Islamic banking – a low-risk alternative?

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August 2016

The Islamic finance sector has seen rapid growth since the financial crisis. But is it really less risky than conventional banking – and how will new regulations affect the industry?

As the world’s financial system teetered on the brink of disaster, governments stepped in to shore up the banks and shock waves rippled through the global economy.

Yet the financial crisis did not have a negative impact on all institutions – in fact the failure of confidence in conventional banks helped to spur on the growth of the Islamic finance industry. In the 12 months in which the crash occurred, Islamic banks’ worldwide assets grew by 32% compared to just 13% for conventional banking.

Since then the industry has continued to expand. Its total assets, currently estimated to be in the region of US$2 trillion, are expected to reach US$3.4 trillion by 2018. Some have even proposed that Islamic finance, with its focus on ethics and stringent disclosure standards, is the panacea for the global financial system.

Dr Mamiza Haq, a finance lecturer at UQ Business School, says Islamic banking is an asset-based system with some built-in safeguards: “Theoretically, Islamic banks avoid interest at all levels of financial transactions and promote risk-sharing between the lender and borrower. In contrast to conventional banking, savers are entitled to be informed about what the bank does with their money and to have a say in where it should be invested.

“The Islamic bank and its customers share any profits in a pre-agreed proportion while any loss is borne by the lender. Islamic banks can’t create debt without goods and services to back it – such as physical assets including machinery and equipment.”

However, on the negative side, Islamic banks have fewer options to mitigate risk as they are prevented from using trades such hedging – although some would argue that this in fact reduces their exposure to losses. In addition, Shariah-compliant money markets and government securities are underdeveloped in most countries and Islamic banks’ access to lender-of-last-resort facilities operated by central banks are often limited.

The question is, are Islamic banks more risky overall than conventional banks or less so? And with new standards in the form of Basel III coming into place to force banks to hold higher capital reserves, how will this affect the sector? Indeed, are such measures even relevant to Islamic banks given that they operate in a different way?

In a research project by Dr Haq and her colleague Professor Robert Faff, they examined banks in 22 countries during the period from 1998 to 2011 in an attempt to discover what impact the new standards would have on bank risk in both conventional and Islamic banks.

They found that in general, Islamic banks were less risky and more resilient than their counterparts in terms of their capital requirement and in attracting deposits from investors. In both types of banks, a higher level of capital reserves was associated with lower risk, however the impact was dependent on the type of bank – Islamic or conventional – and other variables.

One interesting finding was that in conventional banks, holding a higher level of reserves actually increases the risk that they will be unable to meet their short-term liabilities and pay back deposits – possibly because measuring bank capital focuses on credit risk and ignores the importance of liquidity.

By contrast Islamic banks do not show a link between the level of capital and liquidity risk. Dr Haq says: “This suggests that bank capital is of a less concern in that riskiness shoots up less when capital is low. Perhaps, the conflict between depositors’ and investors’ interests at Islamic banks is less acute given their financing and lending is tied less to capital.

“The research also confirms that taking deposits reduces bank insolvency and credit risks. This is consistent with the traditional banking approach, and in line with the push by regulators worldwide to encourage banks to reduce their dependency on wholesale funding and increase reliance on deposits in order to maintain bank safety and soundness.”

While the research relates to the period up to 2011, it suggests that in terms of banking regulation, one size does not fit all. “While our analysis in general supports the tightening of capital regulation, it suggests that regulatory reform may not be as simple as imposing a single capital requirement across all types of banks,” Dr Haq adds.

“Such regulation may also create an uneven playing field, mainly because Islamic banks are bound by Islamic law and, for instance, have limited access to Shariah-compliant money markets, government securities, and lender-of-last-resort facilities, severely constraining their ability to raise funds or increase liquidity quickly.

“Formulating policies that are relevant and effective across the various stages of the business cycle for both conventional and Islamic banks presents a formidable challenge to policymakers.”