Islamic Banking: Lessons from the credit crisis

When it comes to the current economic environment, it can be said that we are all watching a “horror movie”. This is the ominous verdict delivered by the prestigious think tank, Ernst & Young Item Club.

All conventional indicators point in one direction: Euro Libor fixed rate touched 4.57 per cent (one month); sterling Libor reached 5.38 per cent; dollar Libor hit the level of 2.50 per cent - these are some of the highest levels seen in recent memory. Similar pattern is observed in the Swap market - with the difference in swap rates and government bonds being the highest in 6 months. TED spread, which captures the difference between 3-month Treasury bills and 3-month Libor rose to over 200bp. So what does all this mean?

It means two main things. Firstly, there is a significant concern about the conventional financial system and indeed the model used by many investment banks (Lehman Brothers) and retail banks (HBOS) has been questioned. Secondly, these indicators show that there is a large flight to quality, with gold prices surging and money managers facing mounting challenges of buying Treasury bills.

Confidence and trust, two of the most precious commodities, are at record low following the bailout of Fannie Mae, Freddie Mac and AIG. The collapse of Lehman Brothers, Bear Stearns and Merrill Lynch's takeover by Bank of America makes this crisis arguably the worst since 1929. This chaos has led many observers perplexed, with the BBC asking: Where now for capitalism?

While the conventional financial system disintegrates, Islamic banking seems to be flourishing, accounting for 17% of Qatari and 15% of Malaysian banking assets and impressively, over 95% of banking activity in Saudi Arabia conforms to Islamic principles. The Wall Street Journal, points out that we are in the midst of an “anti-credit crunch” with Islamic banking playing an important role in over $300bln worth of projects gripping the MENA region.

Given this level excitement around this fledgling, but promising industry – we must ask ourselves some tough questions. Can this level of growth be sustained? What are the main challenges facing the industry and what can we learn from the credit crisis?
The rise and rise of the property market. In Dubai, the property market and the fortunes of many Islamic banks are closely intertwined – and with a 79 percent increase in the property prices since 2007, many market watchers are feeling quite uneasy. More recently, this concern was compounded by a research note published by Morgan Stanley, predicting a 10 percent fall by 2010.

Alarmingly, Morgan Stanley’s worst case scenario envisages a fall to the same degree as Singapore property market crash in the 1990s, where prices collapsed by 80 percent in 18 months. Therefore, the risks associated with the real estate boom in Dubai and some of the other MENA regions are one of the primary concerns for stakeholders of Islamic banking. More broadly speaking, this concern can be tied to excess speculation, known as maysir.
Fatwa risk and product development. The race to join Islamic banking has led to a dramatic rise in the development of innovative and creative products. A significant amount of this development has taken place in the sukuk space, where more and more diverse sukuk products have been created.

This is a double edged sword: on the one hand, Islamic banking is a nascent industry; product development is absolute key to its survival. However, the risk lies in the over-use of conventional industry as a benchmark. This point can be expanded further – Islamic banking relies heavily on the concept of securitisation, where the focus is on greater transparency. This is a key selling point of Islamic banking, especially as the industry seeks to capitalise on the recent failing of the conventional market. There is a fatwa risk, however, associated in placing too much emphasis on product development and not enough on the Shari’ah principles. This point was illustrated recently when a top scholar at the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) claimed that 80 percent of sukuk structures are not Islamic.
Liquidity risk.

Ironically, the collapse of Bear Stearns had little to do with sub-prime mortgage meltdown, in which it was a major stakeholder. It collapsed as a result of plummeting market value for ultra-safe assets, such as the triple A-rated bonds by Freddie Mac and Fannie Mae.
Peloton, Carlyle Capital and many other hedge funds, which had absurd level of leverage, were forced to sell their ultra-safe assets, after banks became reluctant to roll over short term loans held by these hedge funds.

This was followed by a fall in the prices of the triple-A rated assets, even though there was little change in the probability of default for many of these bonds. Given the fall in prices of these “safe” assets and multiplied by the leverage, many hedge funds went bankrupt. Bear Stearns was a significant holder of these ultra-safe assets, which were used as collateral to fund its obligations to other banks. Following these price falls, other banks were simply not willing to accept the triple-A value of Bear’s collateral.

The latter point was confirmed by a Standard and Poor’s research note before the collapse of Bear Stearns, which reiterated that most of the sub-prime losses had been realised. Therefore, the final “knock-out” came from the lack of liquidity for these triple-A rated assets, rather than sub-prime losses.

From an Islamic banking perspective – liquidity risk is one of the key concerns, which has been given extra heat by recent events around the credit crisis. Of course, the money market is out of reach for Islamic banks, due to Shari’ah constraints. In addition, surplus liquidity cannot simply be given to conventional banks, since the interest revenue would be prohibited. Having said this, it is possible for exchange of funds between Islamic banks, by the use of Mudarabah and Musharakah instruments. The effectiveness of this depends on number and diversity of Islamic banks.

It is promising to see some of the most respected names in Islamic banking playing an important role in this area, such as the Islamic Development Bank, Bahrain Monetary Agency and Bank Negara Malaysia. Currently, the focus is on learning from some of the liquidity management schemes operating in Bahrain. In addition, Bank Negara Malaysia has introduced a PLS scheme for Islamic banks to obtain short-term funds. With the credit crisis in mind, efforts that are currently underway, need to be extended.