This article was first published in Quantum magazine.
Shariah banks and financial markets have been affected by the international financial crisis, but, according to a recent International Monetary Fund study, they have proved more resilient and less unstable than their conventional competitors.
This means that they are also well placed to take advantage of any economic upturn, particularly as the Basel III reforms are highlighting structural weaknesses in conventional banks and financial markets and the strengths of shariah finance.
The reforms will also put the two systems of banking on equal terms in the two critical areas of liquidity and capital structures. However, to take full advantage of these opportunities the Islamic sector will also have to adopt other measures, including the development of standardized international products through organizations such as the recently established International Islamic Liquidity Management Corporation (IILM).
The Basel III reforms will have a major impact on capital structure by making conventional banks change from a system dominated by debt capital to one in which equity, supported by contingent capital, is the most important element.
Shariah Banks, Capital Structures, and Liquidity
At present shariah banks are at a competitive disadvantage. Their capital structures are of necessity dominated by equity because they cannot use debt capital, and this has a materially lower cost than equity. Consequently, a conventional bank will offer equity investors a significantly higher return than an Islamic financial institution with a similar balance sheet. This advantage will be substantially reduced by Basel III, because it will force conventional banks to hold much more equity.
The greater emphasis on contingent capital—a new and not well understood concept—will also benefit Islamic banks. The few contingent capital structures issued so far are dominated by a form of convertible bond (often called CoCos), where the convertibility “option” is not exercised at the discretion of the bondholder but is mandatory, based on “triggers” such as a fall in the bank’s equity-to-asset ratio and/or supervisory intervention in the management of the bank.
Clearly the bond nature of the CoCos makes them unsuitable for shariah banks. But contingent capital as a concept and a product can trace its origins to the insurance industry, and specifically to structures that are based on those of an “indemnity fund.” These can be made shariah-compliant relatively easily, and one already exists with a fatwa issued by Gatehouse Bank’s shariah board.
Such structures are very competitive on cost and feature terms with current CoCos. They hold out the very real prospect of helping to equalize the capital structures of shariah and conventional financial institutions, thereby making Islamic banks relatively far more attractive to investors by leveling the returns on capital.
Liquidity Requirements under Basel III
The balance between the conventional and Islamic sectors will also be impacted by the changes in liquidity demanded by Basel III. While these liquidity and capital requirements will benefit the Islamic financial sector, there are nonetheless challenges which have to be addressed.
At present, a bank has access to funding liquidity based on its funding structure. If it has plenty of stable retail deposits and medium- to long-term contractual funding through, say, bonds, certificates of deposit, or profit and loss sharing accounts, the bank can use these stable sources to fund its asset base, even in difficult economic circumstances. Shariah banks are by and large well-funded institutions, though with very limited capability to transfer their liquidity across national frontiers. This limits their capacity to create rivals to conventional international banks.
Liquidity can also be raised in the market, enabling a bank to turn its assets into cash either by selling them or by pledging them in order to borrow funds. Market liquidity has grown substantially in recent years, largely due to the growth of so-called “repo” (repurchase) transactions, where banks can pledge assets so that they can receive funds.
Conventional banks have been able to take advantage of this market’s growth to fund new business in areas where they have been less able to attract retail deposits or issue debt securities. In contrast, shariah asset products lack this degree of standardization, sometimes even within national boundaries, and where national markets have developed they have not been able to support international growth.
To address this problem it is necessary to create international product structures which will lead to the creation of common product features and legal contracts on which asset transfers can be based.
In doing so, however, it should be remembered that the short-term nature of repo markets makes them a potentially unstable source of funding. In the recent financial crisis, lenders became unsure of the capability of the underlying assets to be a secure source of repayment for the loans. It should be possible for the Islamic sector to avoid this problem, as transparency and reference to assets with readily observable cash flows are both features of shariah assets.
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