Stress-testing Islamic Finance

Now that the results of the US Treasury’s stress test of US banks have been released, it seems apt to also turn the attention to other financial systems.

Islamic Finance has been touted as an alternative model, less exposed to securitization, with ethical guidelines, and its proponents hoped better insulated from global trends.

However, Islamic banking and finance faces many of the same vulnerabilities as conventional finance (See more on the outlook for Islamic financial institutions in this recent presentation). These financial institutions, both Islamic banks and those issuing Sharia-compliant investment products, are vulnerable to changes in liquidity and growth conditions globally and in the targeted regions. The countries of the Gulf Cooperation Council (GCC) a particular source of growth in demand for Islamic financial products continue also to suffer from tight liquidity.

In this piece we look at some of the vulnerabilities but also the opportunities of Islamic finance, to discuss how one might test this financial model. We focus on the dynamics in the GCC especially in relation to GCC investors, sovereign and private, and to Islamic banks operating in the GCC and MENA region though some of the analysis is also relevant to South East Asia.

Just as Nouriel Roubini has noted frequently with respect to the US stress tests, it is essential to perform such tests based on plausible stress scenarios that could come to pass. As such the relative optimism of the US stress scenarios in terms of unemployment projections could imply that the banks capital needs are even greater than those announced in a worse case scenario. For Islamic financial institutions, a plausible scenario means factoring in possible contractions in several of the economies that have been the centers for Islamic finance. as well as significant asset market corrections which would weaken the balance sheets of Islamic financial institutions. We now look at a few of these factors to lay out how one might test their balance sheets.

Preliminary estimates for the sector (but not individual banks) suggest that most are relatively well capitalized but most still have relatively small market shares. Moreover the rate of growth of Islamic bank assets and of funds placed in Sharia-compliant securities and funds is likely to be significantly slower than many predicted in 2008 as slower growth and tighter liquidity restrict the funds to be invested.

Growth outlook

So what might a macro stress scenario look like? In its most recently released global outlook, RGE Monitor forecasts a contraction in 2009 for Malaysia and an increasing risk of slight contractions for some of the GCC countries. The UAE and Kuwait are perhaps most vulnerable – Kuwait because political dynamics delayed the economic response and the persistence of its hydrocarbon dependency. The UAE faces not only a decline in hydrocarbon output but also reduction in demand for non-oil products with the property markets, export and other sectors under pressure from weaker external demand. Furthermore, the population of the UAE and bank assets might shrink as the population does on expats leaving. The latter risk might be of greatest concern for conventional banks though. Sharp OPEC cuts and slowing non-oil growth will also worsen the outlook for Saudi Arabia (home of the second largest Islamic banking assets after Iran). The worsening economic outlook which is contributing to greater job losses among other factors will limit both profits to be reinvested and is likely to impair the balance sheets of financial institutions as delinquencies rise. So far non-performing loans are on the rise from very low levels in most countries (around 1%).

Geographic breakdown of Islamic finance (End of 2007)

Asset market correction vulnerability Islamic Banks were thought to be spared from the worst of the global financial crisis, due to their lack of exposure to sub-prime mortgage assets and CDO’s. Yet, the core of Islamic finance stipulates that financial transactions should be backed by real assets – In practice, real estate and sometimes commodities. As a result, Islamic banks are greatly exposed to the ongoing property sector downturn and a phase of price correction especially in the GCC. Thus any stress scenario should factor in at least another 40% drop in property prices in Dubai and considerable drops in other markets. Islamic banks operating in advanced economies like the UK or the US are also exposed to such property declines. However, at least in the U.S. the community banks focused on Islamic finance may suffer fewer delinquencies than their counterparts given a reluctance to lend to subprime borrowers and lack of securitization.

Islamic banks are exposed also but to a lesser extent to the equity market correction in the region, through deterioration of investment portfolios and investor confidence which has made it difficult to raise funds. Moreover the market capitalization of Islamic banks has fallen dramatically as global and regional equity markets slumped. A recent article in the Financial Times (citing Nomura research) stipulated that Islamic banks in the GCC lost almost 45% of their market cap since the peak in the price of oil in mid 2008, versus a loss of 39% of their conventional counterparts, however, their rebound has also been marginally higher.

Property markets in Dubai will continue to be hardest hit, with property prices possibly falling a total of 80% from the peak (they have currently fallen about 40%). Even markets with more solid demand and more restricted supply like Abu Dhabi and Qatar were somewhat overinflated by speculators who leveraged up their investments, and will face their own albeit more limited price corrections. Given the new supply that will come on to the market and the slightly slower pace of new demand, these property markets could continue to be under pressure especially if credit extension remains constrained.

