmeasures related to bank's capitalization, asset quality, andprofitability in order to provide complementary information about the“health” of a given bank.

• Maturity transformation is at the core of a bank’s role as a financialintermediary : depositors (liquid and risk-free/low risk assets) andborrowers (long-term financing to invest in risky projects).

Banks are inherently exposed to bank runs (many depositorsattempt to withdraw at once)

2. First experiences of Islamic Banks

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Source: A. Chachi (2005) "Origin and Development of Commercial and Islamic Banking Operations" J.KAU:Islamic Economics Vol. 18, No. 2.

1950s: in a rural area in Pakistan: a small experimental Interest-FreeBank founded by a small number of landowners to finance poorerlandowners for agricultural improvements. Failure due to shortage offunds and problems of specialized staff.

1963: in Egypt: Mit-Ghamr Islamic Savings Bank (MGISB) Adapting the business model of German savings banks to Sharia

rules. Within three and a half years, MFISB counted 251,000 depositors

and the deposits grew at higher rates Stopped in 1967: the success of the bank created conflicts with the

local social authorities who saw it as interfering in their own areaof authority...

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General principles of Islamic Finance

• The remuneration of capital is the counterpart of risk inherent totrade and investment activities based on:

Profit and Loss Sharing when capital finances investment activities.

Difference between the selling and buying prices when capital finances trade activities.

• All financial transactions must be backed by real assets.

• Debt (originated from a trade transaction) cannot betraded, rescheduled or discounted for interest.

3. The specificity of the Islamic Banks’ business model

The “two-tier Mudaraba” model

3. The specificity of the Islamic Banks’ business model

Assets Liabilities

Entr

epre

neurs

PLS modes of financing(Mudaraba, Musharaka)

Mark-up financing(Murabaha, Ijara, Istinaa, Salam)

Equity

Investment deposits (PSIA) (restricted or unrestricted)•Neither the principle nor the return are guaranteed

• Depositors share the bank’s net profit according the PLS ratio stipulated in the contract

• Can be withdrawn only on maturity

PS

IA hold

ers

100% reserve on the demand deposits

Demand deposits•Yield no return and repayable on demand at par value

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3. The specificity of the Islamic Banks’ business model

• Any loss on the asset side is totally absorbed on the liability side IBs maintain their net worth under difficult economic situations.

• Removal of the fulfilling prophecy behind the bank runs in Diamondand Dybvig (1983) : “During a bank run, depositors rush to withdraw theirdeposits because they expect the bank to fail. In fact, the suddenwithdrawals can force the bank to liquidate many of its assets at a lossand to fail.”

o "An illiquid asset in one in which the proceeds available from physicalliquidation or a sale on some date are less than the present value of itspayoff on some future date“ (Diamond, 2007, p. 190)

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3. The specificity of the Islamic Banks’ business model

• Prohibition of Riba and derivatives + linkage with the real economy principle

Source: EIR, october 2008.

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4. The practice of Islamic Banks in a dual banking system

• IBs deviate from their theoretical model on the liabilities side

Malaysia and Turkey : returns on PLS accounts are dependent(Granger causality) on CBs deposit rates (Zainol and Kassim, 2010;Cevik and Charap,2011)

Malaysia : rate on Islamic deposits mimics the behavior ofconventional interest rates (Chong and Liu, 2009)

• Explantions

The holders of unrestricted PSIA tend to behave similarly todepositors rather than investors withdrawal risk liquiditycrisis .

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4. The practice of Islamic Banks in a dual banking system

Archer and Abdelkarim (2010): …In Jordan, Malaysia andQatar, Central Banks require the U-PSIA to be managed in order toavoid passing losses to holders of this type of accounts andsmoothing the periodic returns

Profit Equalization Reserve (PER) + Investment Risk Reserve

Lack of Transparency, …

In Bahrain, there is no regulation imposing these requirements butIBS are using them.

