Aurora Borealis
1 October 2015 CFA Institute Journal Review

The Unique Risk Exposures of Islamic Banks’ Capital Buffers: A Dynamic Panel Data Analysis (Digest Summary)

  1. Marc L. Ross, CFA
  2. Natalie Schoon

Shari’a-compliant banking has grown into a viable alternative-banking model, which has implications for policymakers when considering overall capital adequacy of the financial industry. The authors consider the adequacy of Islamic banks’ capital buffers given the unique risks originating from their operations.

What’s Inside?

Ample literature is available regarding the effects of business cycle fluctuation on banks’ capital buffers, but all research excludes Islamic banks. Because of the difference in operating environment, these institutions are not subject to interest rate risk, but they are subject to rate of return risk (ROR) and displaced commercial risk (DCR). The authors examine the overall exposure of Islamic banks’ capital buffers to specific operational risks in countries where both Islamic and conventional banks operate. Shortcomings in the current capital adequacy guidelines for Islamic banks allow for privately held banks to mitigate risk by maintaining higher capital buffers. To enhance the soundness of Islamic banks within the overall financial industry, capital adequacy guidelines and risk management practices for Islamic banks will need to be enhanced.

How Is This Research Useful to Practitioners?

Practitioners may find it useful to learn that as a result of the requirements of shari’a, Islamic banks face risks that differ from those faced by other banks. These risks include ROR, DCR or asset/liability mismatch, and equity investment risk resulting from profit and loss financing arrangements. These risks are typically mitigated by adjusting their capital buffers independently of capital adequacy guidelines. The unique nature of profit sharing investment accounts (PSIAs) results in a requirement to protect both account holders and shareholders. To prevent mass withdrawals as a result of varying returns, banks effectively subsidize returns to these account holders, and to smooth the profits, two types of reserves are associated with these.

State-owned Islamic banks show a significantly higher risk tolerance than privately owned institutions, resulting from a reduced requirement for shareholder protection. Capital adequacy measures do not capture these differences and will need to be enhanced to more accurately reflect the capital requirements associated with ROR and DCR exposures. In turn, these changes will enhance the resilience of Islamic banks and improve their competitive positions. DCR is partly managed by special reserves used to smooth payouts to PSIAs and to avoid large-scale withdrawals. These reserves are not subject to specific disclosure and regulatory requirements.

Islamic banks are found to be more reliant on return on equity to increase capital compared with conventional financial institutions. The authors find a number of differences by region. Reliance on capital buffers to mitigate ROR and DCR is higher in banks in southern Asia, which is likely a result of the relative underdevelopment of financial markets for funding purposes. In other Asian regions, this reliance is lower, probably a result of the fact that Islamic banks are required to apply significantly higher risk weights to profit and loss sharing models of finance. Although Islamic banks in the Middle East are more risk averse than Islamic banks in other regions, the authors’ findings support earlier research, and they conclude that the complexities associated with the management of profit and loss sharing financing result in adverse selection and moral hazard, which, in turn, results in higher capital buffers.

The authors find the presence of regulatory forbearance toward Islamic banks along with a greater propensity of these institutions to disintermediate.

How Did the Authors Conduct This Research?

The research focus is on countries where Islamic banks and conventional banks operate side by side in a dual regulation system. The authors develop and test an empirical model that draws on the wider banking literature. By eliminating banks with negative capital buffers, the authors create an estimation sample consisting of 128 commercial banks in 18 countries, out of which 44 are Islamic banks. For each of these institutions, data are gathered from the Bureau Van Dijk Bankscope database, publicly available audited reports, and various World Bank databases covering the period 2005–2012.

The capital buffer adequacy that the model tests for is a function of several metrics and ancillary factors to those metrics that attempt to capture banks’ management of asset and liability flows, loan nonperformance, ratio of loans to deposit base, and bank size. Additional inputs include measures of regulators’ supervisory reach and degree of incentives for institutions’ market discipline and compliance with disclosure requirements. The fact that Islamic banks’ application of shari’a law is not uniform across banking jurisdictions complicates the regulatory environment. Inconsistency in disclosure obligations makes controlling for such disparity difficult, if not impossible. The authors use a generalized method-of-moments procedure to control for potential endogeneity in the model’s application and subject the results to robustness checks.

Their methodology appears to support findings in the existing literature and highlights inconsistencies in the application of risk controls between banking jurisdictions. Volatilities inherent in global banking operations extend in some ways to Islamic banks that are more likely to disintermediate under financial stress and prone to inconsistencies in disclosure and reporting.

Abstractor’s Viewpoint

The authors raise an interesting point in that capital adequacy guidelines for Islamic banks operating in the same environment as conventional banks do not sufficiently capture the specific risks Islamic banks are exposed to. But it needs to be considered that some of the literature underpinning the findings is outdated and has been superseded. The research results need to be evaluated carefully when used to draw conclusions. In addition, the lack of investable assets naturally results in the fact that many Islamic banks are overcapitalized, which may skew the results.

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