If an Islamic bank fails

Asiamoney, August 2008

One day, an Islamic bank will fail. That’s a fact. It’s not because there’s anything wrong with Islamic finance; indeed, these institutions have come out of the sub-prime and credit crunch crises in much better shape than many of their conventional counterparts. But banks do fail from time to time, and Islamic banks will too.

And that raises some big issues, because just as so much of Islamic banking is a voyage into the unknown, so are the consequences of a collapse. When a bank operates under Shariah principles, but in a common law jurisdiction, which governing law or courts will handle its bankruptcy, or any creditor claims on the institution? And since Islamic finance is underpinned by the concept of an equal sharing of risk, does that mean that when a bank goes under, all its depositors share in the losses? Generally, when there’s a risk of that happening in the conventional financial world, a government steps in to bail out the individuals. Would that happen in an Islamic banking collapse?

“In theory, the depositors of an Islamic bank are on the hook for the losses of the bank,” says Abdulkader Thomas, president and CEO of Shape Financial, a consulting and training group in Kuwait and the USA. “If there are no profits, they should not make money, and if there is a loss of capital, they can be at risk to lose their capital. But that, to my knowledge, has never happened.”

In theory, though, it could. “At this stage, those governments that are promoting Islamic finance find it in their interests not to let an Islamic bank fail,” Thomas says. “Eventually, though, someone is going to build a large Islamic bank, get into trouble, and the secular authorities are going to say: well, this is how the system works, the depositors contracted to participate in the loss.”

One of the complications of Islamic banking is that the status of the banks’ owners differ from those in the conventional financial world. In particular, the role of the depositor is crucially different. “There is a difference between conventional and Islamic finance that adds another dimension to corporate governance,” explains Mark Stanley at Ernst & Young in Bahrain. “In Islamic financial institutions there are two types of owners: the shareholders, as in conventional institutions, and the investment account holders, or depositors. The relationship between the investment account holder and the [Islamic bank] can be compared to that of a collective investment scheme, in which participants [the account holders] have authorised their fund manager [the bank] to manage their investments.”

If you start digging into how Islamic contracts work, you start to see the distinction. Mudaraba contracts, which are the basis of the relationship between banks and their account holders, specify that the account holders, as owners of capital, have what’s called a mudarib relationship with the bank – that is, an agency agreement. In other words, they are sharing risks and rewards with the bank, and effectively providing a form of equity to it in a way that is not the case in conventional banking. “As a result, investment account holders are liable to incur unexpected losses in the same way as shareholders because there is effectively no cushion, as provided by equity from the shareholders in conventional institutions,” Stanley says. Some banks handle this uncertainty by using something called a profit equalisation reserve to smooth out returns to their account holders, so they can offset poor performance and continue to give out a good rate, although this practice does tend to raise eyebrows both in terms of its transparency and its sustainability. And, in any event, it doesn’t help the depositors in the event of a collapse.

Knowing this, shareholders would then be very likely to object if they were to find themselves suffering losses in a bank collapse at the expense of depositors. “If you ask the shareholders to bail out investment companies, those shareholders can take you to court,” says Professor Rifaat Ahmed Abdel Karim, Secretary-General of the Islamic Financial Services Board, headquartered in Kuala Lumpur. “They would say: ‘when I entered this, there was a contractual relationship which says these are the investors who bear a risk. Now you are displacing that commercial risk from the investors to the shareholders, and I was not meant to be holding that.’ That can put pressure on regulators: we don’t know what the outcome of that is, we don’t have certainty in enforcement.”

So what can be done about that uncertainty? “That’s what I’m saying, this will be the challenge for the industry,” he says. “This is why we have to follow a road where we should attempt to mitigate that risk. And hence the natural course we have now is on prudential standards that are being issued.”

The IFSB’s mission has been to try to develop standards that would put the behaviour of Islamic banks on a par with those in the conventional world following best-practice regulation and standards like Basel 2. It’s a long road – developing the regulations is one thing, getting central banks in Islamic countries to adopt them is quite another – but the approach is partly to ensure that the whole industry has a decent understanding of, and practice for, risk.

