Islamic banks and financial stability

By Habhajan Singh
The unique features of the financial contracts of Islamic banks mean that their operational risk can be substantially different from what the conventional ones are exposed to, according to a paper presented at an Islamic economics conference last week.
The potential risks faced by Islamic banks were among the topics of dicsussion at the International Conference on Islamic Economics and Economies of the OIC Countries (ICIE) 2009.
It is timely to look at the this aspect of the growing business, more so as some harbour the notion that Islamic banks are altogether free from the potential rough ride faced by their conventional counterparts. Although in terms of operational risks, Islamic banks have certain similarities to the conventional banking system due to working in a similar financial environment, the challenges are more complex for Islamic banks owing to their particular contractual and financial transactions, according to two scholars from the United Kingdom's Durham University.
"For this reason, it is understood that operational risks faced by Islamic banks are perceived to be significantly higher," explained doctoral fellow Hylmun Izhar and lecturer Dr Mehmet Asutay in a paper entitled 'A theoretical analysis of the operational risk framework in Islamic banks'.
This paper was among 78 presented at the two-day conference organised by the International Islamic University of Malaysia's (IIUM) Department of Economics at its Kulliyah of Economics and Management Sciences, whose dean is Associate Professor Dr A Khalid Ahmed.
The conference, which ended last Wednesday, was jointly organised in association with the Islamic Research and Training Institute (IRTI) of the the Islamic Development Bank Group.
The authors noted that operational risk management within financial institutions has undoubtedly attracted more attention from regulators, practitioners, and academics over the last decade.
One of the reasons is because of the huge losses incurred by a number of financial institutions such as Barings, Daiwa and Merril Lynch, due to the malfunctioning of their operational risk management systems.
"The relative complexity of contracts, combined with the fiduciary obligations of Islamic banks, imply that for Islamic banks, operational risk is a very important consideration.
"More importantly, Shariah compliance risk as part of operational risk is paramount to Islamic banks, which means Islamic banks must ensure, at all times, that all activities and products are in conformity with Shariah principles.
"It is, then, apparent that the dimension of operational risk exposure in Islamic banks is more sophisticated than in conventional banks," they argued.
Operational risk is a recent addition to the list of risks faced by financial institutions. The management of operational risk in Islamic banks is similar to that of conventional banks but includes several additional elements. They said that an operational risk is now recognised as a type of risk which can contribute to significant losses within all financial institutions.
"Having been regarded as an alternative financial intermediary with profit and loss sharing contract (within the mudarabah and the musharakah contracts) as its cornerstone, an Islamic bank is, theoretically, expected to bring more stabilisation and efficiency in resource allocation.
"In addition to that, an Islamic bank is also equipped with contracts which may, slightly, look similar to what a conventional bank has been commonly practising; ie debt financing (within the murabahah contract).
Nevertheless, they noted that the nature of debt in an Islamic bank is qualitatively different from that of conventional banks since the debt contract in an Islamic bank requires to be tied to some underlying assets.
"Consequently, the distinctive contractual structure that an Islamic bank embodies necessitates a different type of treatment on the management of the operational system within an Islamic bank," they wrote.
In another paper, it was pointed out that though Islamic banks operate on an interest-free basis, the economic environment in a dual banking system may expose them to the problem of rate of return risk. The paper entitled 'An analysis of Islamic banks' exposure to rate of return risk', notes that Malaysia's dual banking system with Islamic banks and conventional banks operating in parallel means customers are free to choose either system and also gives them the right to switch between systemd.
"In this regard, the customer would act to take advantage of any arbitrage opportunity due to the rate differentials and fund flows," said the authors, doctoral candidate at IIUM's Institute of Islamic Banking and Finance Zairy Zainol and assistant professor Salina H Kassim. At the same time, the study indicated the profit motive among the Islamic bank depositors when the Islamic banks' rate of return have a significant impact on Islamic banks' total deposits.
"The implication of this finding is that Islamic banks might be exposed to the rate of return risk. Ironically, the depositors will increase their deposits only when the rate of return is increased. "Otherwise, when the rate of return decreases, they will definitely decrease their total deposits within Islamic banks and they could switch their funds to the conventional banking system. This also implies the problem of rate of return risk and displaced commercial risk within the Islamic banking system," they concluded.
Hence, they said that policymaker should be aware that Islamic banks are largely exposed to the rate of return risk, noting that one previous sugestion to protect Islamic banks from risks which are caused by the interest rate movements is to reduce the maturity on loans on the asset side. However, the method is dangerous since it can harm the Islamic banking structure in general.
"Thus, two alternatives are recommended for Islamic banks. Firstly, Islamic banks should move away from fixed rate instruments like murabahah and BBA (bai bithaman ajil) into profit and loss sharing contracts like musyarakah and mudharabah.
"The advantage of the profit and loss sharing contracts is that the financing will be detached from the rate movements since they are directly independent on profit or loss from the financed business," they said.
Their second suggestion is that a risk-sharing agreement between Islamic banks and their customers should take into account the customer of long maturity loans agreeing to partially compensate the banks if the average rate of return exceeds the predetermined level. In return, the banks would agree to reduce the mark-up on an outstanding balance if the rate is below the predetermined level.

(This story appeared in The Malaysian Reserve on May 4, 2009. The Malaysian Reserve is a daily business/finance newspaper published out of Kuala Lumpur, with a sectoral page on Islamic finance on Mondays, edited by Habhajan Singh)