Regulating the banking sector
Part 2. Solving the conflict of interest
JULY / 2022
Continuing the previous contemplation on banking regulation, the mechanism of systemic risk management and impact on banks’ profitability, it is a good time to consider how the trade-off between financial stability and the commercial interests of banks can be sustainably managed.
The Islamic finance system
The simple solution to the conflict would be reduction of liquidity requirements to free-up assets. But this approach has shown to be quite detrimental to the incidence of early withdrawals by the depositors. The solution must lie elsewhere.
An interesting direction to explore is Islamic banking. It significantly rethinks the financial system and may support elimination of systemic risk completely because it’s a financial system model that rejects the notion of risk altogether. Putting aside the theological aspects and the debates on the role of inflation and which instruments are and are not sharia compliant let’s consider only the concepts and principles of Islamic finance as a potential resolution to financial crises and elimination of conflict between regulation aimed at reducing the impact of crises and performance of banks.
There is a body of literature that illustrates how the Islamic banking system has fared better in the 2007-2008 financial crisis than conventional banks. There is some data showing that market capitalization, profit and assets were affected to a lesser extent by the crisis whilst the Islamic banks’ leverage was much lower and there was no government assistance provided to any of the Islamic banks as a result of the crisis.
Islamic financial framework is characterized by several unique attributes which contribute to a more stable financial system (Hassan, 2018: p.14-17):
Interest prohibition and risk-reward sharing make the Islamic finance model seemingly insulated from crises (Alam, 2014: p.195). If the cause of a crisis is the unquenchable thirst for higher returns on investments by exploiting risky opportunities then an interest-free financial system can potentially be crisis-proof. This financial system model maintains stability through rational risk allocation and the correctly incentivizing the participants to transactions.
The simple solution to the conflict would be reduction of liquidity requirements to free-up assets. But this approach has shown to be quite detrimental to the incidence of early withdrawals by the depositors. The solution must lie elsewhere.
An interesting direction to explore is Islamic banking. It significantly rethinks the financial system and may support elimination of systemic risk completely because it’s a financial system model that rejects the notion of risk altogether. Putting aside the theological aspects and the debates on the role of inflation and which instruments are and are not sharia compliant let’s consider only the concepts and principles of Islamic finance as a potential resolution to financial crises and elimination of conflict between regulation aimed at reducing the impact of crises and performance of banks.
There is a body of literature that illustrates how the Islamic banking system has fared better in the 2007-2008 financial crisis than conventional banks. There is some data showing that market capitalization, profit and assets were affected to a lesser extent by the crisis whilst the Islamic banks’ leverage was much lower and there was no government assistance provided to any of the Islamic banks as a result of the crisis.
Islamic financial framework is characterized by several unique attributes which contribute to a more stable financial system (Hassan, 2018: p.14-17):
- Prohibition of interest (riba) – the Islamic finance model does not allow interest - that is growing money out of money. This limitation prevents susceptibility to excessive risk-taking behavior and speculation by bank managers looking to make a profit from high-risk, high return ventures;
- Concept of real underlying assets – every transaction in the Islamic finance model must have an asset backing. It is not possible to purchase a mortgage that is over 100% of the value of the property because any transactional value must be tied to the asset for its full amount;
- Uncertainty or gharar closely linked to risk has a significant role in Islamic finance where risk cannot be bought or sold as was the case in 2007-2008 financial crisis with instruments such as CDOs and derivatives. The sale of risk in a transactional exchange is prohibited which in turn promotes information symmetry and reduces opportunity for speculation;
- Risk-sharing is a key theme – musharakah contracts ensure that the risks are shared between the bank and the customer when the bank provides finance to a venture in a form equity rather than debt which ensures that the bank is vigilant when assessing the risk profile of a potential investment;
- Sustainability – Islamic finance system is based on ethics and sustainability. All transactions must be fair and just and full information disclosure to the customer is required. There is also a stable and transparent regulatory system in place which was missing at the time of the last financial crisis and an Islamic finance system would likely have fared better in this aspect.
Interest prohibition and risk-reward sharing make the Islamic finance model seemingly insulated from crises (Alam, 2014: p.195). If the cause of a crisis is the unquenchable thirst for higher returns on investments by exploiting risky opportunities then an interest-free financial system can potentially be crisis-proof. This financial system model maintains stability through rational risk allocation and the correctly incentivizing the participants to transactions.
Profitability versus stability
The logical question that arises from this is whether the potential profit on Islamic products can match the sky-high profits that can potentially be earned on traditional instruments. Would the banks would be willing to forgo higher profits in the name of stability and isn’t this the same as regulatory limitations which impact the bank’s profit-making capabilities?
Research suggests that there is little difference in the performance of Islamic financial products compared to conventional products (Hassan and Girard as quoted in Hayat and Malik, 2014: p.82). Bader et al (as quoted in Hayat and Malik, 2014: p.81) shows that the profit efficiency of the Islamic banks and conventional banks do not differ much. Other instances show otherwise with Islamic products such as sukuk performing better than conventional bonds (FT, n.d) and asset growth of Islamic banks outperforming that of conventional banks as shown in the graph (Source: S&P Global Ratings, 2019: p.46)
The logical question that arises from this is whether the potential profit on Islamic products can match the sky-high profits that can potentially be earned on traditional instruments. Would the banks would be willing to forgo higher profits in the name of stability and isn’t this the same as regulatory limitations which impact the bank’s profit-making capabilities?
