NOVEMBER 28, 2010
Gulf News has an interesting article they wrote about the decline in profitability at Islamic banks during 2009 compared to conventional banks. The article cites higher provisions and lower investment income for Islamic banks as the source of the decline in profitability (in part due to larger exposure to real estate than conventional banks). They also highlight the higher expenses of Islamic banks without any offsetting lower cost of funds or operational efficiencies that they could have generated had the industry been around longer and been able to streamline its operations in a way that conventional banks have.
The article’s explanations for the lower profits at Islamic banks are interesting and raise a few questions about what Islamic banks could do to improve their performance without putting the institutions at greater risk of having more future non-performing loans. To start with, I would suspect that part of what is creating the divergence between conventional and Islamic banks has nothing to do with the banks themselves. It would be natural to expect higher profitability in conventional banks in 2009 than 2008 (both on a stand-alone basis and in comparison to Islamic banks). The conventional banks had much greater losses in 2008 than Islamic banks, which was due in part to the subprime crisis, but also their wider focus; many Islamic banks have high exposure to the GCC, where the recession’s impact was delayed compared to many other parts of the world (mostly the US and Europe). Then there is the issue of whether the study took into consideration the larger hole that conventional banks faced in 2008 compared with Islamic banks because of their subprime and Lehman-related exposure. Without any adjustment, these banks might look more profitable than Islamic banks in 2009 because they were so much more unprofitable in 2008.
However, once those factors are considered, it does not leave the Islamic banks blameless. They certainly had too much exposure to real estate in the go-go years leading up to 2008/2009. They (mostly investment banks) also derived too much of their income from investment-related fees that were not sustainable (i.e. recurring revenue sources). This may have also affected the commercial banks if they used some of their capital to invest in the real estate deals originated by the investment banks.
However, there may be other factors at work. For example, the cost of funds is cited as a factor where Islamic banks lose ground on profitability compared to conventional banks. From reading the more optimistic theories, an Islamic bank should be able to raise funds more cheaply from debt financing because the bank’s depositors (those in profit-sharing investment accounts) are required to take losses if the investments the bank makes are unprofitable. However, this is probably not likely to ever happen because if depositors believed their funds placed with an Islamic bank were at risk, they would withdraw them, which could create a run on the bank. To prevent this, the Islamic banks have reserve accounts and will take almost whatever steps are necessary before they subject depositors to a loss of capital. If that happens, then the supposed advantage of profit-sharing investment accounts disappears. (The MD of KFH-Bahrain discusses Islamic banks’ depositors’ positionvis-a-vis conventional banks depositors in an interview with CPI Financial)
There are many factors that could lead Islamic banks to underperform conventional banks in a year like 2009; there are also large heterogeneities between Islamic banks so one bank’s losses from badly managed real estate investments may reveal more about that bank’s management than Islamic banks as a whole. There are also other factors that could play a role like Islamic banks’ larger holding of cash compared to conventional banks in a year when markets recovered from a significant crash. If any readers have seen the McKinsey report that Gulf News reviewed, I would be interested in reading it in full and not just the summary provided in the Gulf News article.
NOVEMBER 21, 2010
My posting was rather more active than it has been recently this week and so I am shifting the focus of this week’s letter from me sharing my opinions to asking for your feedback. In response to several requests, I decided to add a post to the blog that tries to give a quick primer on Islamic finance to those who may not be as familiar with the industry. It is the first post below.
My request from you, my readers, is to help me fill out the primer (which is linked from the front page of my blog now). I am asking specifically for the following assistance:
- Suggesting points that are unclear or just flat out wrong that I overlooked when I was putting it together;
- Suggesting additional key points that someone would find useful with no or limited experience reading about Islamic finance
- Suggestions for links to other resources that provide a more comprehensive primer. The blog post is meant to be a quick read, but I would like to also include links to more detailed “introductory-level” websites (free websites and those with free registration only please).
- Any other suggestions that you think that you think should be included to help someone who is new to Islamic finance get past the use of Arabic words and otherwise unfamiliar concepts.
I appreciate your help in advance and I would welcome feedback on the other posts I wrote this week (and suggestions for future posts/newsletters).
NOVEMBER 14, 2010
Before I get to the subject of this newsletter, I wanted to let you know that Sharing Risk was nominated for “Best Islamic Research” in the Islamic Business & Finance 2010 Awards from CPI Financial. I would appreciate your support when voting begins and I will send out another email with the voting details when they are released.
