Interpreting Middle East Economic News and Analyzing Market Trends

The next financial crisis will wipe out the lagest financial institutions. How will Islamic financial institutions fare?

http://www.novares.com/gfs_images/656_m1.jpg

 

The headline in Forbes from this past March reads “Risk is Back.”  Financial institutions today are riskier and have more derivative exposure than they had prior to the Lehman failure in 2008.  More specifically, a handful of banks carry over 95% of the estimated $250 trillion global derivative exposure.  This is trillion with a ‘T’ and not billion with a ‘B’.  To put this in perspective, the total US GDP in 2012 was about $16 trillion.  It’s already a foregone conclusion that the next financial crisis will wipe out these mega-institutions as they will be too-big-to-save.  What will happen to Islamic banks and financial institutions as the dominoes begin to fall?

 

Until recently, the four banks with the highest derivative exposure were thought to be;

 

http://b-i.forbesimg.com/halahtouryalai/files/2013/03/deriv-risk.png

Source: Forbes

 

However, a recent report shows Deutsche Bank holding the top spot with over $72 trillion in derivative exposure.  This is beginning to set off alarm bells from banking regulators:

  

A top U.S. banking regulator called Deutsche Bank’s capital levels “horrible” and said it is the worst on a list of global banks based on one measurement of leverage ratios.

It’s horrible, I mean they’re horribly undercapitalized,” said Federal Deposit Insurance Corp Vice Chairman Thomas Hoenig in an interview. “They have no margin of error.”

Hoenig, who is second-in-command at the regulator, said global capital rules, known as the Basel III accord, allow lenders to appear well-capitalized when they are not. That is because the rules allow the banks to use complicated measurements of how risky their loans are to determine the capital they must hold, he said.

Read the full story from CNBC.

 

During the last financial crisis we kept hearing about how inter-connected the financial system was at that point.  So much so that regulators had to step in and bail-out AIG, an insurance company, to stop what regulators believed to be systemic risk to the global financial system.  Trillions of dollars in bail-outs were handed out to financial institutions all over the world to stop the crisis.  As a result, financial institutions, which were too-big-to-fail at that time became even bigger.  Today they carry more risks and are exposed to more derivatives.  When, not if, the next crisis happens, only one of these mega-banks needs to fail to drag down the entire system with it.  This is when we’ll start hearing another term again; ‘counter-party risk.’  Back in 2008 this when financial institutions panicked after the Lehman failure and refused to take risks from other banks.  So if you invested money with say, Barclays, all of a sudden you’re calling Barclays to get your money back because you’re worried that they will fail next.  Or you refuse to take collateral from another bank.  This is what caused the system to freeze up in 2008.

 

This will happen again.  No one can tell when for sure, all history tells us it that it will happen again.  When it does, how will Islamic financial institution navigate through this?  And will they suffer too or survive?

 

Theoretically, Islamic banks will make it out with a few bumps and bruises.  This is primarily due to the fact that Islamic banks are prohibited from taking derivative exposure.  Their balance sheets are pretty clean compared to the toxic waste sitting on conventional bank balance sheets, and the bigger the bank, the more toxic the waste… but it’s all covered with ‘acceptable’ accounting maneuvers.

 

Islamic financial institutions, as you might expect, will suffer losses due to the fall of asset prices across the board, most notably real estate and stock prices.  However, a closer look at how Islamic banks invest and park their excess cash and you begin to hear a now-familiar term; counter-party risk.  Islamic banks park a large portion of their excess liquidity with conventional financial institutions using Shariah compliant contracts to ensure the funds are invested according to Islamic banking guidelines.  However, they now have counter-party risk.  The most common banks that manage Islamic bank liquidity are HSBC, Deutsche Bank, Citibank and JPMorgan…. all having the highest exposure to derivatives.  Once the first domino falls in the next crisis, this excess liquidity will evaporate before Islamic banks can say ‘counter-party’.

 

What can be done about this?  Nothing really.  Islamic banks are doing what their regulators asked.  They do have to manage counter-party risk, but diversifying between the top banks does nothing in a crisis.  So in a nutshell, even though derivatives are not Shariah compliant, and you will not find Islamic banks holding derivatives, when the next crisis comes and the trillions of dollars in derivatives come crashing down, the damage will be so wide and great that no institution will be spared.