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Islamic Banking regulation requires a rethink
Islamic banking, after more than a 30 year presence, today has the look and feel of conventional banking. Though the terms are all Arabic, in essence, the products and processes are the same. Islamic banking, especially in pioneering countries like Malaysia, began on a replication mode. Conventional banking products and processes were mimicked. Such a replication strategy may have made sense back when Islamic banking was beginning to take root. Today however, the balance sheets of most Islamic banks are not too different from those of debt based conventional banks. An attestation to their heavy reliance on “debt” type contracts like Murabaha, Ijarah, BBA and the like on the asset side. It is not uncommon for Islamic banks, especially in countries like Malaysia to have 80 to 90 percent of their total assets under such fixed-rate contracts. To make matters worse, Islamic bank assets are dominated by long term financing like home mortgages, vehicle hire purchases etc. Since the liability side has deposits that are short term in nature, the duration gaps for Islamic banks are large, in many cases much larger than that of conventional banks. Previous studies have documented this.
What these large duration gaps mean is that, Islamic bank balance sheets are much more vulnerable to interest rate hikes than that of conventional banks. An ironical result, since Islamic banks are supposed to be operating in an interest free environment! Global interest rates have been falling for the last several years. Today they are at historic lows and all the evidence is pointing to a regime switch, to one of rising rates. Should inflationary pressure cause rates to rise rapidly, Islamic banks, especially those with large duration gaps could be in serious trouble. Since the duration of assets is much larger than that of liabilities, its value falls much more than that of liabilities. The result will be a huge squeeze on the Net Worth of the bank. Should an Islamic bank's equity or net worth not be sufficient to take the squeeze, it will be rendered insolvent. The same fate that befell American Savings and Loans in the 1990's could happen to Islamic Banks, should rates rise fast. The reason conventional banks have smaller duration gaps has to do with their extensive use of floating rate loans and their flexibility to use derivatives like Interest Rate Swaps. So, where interest rate exposure is concerned, conventional banks have lower exposure than Islamic banks.
Aside from product profile, regulation too has helped to perpetuate if not enhance the problem. Conventional banks are required by regulators to follow Basle (BIS) Requirements for capital adequacy. The IFSB (Islamic Financial Standards Board), plays the same role for Islamic banks as does the BIS for conventional banks. Unfortunately, IFSB standards appear to have been formulated from the same BIS template. Thus, loan contracts have lower capital adequacy requirements than funding under risk sharing contracts like Mudarabah or Musyarakah. While such requirements make sense for conventional banks that are really in the business of making loans, Islamic banking's real value added lies in the risk sharing contracts of Islamic finance. Yet, IFSB would require capital adequacy ratios (CARs) of 300 percent for Mudarabah and Musyarakah type financing. This is at least, three times higher than that of loan contracts like Murabaha or Ijarah. Given the punitive CARs, for Islamic banks competing within dual banking systems it makes little economic sense to push risk sharing contracts even though they have the potential of being much more profitable. Thus, one sees very little funding by Islamic banks under risk sharing contracts. Yet, the risk sharing contracts being quasi-equity avoid the leverage, risk concentration and macroeconomic vulnerability of debt contracts. In many ways, regulation, instead of enabling Islamic banks to take advantage of their ability to provide risk sharing contracts and truly differentiate themselves, acts to hinder them. Unless such requirements are reviewed, Islamic banking is bound to continue on its current path towards convergence.
When Islamic banks produce the same outcomes and cause the same externalities as conventional banks, they bring little value to the society. Furthermore, competing with conventional banks on loan based financing is a losing proposition. Conventional banks have far more advantages in loan origination than Islamic banks, their size and scale cannot be matched. If Islamic banks are to thrive over the long haul, there is need for them to rethink their business model.
Moving away from loan origination to participatory risk sharing finance can change the game, but Islamic banks need to be helped to make that change. For a start, the regulatory and supervisory models for Islamic banking would first need to change. One cannot expect different results while doing the same things.
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