Crisis Shows Importance Of Islamic Finance

The current economic climate has seen a growing interest in Islamic finance, an ethical approach to economic activity, worldwide.

Anouar Hassoune, Vice-President, Senior Credit Officer, Moody's Investors Service, France, says Islamic finance has been resilient to the crisis, even though it is not risk-immune per se.

He sees Islamic banking as an equivalent of conventional banking, with a robust model.

Hassoune spoke to Emirates Business about what made Islamic finance resilient to the current economic crisis and where lay the opportunities for its future growth.


Islamic finance is being viewed as relatively resilient to the economic crisis. Do you think it is a risk-free economic approach?

Islamic finance has been very resilient to the crisis but it is not risk-immune per se. It's been very resilient to this crisis for many reasons: The institutions could not carry toxic assets, because as per Shariah you cannot invest in speculative instruments; you cannot invest in the ribah-based (interest) instruments and typically the sub-prime asset classes that have been securitised in collateralised debt obligations etc.

So by definition an Islamic bank could not carry all this. Islamic finance institutions have their own set of risks; they face 'reputation' risk and liquidity risk.

It is very difficult to manage liquidity under Islamic finance rules as instruments are not available and cash has disappeared anyway from conventional banking and also from Islamic banking for a short period of time. Some of the Islamic banking institutions have been harmed, not so much as the commercial retail-based banks, but more like the specialised investment banks.

What pushed such institutions to that situation?

Some financial institutions, for instance, invest in private equity, venture capital and real estate and these asset classes are very cyclical, illiquid and extremely risky.

On the other side of the balance sheet, these banks were not using retail and stable visible deposits, they were using wholesale funding.

So when liquidity dries up, the values of the assets shrink and as you cannot liquefy your balance sheets, you default.

And when banks ask their money back what do you do?

You cannot liquefy your balance sheets. So you default, this is exactly what happened with these institutions. But are we alarmed by Shariah-compliant banking per se? Not really, it depends. If you are standalone, which means you are lonely, it is difficult, but if you are part of a wider group, it's not so tough.

You mean it has not been totally resilient?

The model has been resilient, some institutions have been hit not so much as they were Islamic, more because structure of balance sheet was designed in a way to outperform in good times and to underperform during bad times.

Generally, Islamic banks have been very strong. They are aware of the fact that liquidity management is difficult; which is why they have set aside, on an average, just before the crisis, 33 per cent liquidity ratio which means that Dh1 out of three captured from deposits was invested in cash. They knew liquidity was a challenge and they had to set aside a large liquidity buffer.

Second, they are highly capitalised; their average capital adequacy ratio was 18.4 per cent at the end of 2008; three points higher than conventional. It was not because they had not foreseen the recession more than others. Fortunately their balance sheets were designed to absorb the credit crisis better than the others and toxic assets were not there, which was good.

Given the robustness of the Islamic model, do you see a higher growth for Islamic banking? Which segments hold the most potential?

Our estimate of potential of financial market of Islamic finance globally is $5 trillion (Dh18.35trn); the current size of the market is $840 billion, next year it would reach $1trn.

Islamic banks are stronger on the retail segment; their market share is now close to 25 per cent in the GCC.

This share would grow. In the GCC, the market is divided into three set of customers – around 20 per cent are those who would go in for Islamic banks no matter what; then there are those who will bank with an Islamic finance institution if products are available, those products are of good quality and they are as cheap or expensive as conventional banks. Finally, there is a segment to which it does not matter whether a bank is conventional or Islamic, it's the brand that makes sense to them. These form almost 30 per cent, so there is room to grow.

The crisis has been a blessing for Islamic banking, not so much of growth or resilience; we saw some were not resilient but more the model – the conceptual model of avoiding speculation, excessive interest, profit and loss sharing. All stakeholders should share profits of good times and mutualise risk in bad times. It makes some sense.

Finally, as financial transactions are required to be backed by tangible, real, economic assets, it places Islamic banks closer to real economy compared to conventional banks that can structure products within an infinite sort of range that are mainly notional, virtual.

Islamic finance is forced by Shariah boards to get close to the real economy; you can securitise once not twice, in conventional whenever you want you can do it.

Would you say it is better than conventional banking?

The crisis has been a fantastic opportunity for Islamic finance to prove its resilience, its maturity, to prove the fact that Islamic finance is a possible alternative to excessive leverage, excessive securitisation, excessive financial innovation that is not closer to the economy. But it is no better, no worse.

Which category of banks are best positioned in the present situation to gain a market share?

Smaller banks are gaining market share.

There were many reasons: There was a perception in the market that these banks were not carrying toxic assets in their balance sheets. Smaller banks are eager to gain market share in times of stress, they position themselves to gain market share when large banks face stress.

In a crisis situation, large banks do not really have interest in gaining an incremental one or two per cent market share. There is no incentive for them to do so. They protect their liquidity and capital at the expense of profit. In the current scenario, you have to protect your liquidity.

How would the coming up of the $10bn Istikhlaf bank in Bahrain help the industry?

The Islamic finance industry now needs organising from inside, discovering new horizons geographically. For that they need capital. A $10bn bank would help spread Islamic finance beyond the borders of Islamic countries. There are many regions, which are in need of cash. Our economies need technology. What Istikhlaf is likely to do is to already use its sister company, Al Baraka Banking Group, it would have a platform of that group to bring retail deposits, geographical diversification and a business model that has proved its robustness. If it is designed as we expect it would be, it has a great future.

From Emirates Business 24|7