Maturing IF industry need empirical research



Roshan Madawela – www.riunit.com

Empirical research incorporating time-series and cross country data is readily available in the conventional finance industry as it has been studied, researched and documented over a long period of time. In the Islamic finance sector, such material is scarce. With time and maturity in the industry, the demand for detailed studies is set to increase.


Whilst the Islamic Banking or Sharia Compliant Banking (SCF) sector has been around for several decades now thanks primarily to pioneering efforts from countries like Malaysia and Bahrain as well as Sudan and Iran, the rapid development of this sector has been a more recent phenomenon. Consequently, the research material that is available on the subject tends to lack the type of empirical analysis that the conventional banking sector enjoys. Despite the industry being valued at some $750 billion (McKinsey & Co) with over 300 dedicated institutions and thousands of SCB service windows operating in over 75 countries, proper research with time series-data and cross-country analysis has not been forthcoming as yet.

In an attempt to fill this gap, the IMF has recently released a working paper using data on 18 banking systems with substantial presence of SCB to provide a cross-country analysis on the impact of SCB on financial stability. It poses the question, ‘Are Islamic Banks more of less stable that conventional banks?’

Different pillars

At the foundation of the SCB system are the two concepts of ‘profit and loss sharing’ and ‘mark-up’. In the former the rate of return on the financial asset or venture is either not know or fixed prior to the undertaking whilst in the latter case, the purchase-resale transaction is determined with reference to the benchmark rate of return. Benchmark rates similar to that offered by, for example, the London Inter-bank Offered Rate (LIBOR) would serve as reference points. The nature of profit share implies that the bank’s ability to secure a sound return is a function of its own investment decision and / or inputs made during the post-investment period as compared to the fixed return nature of the conventional system where the entire risk is transferred to the borrower. Thus, poor investment decisions on the part of the bank will have a direct bearing on the returns gained by depositors as the rate of return is determined by the profit and loss sharing ratio.

Additionally, SCB instruments also differ from conventional banks in the overall legal contracts, governance and the liquidity structure. For instance, Islamic banks have had to operate in an environment sans proper inter-bank and money market functionality, government securities and limited access to lender of last resort facilities of the central banks. Due to the principal requirement to be Sharia compliant, the Islamic Banks have less access to the risk-hedging techniques available to the conventional banks such as derivatives and swaps according to the IMF paper.

Comparative stability

With all these factors limiting the operations of the SFB, can the IMF study indicate the comparative financial stability of SCB vis-à-vis their conventional counterparts?

The findings suggest that SCB may be better able to transfer the risk of a negative shock from the asset side to the depositor. This aspect of the FCB tends to make them less risky from the depositor side. The paper also suggests that the need to provide a stable and competitive return to investors under the constraint of limited access to liquid instruments may place pressure on SCB entities to be more conservative. The SCB players are also said to hold a larger proportion of their assets in reserve accounts of central banks than the conventional commercial banks. Furthermore, the depositor’s position in the deal of risk sharing with the bank will render him towards exercising tight oversight over the bank’s management. This too will serve towards less risk taking on the part of the SCB sector.

The IMF study uses z-scores in order to analyze the combination of a bank’s capitalization, profitability and risk. The higher the z-score the less likely it is that the bank will run out of capital. Using a definition where banks with more than $1 billion in assets are categorized as large banks and those below $1billion as ‘other’, a number of results have been quoted. The following are the key points;

• Small Islamic banks tend to be financially stronger (that is, have higher z-scores) than small and large commercial banks.

• Large commercial banks tend to be financially stronger than large Islamic banks.

• Small Islamic banks tend to be financially stronger than large Islamic banks.


The paper suggests that the finding could be explained with reference to the contrast between the high risk stability in SCB entities as compared with larger SCB organizations in that it is significantly more ‘complex for Islamic banks to adjust their credit risk monitoring system as they become bigger. For example, the profit share modes used by Islamic banks, are more diverse and more difficult to standardize than loans used by commercial banks.’

As the scale of the banking operations grow, monitoring of credit risk becomes rapidly more complex and the issues of adverse selection and moral hazard might also emerge. With reference to the Mudharaba type of transactions this argument has a clear basis. Where a SCB enters into a large investment under a profit share structure, it would also invest in ongoing consultation and exercise oversight of that project in order to safeguard their investment. The Islamic bank can even ask to be represented at the Board Room in order to actively play a role in the decision making process.

Another finding of the study is that ‘as the presence of Islamic banks grows in a country’s financial system, there is no significant impact on the soundness of other banks. This suggests that Islamic and commercial banks can coexist in the same system without substantial “crowding out” effects through competition and deteriorating soundness.’

Academic limitations

Despite the study’s recourse to a large and extensive amount of cross-country data, its limitations in describing the ground operations realities cannot be under-scored. For instance, the finding regarding co-existence, may be relevant for those ‘fully-fledged’ Islamic Banks but the reality in the industry is that most players are conventional banks that have Sharia compliant windows. Thus the overlapping in the overall banking industry is significant in many respects as the exchange of information and resources between the conventional and SCB system will not be hindered by any academic definitions.

The suggestion that Mudharaba instruments may give a comparative advantage to smaller SCB operators based on their ability to better monitor their investment may find broad agreement at first glance. However, large SCB entities can factor in the additional costs of oversight and monitoring into their Mudharaba deals and even leverage on economies of scale to be more competitive in the market. Thus the argument the small Islamic banks are more stable than larger banks is not entirely convincing.

Moreover, larger SCB organizations typically have an entire range of financial products and services that go beyond the ‘profit share’ and ‘mark-up’ principals. The ability of larger players to issue sukuks (Sharia compliant bonds) on various types of transactions including Ijarah’s ( Leasing facilities) to be factored in. The fact that smaller SCB service providers tend towards a limited portfolio based on profit share and mark-up is possible a consequence of their own financial constraints that prevent them from engaging in some of the larger Sharia compliant operations.

The study also takes the aggregated portfolios of banks and makes sweeping statements regarding their overall operations with no reference to specific areas of activity and lending instruments of either the conventional or SCB entities. The prevailing economic environment will impact investors and depositors in difference ways that could perhaps be better analyzed under different asset classes or industry sectors. In this way, greater similarity between sectors or asset classes that contribute to financial stability may be found, across both the conventional and Islamic banking sector, at any given time period. Only disentangling the various components of the overall banking sector that is entwined at many levels will reveal an accurate account of financial stability for most countries.

One further point on the IMF study is that it needs to factor in the impact of regulatory authorities in any given country as it may be the key contributing factor. Strong regulatory institutions with powers to enforce laws serve to stabilize both conventional and Islamic banking systems.

In the absence of a healthy supply of such studies, it is difficult to rate the IMF paper for its usefulness to the industry. Whilst it is a positive contribution and ‘serves as food for thought’, the claim that large Islamic banks are less financially stable than their conventional counterparts or smaller small Islamic banks needs to be further researched.

Sources: http://www.vanguardngr.com, The International Monetary Fund, the Research Intelligence Unit.

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