BANKING
Islamic Finance: Size Matters
May 30, 2008
Martin Cihak and Heiko Hesse

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 U.S. According to McKinsey & Company, Islamic banking assets and assets under management reached $750 billion in 2006 and the Islamic finance sector is expected to reach $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 $1 billion, 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.

The contrast between the high stability in small Islamic banks and the relatively low stability in large Islamic banks is particularly interesting. It suggests that Islamic banks, while relatively more stable when operating on a small scale, are less stable when operating on a large scale. Since we have adjusted both for differences in bank-level variables such as size and the structure of balance sheet, and differences in system-wide variables, such as market concentration, these differences reflect characteristics of Islamic banks. A plausible explanation of the above findings is that it is significantly more complex for Islamic banks to adjust their credit risk monitoring system as they become bigger. Given their limitations on standardization in credit risk management, monitoring the various profit-loss-arrangements becomes rapidly much more complex as the scale of the banking operation grows, resulting in a greater prominence of problems relating to adverse selection and moral hazard. Another possibility is that small banks concentrate on low-risk investments and fee income, while large banks do more PLS business.

Another interesting finding from the study is that a bigger presence of Islamic banks in a financial system of a country does not have a significant impact on the soundness of other banks. This suggests that changes in the market share of Islamic banks possibly have no or very limited impact on financial sector soundness.

These findings are subject to caveats relating to the cross-country data on Islamic banks. These caveats include less than complete coverage of the database and the fact that the study focused on fully-fledged Islamic banks and not on Islamic "windows" or Islamic branches operated by some commercial banks. Furthermore, data limitations prevented the study from taking fully into account all aspects of Islamic financial contracts, for example, by distinguishing between PLS and other investments. Nonetheless, the main results are encouragingly robust with respect to a range of sensitivity tests, such as using different measures of financial soundness, and different estimation methods.

ACKNOWLEDGEMENTS

This article is based on IMF Working Paper No. 08/16, "Islamic Banks and Financial Stability: An Empirical Analysis," by Martin Cihák and Heiko Hesse.

Copyright © ChinaForum 2008