Interpreting Middle East Economic News and Analyzing Market Trends

Are Islamic banks riskier than conventional banks?

Islamic Bank of Britain

Photo: Islamic Bank of Britain in London.

 

 

With global GDP slowing down and constantly being revised lower by the IMF and World Bank, a question has been coming up in the Middle East regarding the safety of the banking system in the region, especially with the crashing oil price.  Islamic banks have been especially criticized in the past for their loose oversight and perceived reckless investment model.  Are Islamic banks really riskier than conventional banks?  Let’s take a look…

 

 

Being just shy of 40 years old, the Islamic banking industry has experienced its fair share of ups and downs. Islamic banks are seen as inherently riskier than conventional banks because of their business model. They share risk with their clients; they work on a profit and loss basis, not a guaranteed-return model (i.e., interest); they buy and sell assets and get involved in the ownership of assets instead of money lending. These activities are out of the question for conventional banks because they are too risky.  They also fall outside their money lending business model.

There have been some well-publicized cases of Islamic financial institutions running into trouble. In 2010, for example, the Islamic Bank of Britain needed to be recapitalized during the financial crisis due to mounting losses from its business activities. The bank was bailed out with a £20 million capital injection from Qatar International Investment Bank. The fresh capital brought the Qatari bank’s stake to 88 percent and a new strategy and expansion plans.

In the Middle East, dozens of Islamic finance companies fell into trouble as a result of the financial crisis, which caused real estate values to drop. Two prominent companies in the region defaulted on payments and were near bankruptcy. The Investment Dar in Kuwait, which made headlines in 2007 for its acquisition of luxury automaker Aston Martin, defaulted on a $100 million sukuk payment. This pushed the company to the brink of bankruptcy and forced it to scramble to raise money and restructure $3.7 billion in other sukuk and financing.  The other well-publicized company was Gulf Finance House, which was one of the largest Islamic investment banks in Bahrain. The bank was overextended in real estate investments and private equity deals. When the financial crisis hit, the value of its investments plummeted and the bank began hemorrhaging cash.  In 2010, shareholders approved a plan to raise $500 million in new capital to rescue it from bankruptcy.  Many Islamic retail banks were overly exposed to these finance companies either by owning shares in them or by providing them financing, but no Islamic retail bank was closed or went under during the financial crisis.

Islamic finance tends to attract global media attention when there is a company in crisis or when fraud is involved, which has also occurred in the past.  This leads some to view Islamic finance as a high-risk industry. Needless to say, the bailouts, fraud, and criminal activities of conventional finance pale in comparison. As of August 2014, the U.S. Justice Department is said to have recovered nearly $37 billion in settlements from the big banks for their role in selling questionable mortgages up to the financial crisis.  This does not include the billions of dollars paid in fines and for other fraudulent charges, including money laundering by global banks such as HSBC and Standard Chartered.

One way to see whether Islamic banks are safer or riskier than conventional banks is to look at their credit rating by one of the leading credit-rating agencies. In the table below you will see the ratings assigned to some of the key Islamic banks in the Middle East (shaded in grey) compared to some of the leading global financial institutions.

  

Islamic Banks vs. Global Banks Credit Ratings as of Q3 2014

Islamic bank ratings vs conventional

Click on table for larger size

Source: Bloomberg

As you can see, Islamic banks are rated fairly well. Al-Rajhi Bank, Kuwait Finance House, Abu Dhabi Islamic Bank and Qatar International Islamic Bank all have higher credit ratings than Goldman Sachs, according to Moody’s. Bank of America, Citigroup, and Royal Bank of Scotland pose greater credit risks and have a higher chance of defaulting than the Islamic banks listed in the table.  A large part of the ratings support is assigned to these Islamic banks because they are able to piggyback on the sovereign rating of the country where they are based, which are all major oil exporters.  In these cases, the ratings support is given based on implicit or explicit support by the government for all banks operating in the country, which includes Islamic banks as well as conventional banks.  This is not unusual since past history of support for the banking system has led the rating agencies to offer additional ratings support for financial institutions in Middle East oil exporting countries.

