Islamic banks showed more resilience during crisis

The credit and asset growth of Islamic banks performed better than that of conventional banks in 2008–09, contributing to financial and economic stability, the
latest research paper by IMF has said.

The factors related to Islamic banks business model helped limit the adverse impact on profitability in 2008, while weaknesses in risk management practices
in some Islamic banks led to a larger decline in profitability in 2009 compared to conventional banks, it said.

The IMF Working Paper titled ‘The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study’, authored by Maher Hasan and Jemma
Dridi, said that the recent global crisis has renewed the focus on the relationship between Islamic banking and financial stability and, more specifically, on the
resilience of the Islamic banking industry during crises.

To assess the impact of the crisis, the paper uses bank-level data covering 2007−10 for about 120 Islamic banks and conventional banks in eight countries, namely,
Bahrain (including offshore), Jordan, Kuwait, Malaysia, Qatar, Saudi Arabia, Turkey, and the UAE.

These countries host most Islamic banks (more than 80 percent of the industry, excluding Iran) and have a large conventional banks sector.

The key variables used to assess the impact are the changes in profitability, bank lending, bank assets, and external bank ratings, the paper said.

The countries of the Gulf Cooperation Council (GCC) have the largest Islamic banks.

The market share of Islamic finance in the banking systems of the GCC countries at end-2008 was in the range of 11−35 percent, compared with 5−24 percent in 2004,
it added.

While conventional intermediation is largely debt-based and allows for risk transfer, Islamic intermediation, in contrast, is asset-based, and centers on risk sharing. In
addition to providing Islamic banks with additional buffers, these features make their activities more closely related to the real economy and tend to reduce their
contribution to excesses and bubbles.

The evidence shows that, in terms of profitability, Islamic banks fared better than conventional banks in 2008.

However, this was reversed in 2009 as the crisis hit the real economy. Islamic banks‘ growth in credit and assets continued to be higher than that of conventional banks in all countries, except the UAE, the paper said.

Further, with the exception of the UAE, the change in Islamic banks‘ risk assessment, as reflected in the rating of banks by various rating agencies, has been better than
or similar to that of conventional banks.

Hence, Islamic banks showed stronger resilience, on average, during the global financial crisis.

Factors related to Islamic banks‘ business model helped contain the adverse impact on profitability in 2008, while weaknesses in risk-management practices in some
Islamic banks led to larger declines in profitability compared to conventional banks in 2009.

Thanks to their lower leverage and higher solvency, Islamic banks were able to meet a relatively stronger demand for credit and maintain stable external ratings, the paper said.

While Islamic banks‘ exposure to the real estate and construction sectors are lower in Saudi Arabia, Bahrain, Jordan, and Malaysia, it is significantly higher than the
system‘s average in Qatar, Turkey, and the UAE, it added.

However, the research paper said the crisis highlighted a number of sector-specific challenges that need to be addressed in order for Islamic banks to continue growing
at a sustainable pace.

Specifically, the key challenges faced by the Islamic banking industry include, namely, the infrastructure and tools for liquidity risk management, which remains underdeveloped in many jurisdictions; a legal framework, which is incomplete or untested; the lack of harmonized contracts; and insufficient expertise (at the supervisory and industry levels) relative to the industry‘s growth.

Further, the crisis highlighted the importance of liquidity risk, making the strengthening of liquidity management a key part of the global reform agenda.

While Islamic banks rely more on retail deposits and, hence, have more stable sources of funds, they face fundamental challenges when it comes to liquidity management.

The challenges relate to, firstly, a shallow money market due to the small number of participants and the absence of instruments that could be used as collateral for borrowing or could be discounted (sold) at the central bank discount window; and secondly, the inability to attract or maintain deposits by promising higher return.