Resilience of Islamic Finance

Background of Sub-prime

The sub-prime meltdown which began in August 2007 has brought down several of the long established and large financial establishments in the US and Europe. Major banks and other financial institutions around the world have reported losses of approximately US$540 billion as of September 2008, and this has continued to increase. Despite concerted efforts by governments and central banks worldwide to cut interest rates and inject massive liquidity into the stock market and the banking system, the global crisis has yet to show any sign of abating. Countries are already experiencing recession while the more resilient economies are revising their economic growth downwards.

Cause and effect

The sub-prime crisis was mainly due to collateralized loan obligations (CLO), collateralised debt obligations (CDO) and mortgaged-backed securities (MBS) which were bundled and repackaged and combined with swap and options (swaptions). They then led to the creation of the sub-prime loans when interest rates were low which then fuelled an artificial mortgage growth, leading to a property bubble. In some cases, the derivatives originated by the investment banks surprisingly found their way back into the originators’ books. Thus, this time round, the investment banks themselves became victims of their own doings. In the early months preceding the crisis, proponents of Islamic finance were quick to point out that the crisis would not affect Islamic banks because Islamic finance transactions are asset based and shuns gharar – excessive risk or lack of transparency. Critics on the other hand say that the reason is simply because Islamic finance has not achieved the level of sophistication of the conventional finance and therefore, not exposed to derivatives.

Impact to the GCC

The Gulf Co-operation Council (GCC) was not spared the spill-over of the sub-prime crisis. The impact of the sub-prime crisis on Islamic finance has become more obvious by the day. The problem however was not from sub-prime loans, although the GCC sovereign funds have stakes in several of the troubled banks in the US and Europe. Instead the causes were a combination of effects from the decline in world oil prices and property bubble burst. In anticipation of the local currencies appreciating against the US dollar, investors in the GCC began withdrawing funds when instead the dollar appreciated thus causing further liquidity problems among the banks. It was reported that one central bank in a GCC country has intervened to rescue a bank. The banking authorities in various GCC countries have begun pumping in cash to ensure the banks can meet liquidity requirements.

Impact to Malaysia’s Islamic finance industry

• The Malaysian Institute of Economic Research (MIER) has revised its growth forecast for 2009 to 3.4% from its earlier forecast of 5%. The government has introduced a multi-pronged economic stabilisation package aimed at mitigating a sharp slowdown in domestic demand given the substantial weak external environment. The contraction is expected to hurt banks’ income and Islamic financial institutions will not be spared.

• Bursa Malaysia lost 40% of its value as at 31 October 2008. Shariah-compliant stocks (SCS) also took a beating. The impact on the Islamic indices, in most cases, was less severe compared to the overall index because finance counters, being the most adversely affected were precluded from SCS. However, in some cases the off-set effects were the absence of non-SCS but defensive large market cap stocks such as tobacco, gaming and brewery companies.

• The value of sukuk approved until September 2008 was RM24.6 billion, down from RM121.3 billion at end–2007. In the near future, it is expected that prospective issuers may reconsider issuing sukuk as they face higher yields, and the fact that the economic slowdown would require them to reexamine their financing requirements.

• It is rather fortunate that we have not fully liberalized our banking and financial infrastructure. Despite recognising that foreign participation is necessary to help accelerate growth and improve consumer choice, Malaysia operates on a gradual and phased approach to liberalisation based on the framework set out in the Capital Market Masterplan. At each stage of phased liberalisation, an assessment is conducted on the impact and benefits of proposals. By adopting these measures, Malaysia will meet its agenda of building a resilient core of domestic financial institutions and preserve financial stability.

• It is rather fortunate that we have not fully liberalized our banking and financial infrastructure. Despite recognising that foreign participation is necessary to help accelerate growth and improve consumer choice, Malaysia operates on a gradual and phased approach to liberalisation based on the framework set out in the Capital Market Masterplan. At each stage of phased liberalisation, an assessment is conducted on the impact and benefits of proposals. By adopting these measures, Malaysia will meet its agenda of building a resilient core of domestic financial institutions and preserve financial stability.

When reality bites

Islamic finance does not operate in a vacuum as it coexists and interacts with the global financial market and economies. It will, therefore, be affected, albeit perhaps to a lesser extent:

• Where Islamic finance is asset-based, it will be susceptible to a property bubble burst, i.e. when the value of the security falls and becomes inadequate to cover the capital, e.g. the mortgage failures in the US.

• For Islamic financial centres which are highly liberalised and where the foreign/conventional players are market dominant, capital flights will have a more serious impact on the market.

• A bank run (triggered by external factors) does not differentiate between Islamic or conventional finance.

• There are other factors such as currency trades and contingent liabilities (involving counter-party risk) which may impinge on an Islamic bank’s performance.

Challenges for Malaysia

Malaysia’s challenge lies in the following areas:

• Demands from rising inflation which put pressure on the low interest rate regime when savings cannot meet the demands;

• Capital flights and repatriations, which have occurred;

• Since the Asian financial crisis, Malaysian banks too have been aggressively extending retail credit in the form of credit cards and refinancing of mortgages with higher margins. How banks manage the NPL during the contracting economy will be of concern; and

• Property overhang is already evident by many unsold commercial and high-end units with developers deferring launch of new projects indefinitely.

Conclusion

Events like the sub-prime crisis provide important lessons to Islamic finance. The Islamic market is not independent of the financial markets and is, therefore, not totally insulated from any financial crisis – regionally or globally. Thus, the Islamic finance fraternity cannot afford to be complacent. Moving forward, Islamic finance has to truly apply the Shariah spirit not only in form but in substance as well. Hopefully this will make Islamic finance more resilient to economic crises.

The article above was retrieved from the freely distributed Malaysian Securities Commission’s Islamic Capital Market Quaterly Bulletin.