4. The practice of Islamic Banks in a dual banking system

• IBs deviate from their theoretical model on the liabilities side

Ihlas Finance House (Turkish Islamic financial institution) wasclosed during the financial crisis of 2000-2001 due to liquidityproblems and financial distress that originated from its strategicerror to allow withdrawals from Investment Accounts.

“On the contrary other SFHs (Islamic financial institutions) whichsurvived the crisis did not en-cash the investment deposits andadvised their clients to hold them to maturity.”

Source: Syed A.S. (2007) Financial Distress and Bank Failure: Lessons from Closure from

Ihlas Finans in Turkey. Islamic Economic Studies, 14 (1-2), 1-52. )

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4. The practice of Islamic Banks in a dual banking system

IBs deviate from their theoretical model on the assets side

Low use of the PLS modes of finance relatively to “mark-up”financing … Dominance of less risky, low return assets deprivesIBs of the benefits of the portfolio diversification, as PLS contractsare more profitable (El- Hawary, 2007; Greuning and Iqbal, 2008)

Explantions

The PLS financing generate agency problems (moral hazard andadverse selection) and “bankers ascribe the problem of moralhazard or asymmetric information to be an important explanationfor individual preference for short-term liquidity.” (Ul Haque andMirakhor, 1987 - p161) …

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Source: Islamic Banking and Finance Information System (IBFIS) - IRTI

4. The practice of Islamic Banks in a dual banking system

Islamic Modes of Finance for 63 Banks: 2012 (Billion US Dollar)

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5. Are Islamic banks more stable than conventional banks ?

Cihak and Hesse (2010) : compare the stability of IBs relatively to CBs in a cross-country analysis during the period 1993-2004 :

small IBs > small CBs large CBs > large IBs small IBs > large IBs

Resilience to the recent global crisis : “…Although IBs have illustrateda degree of resilience and stability, they have been impacted by the crisisbecause of their higher exposure to real estate and their limited relianceon risk sharing or equity based transactions…” (Shamshad Akhtar

(2009), Speech during the “Symposium on Islamic Finance in Roma: Developments in MENAregion”, Bank Italia, Rome, Italy, November, 11th, 2009)

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5. Are Islamic banks more stable than conventional banks ?

Study Sample (+) (-)

Hasan and Dridi (2010) 120 IBs (~25%) and CBs (~75%) in 8 countries over 2007-2010

IBs’ more resilient in early stages of the crisis.

IBs’ profitability has steeply declined relatively to the CBs in 2009 (crisis moved to the real economy)

Beck et al. (2013) 2956 banks (99 IBs) in 141 countries over 2005-2009

IBs are more efficient than CBs with higher capitalisation

Better stock performance of listed Islamic banks during the recent crisis due to their higher capitalization and better asset quality.

IBs Not distinguishable from CBs in term of stability, business models and asset quality

Bourkhis and Nabi(2013)

matched sample of 34 IBs and 34 CBs in 16 countries over 1998–2009

Some evidence that IBs were in average 1998-2009 are more sound (in regards of the Z-score)

No significant difference in terms of the effect of the crisis on the stability (Z-score and Capital ratio)

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Source: Bourkhis and Nabi (2013)

5. Are Islamic banks more stable than conventional banks ?

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5. Conclusion

The recent global financial Crisis has generated new initiatives torethink economics and to restore the ethics to finance …Freeman(2010): “…Restoring finance to its role as a productive force in theeconomy will require new institutions and modes of compensation, aspart of a general overhaul of the relation between finance and the realeconomy”.

Restoring Islamic Banking to its initial “philosophy”…Moving towardsequity-based financing :

• New set of technical and risk management capabilities• Institutional development (Supervisory and prudential regulatory

framework, Accounting and auditing standards, credit bureau, judicialprocedure, etc.)

• Balance sheet size and economies of scale.• Innovating in products and services to meet the customer needs and

expectations in presence of fierce Competition.

Thank you

msaminabi@gmail.com

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