The subject of this newsletter was inspired by a dialogue I have been having recently with another person active in Islamic finance. It concerns the development of Islamic asset management and the creation of Islamic ‘model portfolios’ that asset managers can use to properly diversify Shari’ah-sensitive portfolios or more specifically the gaps in product availability to fulfill this mandate. The past several years has seen the development of many new products to fill out a Shari’ah-compliant portfolio, from private equity to hedge funds to structured products promising exposure to various other asset classes. However, this activity has been primarily focused on “high-fee” business areas and has excluded (with few exceptions, the “boring” areas like fixed income and money market products. Equity funds are relatively well developed, but typically have higher fees than equivalent conventional funds.
This is not the first time I have talked about the need for more fixed income and money market products (and it will not be the last either). However, the need remains and I worry that as markets and economies recover, the industry will return to the “high-fee” ways of the past. This would be detrimental for two reasons. First, while some of the products are needed to fill out Islamic portfolios, they should represent a small portion of most portfolios, vastly smaller than fixed income and money markets. However, product development has occurred in nearly inverse proportion to need. Islamic financial institutions go after the more lucrative areas to generate profits for their shareholders, as they should as profit-seeking ventures, but it is important that the industry’s growth be balanced by what is needed in the marketplace, not just what maximizes short-term profits.
The “high fee” explosion comes at a cost to these same Islamic financial institutions that is not always apparent in the short-term (but has been demonstrated in the recent crisis). The high fee products are more risky than fixed income products (for investors) and they are also generally “one off” revenue generators for the institutions which develop them. When risk appetite is high, there is a large and relatively stable flow of revenue, but when markets become jittery, the revenue dries up as investors avoid riskier products. This leaves those institutions unable to pay their own debts and in some cases puts them out of business altogether. At the same time, investors in these products with a limited universe of Shari’ah-compliant fixed income and money market products see greater losses than if they could better create more balanced portfolios.
A solution that benefits both institutions and investors would be to shift some of the focus away from the high fee, one-off revenue generators and towards the more “basic” elements of a portfolio: fixed income, money market and equity funds (alongside some alternative asset classes). Along with this new focus, institutions should build up asset management businesses with a focus solely on Islamic asset management (to develop the specific expertise on the available options for creating and implementing Shari’ah-compliant model portfolios. The management fees from the asset management business will offset the lost fees from high fee products to some degree, while the asset management revenue stream will provide a buffer for the firms when markets swoon because they are typically recurring (not one-off).
For investors–from takaful funds to pension funds to high-net worth investors–the development of money market and fixed income funds will provide a much more appropriate universe of assets from which to choose when implementing their model portfolios. This is key because if Islamic portfolios are forced to go through the boom and bust cycle with less diversified, higher risk portfolios, the may withdraw from the Islamic finance industry and the industry’s growth of the past decade may slow or reverse.
NOVEMBER 7, 2010
Since the last issue of the newsletter, I have covered many subjects, from the International Islamic Liquidity Management Corporation, the role of Shari’ah advisory firms, the effect of the financial crisis on Islamic banks and the costs and benefits of developing an ‘Islamic’ pricing benchmark. There are many additional comments I could offer on these subjects, but looking back through the posts (which are at the bottom of the email as usual), it occurs to me that two of those four topics are connected in a way that I did not cover in either post.
The debate about whether an ‘Islamic pricing benchmark’ is necessary can be connected to the development of Shari’ah-compliant liquidity management tools and the former may in fact be alleviated or solved by developments in the latter. This is significant because one of my criticisms of an Islamic pricing benchmark is that it is unnecessary and would divert resources away from more pressing issues in Islamic finance. What I failed to think of was that dealing with the shortage of high-quality, short-term sukuk that could be used to manage liquidity could serve as the benchmark for pricing Islamic financial products.
The way that the current pricing benchmark is done based on LIBOR (and apologies if I over-simplify or miss key details) is that the pricing is based on the ‘offer’ rate in inter-bank loans betwen banks in a given market, which have different maturities. There is a 6-month Euro LIBOR, a 3-month US Dollar LIBOR, etc. These serve as benchmarks for other loans, depending on the currency of those other loans, with an additional spread based on an individual borrower’s credit quality, as well as the bank’s costs.
When the ILMC begins offering sukuk, they will be in US dollars first followed by Euros with maturities of less than a year. The key point, which I mentioned somewhat tangentially in my ILMC post was that using murabaha (or salam as the Central Bank of Baharin does) would stifle the development of a market driven price benchmark. There would still be a benchmark price set every time the ILMC issued sukuk, but because murabaha and salam are not tradable except at par, they could not be used to develop a secondary market for short-term instruments that could provide a daily pricing benchmark for Islamic finance that would be based on a non-interest-based financial product freely tradable in the secondary market. An ILMC secondary market would thus serve the desire to create an Islamic pricing benchmark without taking resources away from the much more necessary task of strengthening Islamic banks’ liquidity management. That would be a win-win in my book.