Research suggests that there is little difference in the performance of Islamic financial products compared to conventional products (Hassan and Girard as quoted in Hayat and Malik, 2014: p.82). Bader et al (as quoted in Hayat and Malik, 2014: p.81) shows that the profit efficiency of the Islamic banks and conventional banks do not differ much. Other instances show otherwise with Islamic products such as sukuk performing better than conventional bonds (FT, n.d) and asset growth of Islamic banks outperforming that of conventional banks as shown in the graph (Source: S&P Global Ratings, 2019: p.46)
However, the benefits of Islamic finance for a simultaneous financial stability and retention of bank profitability should not be measured by how much better Islamic finance products can perform in comparison to conventional finance. It is the sum of a more stable system with an empirically proven similar level of return on Islamic finance products that should be considered. If the financial system can weather the storms better, banks can be more resilient to crises, depositors are protected from losses and the bank can earn the same return by rethinking its product structure.
The Islamic finance system though does change the functionality of banks from a speculator, earning profit from artificial capital that has no link to real production, to a trader buying and selling assets. This “new” species of banks will be agents of development of the real economy that fosters entrepreneurship and will not poof away in a second when the market collapses (Hassan and Kayed, 2018: p.17).
As with economic, social, governance (ESG) instruments, Islamic finance products also have a major ethical and sustainable development aspect to them. Not unlike green bonds, Islamic finance products may have a premium attached to them for this reason and be more appealing to investors. Of course, the premium will not be reflected in the rate of interest earned but it might be incorporated into the sale price of an asset to allow a bank to make a larger profit as an intermediary because the customer is willing to pay for the instrument that is sustainable against a backdrop of conventional financial products.
In the context of Basel II and III, the Islamic finance model is quite favorable. The regulation focuses on capitalization of the bank and reduction of leverage. As Islamic finance principles prohibit debt as an instrument and revolve around equity, this fits nicely within the Basel framework where the bank’s balance will inherently be showing high capital and low leverage.
The Islamic finance system though does change the functionality of banks from a speculator, earning profit from artificial capital that has no link to real production, to a trader buying and selling assets. This “new” species of banks will be agents of development of the real economy that fosters entrepreneurship and will not poof away in a second when the market collapses (Hassan and Kayed, 2018: p.17).
As with economic, social, governance (ESG) instruments, Islamic finance products also have a major ethical and sustainable development aspect to them. Not unlike green bonds, Islamic finance products may have a premium attached to them for this reason and be more appealing to investors. Of course, the premium will not be reflected in the rate of interest earned but it might be incorporated into the sale price of an asset to allow a bank to make a larger profit as an intermediary because the customer is willing to pay for the instrument that is sustainable against a backdrop of conventional financial products.
In the context of Basel II and III, the Islamic finance model is quite favorable. The regulation focuses on capitalization of the bank and reduction of leverage. As Islamic finance principles prohibit debt as an instrument and revolve around equity, this fits nicely within the Basel framework where the bank’s balance will inherently be showing high capital and low leverage.
Final thoughts
Regulation alone such as the Basel Accords will not soften the impact of financial crises as banks will always be motivated to chase after profit through innovation of some new ways to get around the rules. While profit is the end goal and the only factor of economic growth, the paradigm will remain unchanged.
The solution to the issue of financial stability and retaining motivation of banks to continue their business activities lies in structural change. A system needs to be in place that allows a rate of return sufficient to motivate banks to provide capital for investment projects and safekeep depositors cash fostering economic growth. At the same time this system must minimize systemic risk which arises from detachment of money from real assets, risk-taking behavior as a result of interest-focused business model of conventional banks. Islamic finance model might have the solution if it was implemented on a wide scale. It has the potential to be accepted by non-Muslims as a structural solution to maintaining financial stability rather than a religion/moral philosophy.
There are still aspects such as efficiency of such a system and the rate of economic growth that it would bring if it was the status quo as there is little empirical research of “what if” scenarios. Other aspects such as sharia compliance is also of concern as any notion of a product not being compliant can dampen investor confidence and lead to a fall in demand. Importantly, if the Islamic finance model ever becomes mainstream as a solution to the financial stability concerns, it must not become just another tool for profit-making.
Regulation alone such as the Basel Accords will not soften the impact of financial crises as banks will always be motivated to chase after profit through innovation of some new ways to get around the rules. While profit is the end goal and the only factor of economic growth, the paradigm will remain unchanged.
The solution to the issue of financial stability and retaining motivation of banks to continue their business activities lies in structural change. A system needs to be in place that allows a rate of return sufficient to motivate banks to provide capital for investment projects and safekeep depositors cash fostering economic growth. At the same time this system must minimize systemic risk which arises from detachment of money from real assets, risk-taking behavior as a result of interest-focused business model of conventional banks. Islamic finance model might have the solution if it was implemented on a wide scale. It has the potential to be accepted by non-Muslims as a structural solution to maintaining financial stability rather than a religion/moral philosophy.
There are still aspects such as efficiency of such a system and the rate of economic growth that it would bring if it was the status quo as there is little empirical research of “what if” scenarios. Other aspects such as sharia compliance is also of concern as any notion of a product not being compliant can dampen investor confidence and lead to a fall in demand. Importantly, if the Islamic finance model ever becomes mainstream as a solution to the financial stability concerns, it must not become just another tool for profit-making.
References:
- Alam, M. H., Noreen, H., Karamat, M., Ilyas, M. (2011) “Islamic Banking: Insulation Against US Credit Crisis.” International Journal of Business and Social Science. 2(10), 193-201.
- Financial Times (n.d.) Al Rayan debuts sharia-compliant bond backed by UK mortgages. Financial Times.
- Hassan, M. K., Kayed, R. (2018) “The Global Financial Crisis and Islamic Finance. 1-33.
- Hayat, U., Malik, A. (2014) “Islamic Finance: Ethics, Concepts, Practice.” The CFA Institute Research Foundation. 1-107.
- S&P Global Ratings. (2019) Islamic Finance Outlook. S&P Global Ratings.
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