The increased risks of investment losses on the one hand, and rising non-performing loans on the other, adds to the vulnerability of Islamic banks. They are now diverting proceeds towards potential loss provisions. Add to this the fact that many Islamic institutions remain untested to defaults and loss-sharing procedures are relatively untried. Although regulatory processes and risk control measures have been improved since a few Islamic institutions failed in the 80s slump, most have not faced as difficult an external environment as we are now experiencing. The coming quarters will be a key test case, as delinquencies could turn into higher levels of NPLs. And the risk control procedures vary greatly across financial institutions. Given that many of these institutions are relatively opaque, worries about their health could raise the contagion specter. However as with their conventional peers, Islamic financial institutions have benefited from government liquidity provisions.

Many Islamic finan
ce institutions may face pressure to write down some of their loans given the Koranic dictate to renegotiate so that borrowers are able to payoff their debts and will not suffer extreme duress. Foreclosure and repossession would seem to be out of the question. Such renegotiations might though reduce uncertainty both in asset markets – and in the macroeconomic outlook.

Petrodollars Petrodollar liquidity and the rise in wealth in the GCC was a major contributor to the development of Islamic banking and finance. Many Global financial institutions sought to capture a part of the market as increasingly wealthy muslims sought to have religiously approved assets. National governments in the G7 and many Asian economies even started the process towards issuing of sovereign Islamic bonds.

As Moody’s points out in a recent report, “oil liquidity is a key driver of Islamic banks’ growth because Islamic banks contribute to the recycling of such liquidity in the economy. Less oil revenue will therefore mean less appetite for the securities issued by banks and investor risk aversion has directed investors to more liquid global markets. sukuk market needs more issuances to itself become more liquid and suffer less from price distortion”.

At current oil prices most of the oil revenues will be absorbed at home – with most countries running a current account deficit. Some of these funds absorbed at home through domestic investment and spending, may well continue to find their way into Islamic institutions, but the flood of Petrodollars into international capital markets is likely to be much smaller than in 2008 or 2007. As one of us argued in a recent working paper, the increase in domestic spending, especially by GCC governments suggest that even a return to an oil price of $100 a barrel in coming years might reduce the pool to be invested abroad, potentially reducing the potential pool that might invest in Islamic securities.

However, global loss could be regional benefit. Investors wary of foreign investments might prefer more domestic investments, including even regional ones. Yet the massive petrodollar windfall that led some global banks into the area of Islamic finance may not be quite as large as some hoped.

Liquidity Tight liquidity is restricting the growth of Islamic banks in the GCC (at least) as it is conventional finance. While there are small signs that liquidity is starting to return into the UAE at last (it already improved in Saudi Arabia), restoring liquidity to its overheated pre-crisis level is unlikely and arguably inadvisable. Loan growth in the UAE was over 50% in early 2008 as banks re-loaned out the hot money inflows – a prime maturity mismatch. Furthermore, with monetary policy tied to the US because of dollar pegs and inflation rising interest rates were very negative in real terms, further encouraging the bubble.

However, this adjustment to a slower pace of credit growth must now occur as global conditions are tight, global growth is contracting (by almost 2% in 2009 according to RGE’s latest forecast) and growth in the GCC and Asia will be minimal at best.

Despite the aggressive measures taken by governments in the GCC region to boost liquidity, the liquidity that is pumped into their economies merely facilitates further lending activity, as it acts as a tool to substitute for the deposits that leaves the banking system. Banks are now actively attracting deposits by raising their interest rates, but so far the greatest capital boost has come from governments who have increased block deposits.

However, the hope is that policy makers are recognizing the need for increased transparency about the financial health of institutions and increased monetary management tools. Although full data is not available, the UAE government has released figures indicating more subdued lending growth figures for the beginning of 2009 (10% y/y increase – find link). If these figures are accurate and persist, they are a good sign both of credit demand and supply which seems more optimistic than circumstantial evidence would indicate. The slower pace of credit growth will contribute to lower but perhaps more sustainable growth.

Similarity to Conventional Institutions In some cases Islamic securities are primarily tweakings of similar conventional products to avoid breaking Islamic dictates. This suggests they would face some of the same strains. Moreover, despite the fact that the proliferation of equity screens to ensure Sharia compliance which have increased the investment horizon for equity investors, the pool of approved securities remains smaller and some of the funds themselves have less liquidity. However with the increase in listings, some of these vulnerabilities might be minimized.

It is important to note that some Islamic products are quite similar to those offered by conventional banks. Islamic banks, thus, operate through identical channels which would imply increased linkages – if not correlation- with the conventional financial system. In this case, the difficulties they are facing should not come as a surprise to anyone because their performance was relatively similar to conventional banks. Of course individual lending practices do vary from banks to banks. Moreover given that asset market corrections and the reduction in external demand lagged in the Middle East, more pressure may still be ahead. The true test of the pace of development of non-performing loans is coming in Q1, Q2 and even Q3 results. However regional financial institutions may benefit from any continued global and local liquidity improvements stemming from unprecedented monetary and fiscal responses as well as government capital provision and debt raising.

