Islamic Banking: Size Matters

An IMF study of Islamic and commercial banks has found that large Islamic banks are less stable than small Islamic banks or large conventional banks. As a result, large Islamic banks may face credit risk management challenges.

Institutions offering Islamic financial services constitute a significant and growing share of the financial system in several countries. Since the inception of Islamic banking about three decades ago, the number and reach of Islamic financial institutions worldwide has risen from one institution in one country in 1975 to over 300 institutions operating in more than 75 countries.

In Sudan and Iran, the entire banking system is currently based on Islamic finance principles.

Islamic banks are concentrated in the Middle East and Southeast Asia, but they are also present as niche players in Europe and the US. According to McKinsey & Company, Islamic banking assets and assets under management reached US$750bn in 2006 and the Islamic finance sector is expected to reach US$1 trillion by 2010.

Reflecting the increased role of Islamic finance, the literature on Islamic banking has grown. A large part of the literature contains comparisons of the instruments and discussions of regulatory and supervisory challenges related to Islamic banking.

Also, there is a growing literature discussing various Islamic finance instruments. However, there has been relatively little empirical work on Islamic banking and financial stability. This is something that a new IMF working paper attempts to target.

Specifics of Islamic Banks from a Prudential Perspective
Are Islamic banks more or less stable than other banks? A majority of the relevant literature suggests that Islamic banks pose risks to the financial system that in many regards differ from those posed by conventional banks.

Risks unique to Islamic banks arise from the specific features of Islamic contracts, and the overall legal, governance, and liquidity infrastructure of Islamic finance.

For example, profit and loss-sharing (PLS) financing shifts the direct credit risk from banks to their investment depositors, but it also increases the overall degree of risk of the asset side of banks' balance sheets, as it makes Islamic banks vulnerable to risks normally borne by equity investors rather than holders of debt.

Also, Islamic banks can use fewer risk-hedging instruments and techniques than conventional banks and traditionally have operated in environments with underdeveloped or nonexistent interbank and money markets and government securities, and with limited availability of and access to lender-of-last-resort facilities operated by central banks.

However, the significance of these differences has decreased due to recent developments in Islamic money market instruments and Islamic lender of last resort modes, and the implicit commitment to provide liquidity support to all banks during exceptional circumstances in most countries.

There are also several features that could make Islamic banks less risky than conventional banks. For example, Islamic banks are able to pass through a negative shock on the asset side to the investment depositors. The risk-sharing arrangements on the deposit side thus arguably provide another layer of protection to the bank, in addition to its book capital.

Also, it could be argued that the need to provide stable and competitive return to investors, the shareholders' responsibility for negligence or misconduct (operational risk), and the more difficult access to liquidity put pressures on Islamic banks to be more conservative. Furthermore, because investors (depositors) share in the risks (and typically do not have deposit insurance), they have more incentive to exercise tight oversight over bank management.

Finally, Islamic banks have traditionally been holding a comparatively larger proportion of their assets than commercial banks in reserve accounts with central banks or in correspondent accounts. So, even if Islamic investments are more risky than conventional investments, the question from the financial stability perspective is whether or not these higher risks are compensated for by higher buffers.

Whether Islamic banks are more or less stable than conventional banks therefore is an empirical question. The answer to the question depends on the relative sizes of the effects discussed above, and it may in principle differ from country to country and even bank from bank.

Islamic Banks and Financial Stability

Defining large banks as those with total assets of more than US$1bn, and small banks as all others, the paper finds that

(i) small Islamic banks tend to be financially stronger than small commercial banks;

(ii) large commercial banks tend to be financially stronger than large Islamic banks; and

(iii) small Islamic banks tend to be financially stronger than large Islamic banks. Figure 1 provides a summary. The results from this comparison are valid also when the data are subjected to a more formal regression analysis....Read More