The Rise of Islamic Finance 4 lessons that western banks can learn from their Islamic counterparts

The Rise of Islamic Finance 4 lessons that western banks can learn from their Islamic counterparts

Perhaps, Islamic banks can teach its western counterparts some basic principles very much linked to common sense which could enhance their financial stability three years after the credit crisis.

During 2008, UK accountants joked about the balance sheet of their banks: “On the left side there is nothing right; on the right side there is nothing left.” Languages in other countries did not offer the same potential when referring to the balance sheet of banks, yet the underlying situation was more or less the same. However, it is remarkable the strength that Islamic banks (those subject to Islamic finance) have shown over these years. Three years after the ignition of the crisis, several lessons can be learned from these banks, but the four most important are:

Islamic banks can stabilise credit growth. A major danger for an economy lies in excessive credit growth. Central banks can influence this inter alia through interest rates, but sometimes this tool is ineffective, banks lend too much in good years and too little in bad years, creating Hyman Minsky’s credit cycles that can worsen economic cycles. In “good” years non performing loans come down, there is plenty of liquidity and it is very easy to obtain credit, which in turn further drives down NPLs (non-performing loans). The opposite occurs during “bad” years. We have learned from this crisis that (a) incentives drive human behaviour, and (b) an incorrect incentive scheme can lead to exponential credit growth that creates the basis for future banking and economic damage. As Islamic finance only allows financing to happen as long as it is linked to the value-creating real transactions, ultimately “credit growth” (although under Islamic finance “credit” should be read as “coinvestment”) is very much restricted by growth in productivity and income, creating a natural brake for credit growth in “good” years. Structural reforms in the western banking system point towards creating similar “brakes” for credit growth normally linked to incentive schemes.

One bank can lose most of its investment in a “complex” to value synthetic product, such as a CDO (Collateralised debt obligation), a CDO squared or a CLO (Collateralised loan obligation), yet if the investment is a physical asset (property, infrastructure, energy) the risk of losing 100% of the position is almost nil. As Islamic banks are only allowed to invest in physical assets generating free cash flow, valuation of these instruments is more transparent; as a consequence financial stability is intuitively reduced compared to that of an investment in a theoretically risk-limited AAA rating CDO squared. Indeed, reforms in Basel II and III in general penalise in capital consumption the holding of positions without underlying physical assets.

Systemic risk is reduced if risk-managing instruments are used in tandem with wealth creating activities rather than trading risk independent of economic productive transactions. Comparing the replacement value of global derivatives with global GDP shows how side-betting can grow to almost reach world production of goods and services mostly through over-the-counter (OTC) transactions which enhance systemic risk. Islamic finance allows risk-taking only if it is integrated with wealth creation, rather than pure zero-sum side-betting (betting would be forbidden under the principle of gharar). This has produced the fact that Islamic banks were much less affected by the OTC derivatives meltdown that followed the demise of Lehman Brothers. The recent US reforms of the financial system which seriously limit proprietary trading could illustrate this vision.

Too much leverage is bad. This is a consistent lesson throughout history. Islamic finance prevents investing in the equity of companies if they use leverage (debt to assets must be one third at maximum) and investments in assets which are financed heavily through interest bearing debt (these would be considered too risky and consequently unlawful). The result is a low beta investment portfolio that will yield low in good years, but very resilient to changes of cycle. New trends in banking regulation will also impose caps on the absolute level of debt a bank can use to finance its operations.

These lessons do not imply that Islamic banks are free of risk. Other significant perils can arise. On one hand, limiting finance to physical assets can create asset bubbles, due to an imbalance between liquidity and collateral, which sooner or later can create a serious banking crisis. Spain is a good example of a banking system that invested in physical assets (property developers) and saw credit growth exceed 20% during the credit boom. The result was an intense banking crisis. On the other hand, the recent default of some Islamic Sukuk (hybrid instruments which work as a bond) could damage some of the Islamic banks holding these assets.

What is the difference between a bank and a hedge fund? A bank is a hedge fund with much more leverage. On average a hedge fund uses a leverage of one to three; a bank uses a leverage of one to twenty. In 1900, banks in the West would use a leverage of one to three. During the summer of 2007, many banks had reached positions of one to thirty and one to forty. Priced for perfection, but as behavioural finance teach us, human beings are imperfect. Perhaps, Islamic banks can teach us some basic principles very much linked to common sense which could enhance financial stability. Indeed, it was during the XIII century that the Catholic Church stopped its prohibition of charging interest rates on loans; exactly when the 800 years of financial folly described by Professors Rogoff and Reinhart started!

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