Therefore, this may not fully answer the question on whether or not Islamic banks are safer than conventional banks.  So let’s find another way to answer this question.  In June 2012, a research paper titled “Failure Risk in Islamic and Conventional Banks” was published by researchers at Lancaster University and Cass Business School in the United Kingdom. The researchers wanted to see if Islamic banks have a higher risk of failure compared with conventional banks in the same country. The researchers detailed their findings after studying 421 banks (both conventional and Islamic) in 20 countries in the Middle East and the Far East from 1995 to 2010.

The research concluded that Islamic banks were 55 percent less hazardous than conventional banks in the same country. What is interesting is that they found Islamic banks to have higher operational risk because of their business model of acquiring assets and risk sharing on the profit and loss side. However, a direct result of this business model is the removal of moral hazard, which is quite apparent in conventional finance. Let’s not forget that up to the financial crisis Wall Street banks were selling subprime mortgages to their clients while at the same time betting that they would lose. This is still happening today.

The research also found that Islamic banks had lower leverage and a lower concentration of investments in the banking sector. Islamic banks by their nature avoid leverage, but some conventional banking analysts lump their financial activities into the leverage category in order to compare them with conventional banks. They also tend not to borrow and lend to each other, so this is why there would be a low concentration in the banking sector.  In other words, Islamic banks have lower counterpart risk and contagion risk should one of them default or fail.  While they are quite often criticized and chastised by rating agencies for their high concentration in the real estate sector, they are not commended for their low exposure to other banks. Counterparty risk is a big issue for banks. The contagion effect of banks falling like dominoes after the Lehman Brothers failure is what led regulators and rating agencies to pay close attention to counterparty risk. Conventional banks are overexposed to other banks more than they were before the financial crisis, while Islamic banks are underexposed. The exposure Islamic banks have to other banks is mainly through their treasury activities.  For example, an Islamic bank would park some of its excess cash at one of the global banks such as Deutsche Bank. Deutsche Bank, in turn, would invest this cash on the Islamic bank’s behalf in order to generate a Shariah-compliant return. This is usually done through commodity trading. Nevertheless, the Islamic bank becomes exposed to Deutsche Bank in the event of a Deutsche Bank failure.

At the end of the report, the researchers concluded that banking regulators and rating agencies are placing unwarranted regulation and requirements on Islamic banks, fearing that they are riskier. They suggest that Islamic banking is misunderstood by these regulators, which is evidenced by the way regulators have asked some Islamic banks to raise their capital as a consequence of placing higher risk on Islamic banks’ financing activities. They have also required Islamic banks to hold larger cash reserves, even though their financial activities typically come with ownership of assets (i.e., collateral), which should reduce the requirement for high cash reserves.

Needless to say, we will have to wait until the next financial crisis before regulators and rating agencies reexamine the risk assessment of Islamic banks. In the meantime, rating agencies will continue to underrate Islamic banks while looking the other way at conventional banks that are now exposed to over $710 trillion and counting in derivatives.

  

  Derivative Exposure Chart

Derivatives exposure of top 6 banks in the world as of year-end 2013 compared with US GDP, German GDP and total Islamic bank derivatives exposure.

Sources: OCC, Deutsche Bank 2013 Annual Report, World Bank.

 

Islamic banks’ exposure to derivatives is nearly zero. It’s not quite zero because they are exposed to conventional banks by way of their commodity trading and investment activities. In a crisis scenario where the derivatives market blows up, conventional banks’ capital will be wiped out many times over. No bailout would save them from the trillions of dollars in collapsing derivatives. Islamic banks, on the other hand, would only be exposed to the portion of cash and capital they have parked at conventional banks, so they would be hurt but not wiped out. This is the banking model conventional banks want to avoid because they say it’s too risky!