Islamic Finance and Financial Stability

Tariqullah Khan, Professor Hamad bin Khalifa University

Tariqullahkhan.me

A note on the gaps existing in Islamic financial architecture

Several studies conclude that Islamic finance, because of its inherent risk sharing and risk spreading features will enhance financial stability Such conclusions are in fact similar to theoretical works in conventional finance which argue that if such and such conditions are met financial stability can be enhanced

However, financial crises reoccur because the theoretical conditions of stability are not met in practice. Therefore, the practice of Islamic finance may be far from its ideal architectural principles and hence Islamic finance may not promote financial stability or may even cause instability

Like conventional finance Islamic finance may lead to financial instability

The 5 channels of financial instability that may also exist in Islamic finance

The 5 channels of financial instability that may also exist in Islamic finance

Channel One: Excessive credit creation and leverageChannel Two: Trading in future expectationsChannel Three: Unstable funding sourcesChannel Four: Rigidities of financial infrastructuresChannel Five: Structural Risk of the Opaque Products

7% interest10% interest

5% interest

15% interest

BANK Murabahah for asset

$100 Tawaruq

$100 Tawaruq

$100 Tawaruq

$100 Tawaruq

$100 Tawaruq

20% interest

Crisis Channel 1: Credit creation and excessive leverage

$100

$100

$100 $100

$100$100

Excessive credit creation and leverage

Scenario-1: Lending being as the core commercial activity of banks, credit creation is primarily based on ratings and credit risk and interest rates that different borrowers have to pay causing unbridled leverage subject to reserve requirments.

Scenario-2: If we make genuine Murabahah as the core business of banks, financing cannot get out of the real economy. In this scenario, we can benefit from the advantages of the fractional reserve banking system but at the same time also avoiding the excessive and unhealthy credit creation by banks.

Scenario -3: But if we make non-genuine Murabahah like Tawaruq as the core business, this scenario prevails which is almost similar to Scenario -1, where financing gets out of the real economy.

The excessive leverage channel to financial crisis is open for Islamic finance through

Tawaruq

Crisis Channel 2: Trading in future expectations

Jun-07 Jun-08 Jun-09 Jun-10

516.4683.8 604.6 582.6

BIS reported total OTC derivative contracts outstanding (trillion US $)

FX9%

interest rate deriv-atives72%

Equity1%

commodity0%

credit5%

others7%

June 2008

FRAs12%

Interest rate swaps78%

options11%

Jun-2008

Of all BIS reported derivatives (US$ 684 trillion in June 2008) 72% were interest rate derivatives of which 78% were fixed-to-floating rate swaps.Islamic finance has also created an exact replica of the fixed-to-floating rate swaps known as “profit-rate-swaps”

The derivatives’ channel to financial crisis is open for Islamic finance through “Islamic” derivatives

Crisis Channel 3: Instability of funding sources

Sample of Islamic Banks

Average US GSSBs

Average non-US GSSBs

EU 28 Banks

0

2

4

6

8

10

12

14

16

18

Source: IFSB “Islamic Financial Services Industry Stability Report 2015”

*GSSB – Global Systemically Significant Bank

% tier 1 capital adequacy ratios

Sample of Is-lamic Banks

US GSSBs Non US GSSBs0

5

10

15

20

25% balance sheet leverage multiples

% of PSIAs in the funding of Islamic banks

2012 2013 20140

5

10

15

20

25

Islamic retail banks

Islamic wholesale banks

Liquid assets as % of total assets

Rigidities of financial infrastructures The IFSB’s Islamic Finance and Financial Stability Reports address what the IFSB is doing in setting standards. The report doesn’t address the actual implementation of these standards.

1. In fact the prudential standards of IFSB, and the Shariah and accounting and auditing standards of AAOIFI are not under implementation except for a few countries.

2. PSIAs as the core deposits of Islamic banks are not uniformly treated in different jurisdictions

3. The relevant two prudential reserves, respectively for “displaced commercial risks” (profit equalization reserve) and for “commercial risks” (investment risk reserves) are not established

4. Instead of taking and managing PSIA related risks since the financial crisis Islamic banks are either avoiding PSIAs or placing the PSIA funds into lowest risk commodity Murababahs

5. Disputes among key architectural players about foundational principles; example Tawaruq, Promise, Ee’na, sale of debts, etc

Promise to repurchase the Sukuk assets at the initial price is not permissible

“Sukuk and their Contemporary Applications” open source document 2007 by Muhammad Taqi Usmani, President of the AAOIFI Shariah Council

Promise to repurchase the Ijarah Sukuk assets at the initial price is permissible

AAOIFI Sukuk Resolution 2008

“The issuer or the partner or the agent must not undertake any of the following: Purchase of sukuk or their assets in their nominal value or for a prefixed price so that it ensures the capital. -------------------The decisions issued by the Board come into effect from the time of its issuance and do not affect the previous contracts and from among them are the sukuk”.

Resolution No. 188 (2012) of OIC Fiqh Academy on the subject of Sukuk

OIC Fiqh Academy

Disputes and Structural Risks of Opaque Products

“Prospective Holders should note that different Shariah advisers, and Saudi courts and judicial

committees, may form different opinions on identical issues and therefore prospective Holders may wish to consult their own legal and Shariah advisers to receive

an opinion if they so desire.”

Sukuk Structural Risk – bundled nature of credit, price and return risk

Sukuk

Credit risk

Interest rate risk

Asset price risk

Bond

Equity

Consequence of disputes and noise between Shariah scholars

Financial Crisis Channels Is this crisis channel open in Islamic finance?

Excessive credit creation and leverage

Yes, the crisis channel is wide open through Tawaruq in which no party is genuinely interested in selling and buying assets.

Trading in future expectations

Yes, the door is opening through the growing R&D efforts and emergence of “Islamic” derivative products and markets.

Unstable funding sources Yes, but not wide open – capitalization and liquidity situation of Islamic banks is better but because of withdrawal risk, profit sharing investment deposits are perceived to be more unstable as compared to the interest-based term deposits.

Rigidities of financial infrastructures

Yes, the crisis channel is open because neither prudential standards of IFSB nor Shariah standards and financial transparency standards of AAOIFI are practiced. Nor there is a mechanism for Islamic financial sector assessment in place.

Structural Risk of the Opaque Financial Products

Yes, the crisis channel is widely open because of the disputes between Shariah academies and boards on even basic architectural issues.

Summary of crisis channels

How to enhance financial stability through Islamic finance?

Strengthen Islamic finance architecture

Islamic Finance Stability Board

By establishing an apex

Finance Ministers;Central Bank Governors;

Islamic Bankers;Sukuk Issuers and dealers

Investors“Independent” scholars

The key architectural players are actually

Looking ahead an Apex Islamic Finance Stability Joint Forum

is the need to avoid structural risks of industry

Finance Minsters of OIC Countries

Central Bank Governors of OIC Countries

Head Office Istanbul, Turkey