The returns on Islamic assets noted below, suggest that they are in line with many conventional investment funds, meaning that their diversification role is limited. In fact in 2008 and early 2009, losses on Islamic indices have been only slightly less than on those that also include other equities (perhaps because they restrict companies with very extensive debt). Those constructing Islamic funds and indices tried to ensure their returns would be comparable (high) to non-sharia compliant funds. However this means that they were also comparable (but on the low side) in 2008. This similarity might prompt a return to basics to really look at what investments will bring good long-term returns.

Rate of Return on Islamic Assets (Annual % rate of Return on Assets Worldwide)

Sovereigns entering the market Corporate issuance is particularly vulnerable to the tight credit conditions in the market and investor wariness, despite the recent revival of risk. The weak investor sentiment and expectation of corporate profit weakness, the prospect of higher financing costs for some time, may make it more difficult for corporations to raise fund directly. But some may receive funds indirectly. Although financial institutions- predominantly banks – and corporates would be less inclined to issue bonds, both Islamic and conventional, sovereign sukuk issuance is on the rise. Bahrain is one such example with plans of selling $500m worth of sukuk towards the end of May 2009 as well as other conventional bonds. Other countries including Singapore, Indonesia, and Thailand may turn to the issuance of Sukuk also even as corporations defer issuance.

There are some stresses particular to Islamic finance It must be stressed that there is a fairly high cost of configuring and issuing sukuk as compared to the issuance of bonds in the conventional banking system, which may
act as an additional bottleneck to the issuance of sukuk- even the sovereign type. However some countries such as the UK have seen both economic and political benefits from proceeding on these paths.

Some of these hurdles could be overcome by more regulatory coordination within countries with Islamic financial institutions. As noted at a recent Islamic finance conference Islamic bankers and their regulators may need to collectively forge regulations pro-actively or else it may be done by others for them (and not necessarily too their liking). While global regulators such as the Financial Stability Forum now have other things on their mind than Islamic finance, they may again turn their attention to these institutions. Moreover absence of any suprational regulatory body that would govern the operations of Islamic financial institutions remains an obstacle to further growth as it requires issuers to manage different taxation and regulatory regimes which limit economies of scale. Issues of double taxation exist in several countries but many governments are seeking to avoid this hurdle.

The absence of liquid Sharia-compliant asset classes does create a challenge to managing liquidity among the Islamic financial institutions. Moreover many securities are based off of libor providing a vulnerability to global credit conditions. Following the liquidity crunch, global sukuk issuance worldwide reportedly declined to $20 billion in 2008, compared with more than $40 billion a year earlier. Nonetheless, although the liquidity crunch of 2008 and pressure on most asset markets contributed to a drop in the global level of sukuk issuance (as it did to conventional bond issuance and equity public offerings), it was not the only factor. Concerns about the Sharia compliance of several sukuk structures contributed to lower demand even before liquidity conditions worsened in the gulf. This uncertainty as well as the regulatory issues will be a check to growth until resolved.

Source: International Financial Services London (

Source: Bloomberg,

Conclusion There are several longer-term trends supportive of Islamic finance including demographic trends and diversification of portfolios within target regions despite the hard time expected in the short term. Yet, as noted in the FT’s most recent (and excellent) review of Islamic finance, one aspect of the crisis of confidence has been a freezing of some of the overly innovative structures especially delays in Islamic derivatives and hedge funds.

Issuance of Islamic bonds and inflows into other Sharia compliant investments may well be lower than expected this year despite the recent revival of risk appetite. Moreover some of the regulatory concerns described above will work with the macro outlook to limit investments. Until these regulatory hurdles are surmounted, there will continue to be scalability issues, particularly as many Islamic institutions face similar pressures to their balance sheets as conventional ones.

Nonetheless as financial innovation advances, the long term prospects of Islamic finance may provide a lot of incentives for investors to enter this market. Moreover there are still a lot of latent assets in Muslim countries that are either invested abroad that could find their way into domestic investment as these markets are developed. More financial development could attract a share of these funds. Government investors are among these – sovereign investors announced plans to invest in Islamic banking and financial institutions especially in Africa and South Asia. Thus, opportunities may lie in actually ensuring that products offered by Islamic financial institutions are distinctive so they do provide such diversification and respond to investor’s long-term needs and desires. Moreover there will be a need for more transparency, a more appropriate approach to the structuring of products, lower transaction costs, more stringent rules and regulation. This would pave the way for an increased international recognition of Islamic finance, better returns and reduced vulnerabilities.