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
| Comments (2)
April 16, 2008
Basel II Plus : Prescriptions for the current Market Turmoil
The month of April has seen prescriptions emanate from two influential quarters: the IMF which released the spring 2008 Global Financial Stability Report, and the Financial Stability Forum which finally released the recommendations on enhancing the resilience of markets and financial institutions. While the GFSR is issued every six months, the FSF report was prepared at the behest of the G 7 Finance Ministers and central bankers with the objective of coming up with recommendations on improving the resilience in the financial system in the light of the current market turmoil.
The IMF report is highly analytical and has some incisive analysis. The IMF says that the risks to global financial stability have increased sharply since the last report in October 2007, and estimates almost $1 trillion in losses and mark-to-market write downs. In terms of the blame game it has apportioned all stake holders: a collective failure to appreciate the extent of leverage taken on by a wide range of institutions. Private sector risk management was found wanting (always the case and especially so in times of turmoil, write downs and meltdowns), regulators have lagged behind financial sector innovation (where did GARP get the courage to award the European Central Bank as Financial Risk Manager of 2007?). Finally, disclosures have not helped in communicating risks, especially in the originate to distribute business model. Net result: disorderly unwinding - the stuff of the nightmares for central bankers - has crystallized into reality.
The FSF report is more prescriptive and provides guidance (as well as a timeline) on the regulatory areas which will receive attention in view of the shortcomings in Basel II. The crisis has helped regulators to test the efficacy of some of the Basel II regulations; it is indeed refreshing to read that BIS acknowledges the need to strengthen elements of Basel II when it is still getting off the ground in most countries! This is an implicit admission that supervision has lagged behind rapid innovation and the shifts in business models. Nevertheless, the FSF report still maintains that the starting point for improving the banks capital adequacy is the timely implementation of Basel II. Going forward, supervisors also need to rigorously assess banks compliance with the Basel II framework.
The IMF and the FSF reports both talk of the procyclicality effects of Basel II capital requirements and fair value accounting practices. It would appear that the presence of both these triggers has actually exacerbated the current downturn in the economy. Thus while the roots of the crisis lie in the US sub prime market; the spreading of the crisis much beyond could be attributed to the procyclicality effects. The FSF report says that BCBS has already put in place a data collection framework to monitor the impact of Basel II on the level and cyclicality of the capital requirements over time and will take further action as appropriate.
Some of the proposals of BCBS relating to capital requirements: the need to raise capital requirements for certain complex structured credit products, the need to capture default risk in the trading book (this is where most of the structured products are held for many banks and securities firms).
By far, the most eagerly awaited sound practice guidance is for the supervision of liquidity (due in July 2008). The FSF report highlights the need for effective liquidity risk management practices and the fact that high liquidity buffers play an important role in maintaining institutional and systemic resilience.
Both the FSF and IMF reports underscore the importance of the Pillar 2 mechanism. The IMF says that supervisors will need to better assess capital adequacy related to risks that may not be covered in Pillar 1; more attention could be paid to ensuring that banks have an appropriate risk management system and a strong internal governance structure. The FSF reports echoes a similar view: Supervisors should use Pillar 2 to strengthen risk management practices and to control tail risks and mitigate the build up excessive exposures and risk concentrations.
Indeed both the IMF & FSF reports suggest that national supervisors have their tasks cut out. Some actions points (1) More intense supervision and ensuring stricter implementation of Basel II (2) greater attention to applying fair value accounting results, (3) ensuring that risk management capital buffers and estimates of potential losses are appropriately forwarding looking taking into account the uncertainties associated with models valuations, concentration risks, and expected variations through the cycle.
Tail Piece: Modelling Financial Stability!
The sub prime crisis has provided IMF the impetus to expand the scope of research to quantitative financial stability modelling. Considering that financial stability as a term came into existence just about 12 years back when the Bank of England first used the term in 1996, this indeed is a major push for FS reporting. I particularly liked the work on the construction of a Banking Stability Index.
In a broad sense, evaluating financial stability in the banking system is nothing but evaluating the interdependencies between the individual banks. A large loss in a systemically important bank is more often likely to trigger losses in other banks in the system. The IMF has modelled this by evaluating the joint probability of default (JPoD) of a portfolio of banks, by taking the individual probability of default and modelling the interdependencies using non parametric copulas. The concept of joint default analysis is also used by Moodys to determine the impact of external support on banks ratings so in a way they are also modelling the interdependencies.
The JPoD represents the joint probability of default of all banks in the portfolio given that at least one bank has defaulted in the system and is thus a measure of the Banking Stability Index. The IMF has actually tested this on portfolio of 15 large systemically important banks in and has determined that the JPoD for this portfolio has risen almost 10 times from mid 2007 till the present!
Posted by aaaaaaa at 08:33 PM
| Comments (0)