For example, when Asiamoney asks Rifaat if the recent turmoil in conventional credit markets presents an opportunity for Islamic banking to prove its worth, his response is cautious. “It would only provide that opportunity if the Islamic financial service industry can establish that it has an inherent resilience to a similar crisis,” he says. “I am aware of those who say it does, and I am aware of those who say it does not. The test will be when it takes place, and God forbid it takes place in the near future. But we should not be complacent, we should try to understand the specificities of the risks that there are in this industry.” He says adoption of the IFSB standards “would certainly enhance the soundness and stability of the financial system.”

Rifaat’s efforts are chiefly to stop collapses happening in the first place. But what issues arise when one comes along?

One is that bankruptcy hasn’t really been tested under a Shariah code. “Islamic scholars in the modern era haven’t discussed what they think bankruptcy to mean,” says Thomas. “Some countries have no bankruptcy code, or have an antiquated 19^th century or early 20^th century bankruptcy code. Whether it’s Islamic or conventional, it’s just not equipped. And some bankruptcy codes haven’t been meshed with Islamic issues, so that’s a problem.”

Regulators and central banks are looking at these issues with varying concern. In Pakistan, Shamshad Akhtar, the governor of the State Bank of Pakistan, is one who has tried to think it through. “Since Islamic banks are based on a different risk sharing methodology, there is a lot of investor education we have to do,” she says. “We need to talk about the displaced commercial risk associated with these transactions.” Separately, Pakistan is now developing a safety net program for depositors, since 80% of deposits (in the conventional or the Islamic system) now fall outside of any official guarantee.  Legislation is also being prepared for a deposit insurance scheme. “So that’s one coverage that Islamic banks will have,” she says.

Others see little difference between the failure of an Islamic or a conventional institution. “We do not believe that sharing of risk and insolvency processes are likely to be very different between Islamic and conventional banking,” says Michael Zamorski, managing director, supervision at the Dubai Financial Services Authority, which is responsible for the authorisation, regulation and supervision of financial services firms in the Dubai International Financial Centre.

In his view, it all comes down to the individual contract. “Determining where the risk lies and how a receiver or liquidator would deal with the underlying asset of a particular contract will always come down to the terms and conditions of the contract, what type of security the bank has taken over it and how he or she can perfect that security.” That’s the case whether the governing law or code of the contract is conventional or Shariah. The DIFC today has no wholly Islamic banks under its watch, although it does have significant Islamic banking activity, and the centre’s exchange, the DIFX, hosts a greater volume of listed sukuks (the Islamic equivalent of bonds) than any other exchange. Zamorski says he belives the regulatory framework and risk management structures are strong enough in Islamic banking. “Our expectations of corporate governance and risk management structures for firms are essentially the same for Islamic and conventional intermediaries,” he says.

It’s likely that the stronger the country, the more orderly the treatment of a collapse would be, if it were every allowed to happen. Malaysia in particular has a strong and ordered regulatory environment for its financial sector with very clear laws and regulations for Islamic finance. Bahrain has a sophisticated code, and the new financial centres in Qatar and Dubai have based their regulatory models on the UK. The greater uncertainty is perhaps with those countries which have less clarity in their legal codes and judicial processes, among them Saudi Arabia and the United Arab Emirates outside the DIFC (although one could equally argue that those countries, with a high level of state involvement in their financial services industries, would be more likely to bail out a flagging Islamic bank before a collapse became an issue anyway).

The better news is that Islamic banks are apparently less vulnerable to collapses than conventional banks anyway. It’s not necessarily a matter of great visionary thinking that no Islamic banks were exposed to CDOs – generally, their Shariah committees would never have permitted it in the first place. “The structures necessarily prevent an Islamic bank from having the same risk profile as a traditional bank,” says Thomas. “So they are never going to be able to leverage as much as somebody else. The theory should be that an Islamic bank rescue is less costly, and the risk of loss to shareholders and depositors is lower, than in the traditional environment.” Take, for example, a Murabaha structure, a staple structure of Islamic banking. “You can’t sell it down, and tranche it, and sell it off,” says Thomas. “There’s an asset there, with a residual value.”

