May 13, 2008
Are Islamic Banks Riskier than Conventional Banks?
The Middle East Financial Services Summit -2008 which was recently held in Bahrain had interesting sessions on the progress of Islamic banking. While the growth in assets of Islamic banks has been satisfactory, the perception among the bankers was that Islamic banks in the GCC region still lagged behind their conventional counterparts when it came to risk management. The evidence presented in this regard was a survey conducted by Mckinseys Risk Summit, November 2007 in which 17 GCC banks had participated.
While perceptions (from a small sample) may not be fully representative, it is nevertheless useful to understand the issue from a conceptual background: other things being equal are Islamic banks riskier than conventional banks? To put in another way, do Islamic banks have different risk structures than their conventional counterparts
One often quoted explanation is that Islamic banks do not face interest rate risks, since they do not pay or collect interest on deposits or loans. On the same note, Islamic banks transfer the risks on the asset side (such as default risk, price risk) to a special class of depositors called as investment account holders and thus spread the risk to both depositors as well as equity holders. It is therefore argued that Islamic banks are relatively less risky than their conventional counterparts.
Both the above statements are undoubtedly true. But remember, risks are part and parcel of financial intermediation; they reappear in some other form. And also remember that these Islamic banks are also competing with the traditional banks, so there are customer expectations to be met notwithstanding the willingness of depositors to bear losses due to their religious convictions. (Islamic bank borrowers can off load their risks to banks in some contracts)
Conventional bank borrowers or deposit holders pay or receive predetermined rates of interest. In Islamic banks, under a special type of contract called as trust financing, borrowers need to invest the funds in real assets. The profits or the losses from these real assets are then shared with the bank. Note that the concept of default is different: if the borrower makes losses due to market conditions and is unable to repay, the bank needs to share the losses along with the borrower-entrepreneur! In turn, Islamic banks pass on these risks to a special class of depositors called as unrestricted investment account holders who do not receive any fixed interest rates, but instead receive a share in the profits or losses generated by the business of the bank. In theory the banks have transferred asset risks, but in reality have they?
In principle, there are unlimited ways in which banks can enter into profit loss sharing (PLS) mode of financing. Moreover, the administration of the PLS modes is complex and the asymmetry of information on the trust financing contracts raises issues of governance and valuation. In reality therefore, these could lead to higher level of operational risks for banks which have a predominance of trust financing contracts. Similarly, Islamic banks need to provide a higher level of disclosure than their traditional counterparts given that the investment account holders (a special class of depositors) need to understand the risks underlying their deposits with the Islamic bank. (For the interested first time reader, there is an useful IMF working paper which provide good insights on PLS and non PLS modes of financing in Islamic banks)
In general terms, the risks in Islamic banks are more aligned to the types of contracts as well as the structuring of the contracts which allows for PLS. In fact the regulations of Central Bank of Bahrain for Islamic Banks is structured to recognise the risks in each type of contract such as cost plus financing, trust financing, etc. For example, a cost plus financing is exposed to both credit risk as well as price risk and the capital charges are accordingly framed to capture both these risks. In a Basel II scenario, note that each risk silo is evaluated independently and normally is not related to the type of exposure on the balance sheet of the bank.
Given this background, it can indeed be argued that the risks in Islamic banks are determined by the types of contracts on its balance sheet. Islamic banks which have a higher proportion of core Islamic assets (PLS assets) are in principle riskier than than conventional banks. On the other hand, banks which have higher proportion of non core Islamic assets (non PLS assets) such as cost plus financing have a similar risk profile as that of a conventional bank. However, credit risk mitigation is almost non existent in Islamic banks. Hedging is also limited given that the hedges also need to be compliant with Islamic principles.
Operational risks are much higher in Islamic banks for the above mentioned reasons. In addition, reputation risks are also higher as compliance to the Islamic principles of lending (Shariah) is extremely important for the bank to continue to attract customers.
For these reasons, it will be interesting to see how regulators set the internal capital guidance for Islamic banks which operate under a Basel II framework. Will the capital adequacy guidance recognise the special risks that these banks are exposed to?
Islamic Banks & Financial Stability: Small is Good
A logical way to end this discussion is to consider the impact of Islamic banks on financial stability. An IMF study of Islamic and commercial banks has found that large Islamic banks are less stable than small Islamic banks or large conventional banks. The authors are of the view that given the lack of standardisation, monitoring the PLS arrangements becomes rapidly much more complex as the scale of the banking operation grows, resulting in greater problems of adverse selection and moral hazard. Another possibility is that small banks concentrate on low-risk investments and fee income, while large banks do more PLS business.
Posted by aaaaaaa at 08:00 PM
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