One can argue – and some do – that the credit crunch shows why Islamic banking is inherently more sound than conventional banking, given the insistence on real, tangible assets, a deep suspicion of speculation, a lid on leverage and a sharing of risk.

But the fact that Islamic banks were prohibited from the riskier assets of the moment does not automatically mean that they follow best practice in terms of risk management, credit research or investment processes. It would be cruel to say that Islamic banking has fluked its current resilience – Shariah avoidance of excessive speculation and leverage is there for a reason – but it is also fair to say that credit and risk assessment expertise is in its infancy in much of the Islamic world. Few doubt there is room for improvement.

BOX: What history tells us.

Twice before, Islamic banks have run into trouble. On neither occasion has the government let them fall.

The most recent example involved Bank Islam Malaysia, which was the country’s first Shariah-compliant financial institution when it opened for business in July 1983. It was for many years the flagship Islamic bank in Malaysia; even today its own website calls it “the symbol of Islamic banking in Malaysia” and “the flagbearer of the country’s Islamic financial services industry.”

All went well for years, until a shock announcement that the bank had incurred losses of RM457 million in the year ending June 30 2005, thanks to a RM774 million provision against bad loans and investments. Most of them had been incurred by the bank’s Labuan branch, which had been converted from a subsidiary to a branch the previous December. The bank had a gross non-performing loan portfolio of around RM2.2 billion.

The precise reasons for these losses have, in some people’s eyes, never been adequately explained, but they threatened the bank’s future. Bank Negara Malaysia swiftly became involved, allowing suitors (initially Bahrain’s Unicorn Bank and then Malaysia’s own Bank Commerce Tijari) to open talks about taking stakes in the bank. Bank Negara also then set up a special purpose vehicle with bank Islam to manage and restructure the debt and loan portfolio, ring-fencing RM1.6 billion, with the remainder (comprised mainly of Islamic home financing loans) staying on the bank’s books.

By October 2006, a recapitalisation had been completed. Bank Islam issued 845 million new shares for a cash injection of RM1.014 billion. 690 million of the shares, representing 40% of the bank, went to Dubai Financial, part of the Dubai Investment Group, for RMB828.2 million. Another chunk, worth 9%, went to Lembaga Tabung Haji, a fund designed to help Malaysian Muslims with their religious pilgrimages. Bank Islam has since returned to profitability, delivering RM253.68 net profit in the first nine months of its 2007-8 financial year.

The Bank Islam scandal followed an earlier crisis at arguably the most well-known Islamic bank of them all – Dubai Islamic Bank. Founded in 1975, Dubai Islamic is widely considered the first major Shariah-compliant financial institution, and while it is partly state-owned and is closely linked with the Dubai government, this actually dates only from 1998. At that point, a fraud believed to be worth almost $300 million caused a run on deposits, endangering the bank’s future.

The government underwrote the losses and took a 30% stake in the bank, a level of holding it retains today (the UAE Federal Pension Fund also holds 4%).

Dubai Islamic is once again under scrutiny for fraud. A number of high-profile people have been detained in Dubai as part of a fraud investigation, though the precise circumstances have not been disclosed. Among them is Omair Mooraj, head of Islamic banking for the region at JP Morgan, who previously headed project finance for Dubai Islamic (and was quoted in this supplement in Asiamoney last year). Also under detention is Rifat Usmani, a vice president in structured finance at DIB. (Usmani has separately filed a suit against the bank in a court in Miami for “conspiring to detain, torture, and cause Platintiff’s forced disappearance”, according to a report by locally-based media outlet Zaywa Dow Jones, which claims to have seen the documents. Asiamoney has not seen this document.) Separately, the chief executive of one of Dubai’s largest real estate developers, Deyaar Development, is also under detention and investigation; DIB owns 41% of Deyaar.

The latest scandals notwithstanding, the Dubai Islamic and Bank Islam problems illustrate that even when an Islamic bank gets into trouble, it’s not a foregone conclusion that the depositors in the banks will suffer with them. As is the case in conventional finance, it’s accepted that the government or central bank will first try to broker a way of keeping the bank solvent, whether through its own involvement or by facilitating the entry of other stakeholders. So while the theory of equal risk among all participants in Islamic finance is still there, in practice it has yet to happen.