The Effects of Financial Crisis on Islamic Banking - Essay Example

The effect of financial crisis on Islamic banking Compared with non-Islamic banking in Gulf council countries (GCC) Summary This paper delves into the effects of financial crisis on Islamic banking compared with conventional banking in the gulf council countries (GCC). It is noted that Islamic banks performs better during financial crisis than their conventional counterparts, largely because of the distinctive principles imposed to them by shariah law. Essentially, Islamic banking and finance operates on a justice principle, which is fulfilled largely through the sharing of risk. On the other hand, the conventional intermediation is debt based, which allows for risk transfer, and which contributes most to risk exposure during a financial crisis. The paper will also discuss the key features of GCC economy, and that one of Qatar in particular. The economic features of this region will be tied to the factors that led to a better performance of IBs in GCC, during 2008 financial crisis. Introduction The largest Islamic banks (IBs) belong to the countries of the Gulf Cooperation Council (GCC). The 2008-2010 global financial crises brought a fresh perspective on the relationship between financial stability and Islamic banking, especial in relation to the flexibility of such an industry during financial crises. Some specialists have argued that the Islamic banks were less affected by the financial crises because of their risk-sharing and asset-based nature as well as the fact that they do not deal with the kind of assets associated with most of the losses that non-Islamic banks suffer during financial crises. Still another section of experts argue that the Islamic Banks, just like the non-Islamic banks, have depended on leverage and have taken on considerable amounts of risks that expose them to the second phase impact of the global financial crises (Čihák & Hesse, 2008). By and large, Islamic Banks suffered less risk compared to non-Islamic banks during the 2008 financial crisis, especially considering that the non-Islamic banks suffered the largest losses in Europe and the US. A close study on 2008 financial crises shows that Islamic Banks did better, in terms of profitability, than the non-Islamic banks. This situation, however, retracted in 2009 as the impact of the crises became more real. Islamic Banks from GCC continuously showed a growth in assets and credit that surpassed the non-Islamic banks in all countries, apart from UAE (Čihák & Hesse, 2008). The nature of Islamic banks business model played a key role in containing the unfavorable effect on their profitability during 2008 financial crisis. Additionally, some Islamic banks experienced a weakness in risk-management practices, which led to larger reduction in profitability compared to non-Islamic banks in 2009. Essentially, Islamic banks maintained stable external ratings and achieved a relatively stronger demand for credit, courtesy of their higher solvency and lower leverage (Čihák & Hesse, 2008). GCC economy The GCC region has the largest confirmed oil reserves in the world, with up to 486.8 billion barrels, which accounts for 35.7 percent of all the oil reserves in the world. As a result, this region is the largest producer and exporter of petroleum oil, globally. The region consists of six countries, which have enjoyed an impressive economic explosion until late 2008, when the effects of global financial crises became unbearable. Between 2002 and 2008, the economy of GCC tripled in size to $1.1 trillion. The GCC member countries takes up 49% of the total OPEC crude oil production and 52% of the total 52% of the total OPEC oil reserves. The regions’ oil and gas sector takes up about 73% of its total exports earnings, 41 of its GDP, and about 63% of the government’s revenue. The annual average OPEC’s oil price reduced by 35.4% to $61.06 per barrel in 2009 vis a vis US$ 94.45 per barrel in 2008. This decline was essentially as a result of the global financial crisis and the fall in world energy demands. The fall in global oil market attributable to the global financial and economic crisis decelerated the rate of investment and development projects, but it is expected that the current global economic resurgence will stimulate a quick recovery in the region. The economy of Qatar The economy of Qatar is largely dependent on petroleum, which represents more than 70% of the total government expenditure, approximately 85% of its exports earnings and more than 60% of its GDP. Qatar has a per capita GDP that ranks among the highest globally, thanks to its large oil reserves. Qatar’s proved natural gas reserves accounts for more than 5% of the global total and it is ranked third largest in the world. The banking sector of Qatar was not directly affected by 2008 financial crises, though it experienced some slight aftershocks. By and large, during the last quarter of 2008, Qatar emerged the best performing of the GCC markets, when most of its banks enjoyed substantial profits. However, the banking sector has experienced problems such as a forced reluctance to lend, declining customer confidence, and issues of liquidity. Impact of financial crises – conventional vs. GCC Islamic Banks Although both Islamic banks (IBs) and Conventional Banks (CBs) have a key role in acting as financial intermediaries in easing moral Hazard and Asymmetric Information, the adherence to Shariah principles give IBs a distinctive feature that significantly determines how such banks are affected by financial crises. In line with Islamic jurisprudence, the transaction can be allowed by default if there is no apparent prove for prohibition. Consequently, this fundamental principle grants Islamic Finance development a greater flexibility. There are two basic prohibitions that account for all distinctions between contracts considered legitimate or illegitimate; that is, Gharar and Riba. The latter means any untenable increase of capital in form of fixed interest rate and the former means the speculative character, which includes any transaction involving gambling. The two principles lead to the implication of money as a unit of measurement, a store of value and as a medium of exchange, rather than a commodity. The arrangement of Islamic finance rotates around the prevention of any interest or any ex ante proceed accumulated on any loan/debt (Riba). Gharar is also forbidden; it engages risk, insecurity, lack of sufficient value -pertinent records (jahl) and assumptions. Islamic finance segment is ranked as one of the fastest growing in the world; therefore, it has become an essential consideration in other markets. While Islamic intermediation is asset-based and focuses on risk sharing, the conventional intermediation is primarily based on debt capital, whereby risk transfer is freely condoned. This feature goes a long way to providing IBs with supplementary shields and brings their activities closer to the real economy. Additionally, their distinctive features seem to curtail their role in bubbles and excesses. In view of this, Islamic banks performed relatively well than their conventional counterparts during the recent financial crisis (Imam & Kangni, 2010). Figure 1: pre-crisis profitability of IBs and CBs The Islamic banks business model largely played role in restraining the negative impact on profitability in 2008. On the other hand, poor risk management practices by some Islamic banks contributed to greater decline in profitability in comparison with conventional banks in 2009, as shown in Figure 3. Specifically, compliance with Shariah laws ruled out Islamic Banks from investing or financing in the kind of assets that have negatively affected their conventional counterparts and stimulated the global financial crises, such as the real estate interest bearing sector (Imam & Kangni, 2010). In some countries, a deplorable performance was experienced as a result of sectoral concentration, which was sometimes stimulated by exceptions from concentration limits. This brought to light the significance of intensification of risk management and ensuring neutral regulatory framework for Islamic Banks and Conventional banks. Although Islamic banks recorded higher profitability prior to the 2008 global financial crisis, their average profitability for 2008-09 was comparable to that of conventional banks, implying a better cumulative performance for pre and post crisis period. Comparison of the profitability of IBs with CBs is illustrated in figure 1 (Aziz, 2009). Figure 2: Impact on profitability as a result of the crisis (IBs vs. CBs) During the financial crisis, the credit and asset growth of Islamic banks was at-least twice that of conventional banks – this implies a larger supervisory accountability and growing market share. Figure 2 shows how the Islamic banks experienced just minor effects on their profitability, during the early stages of the crisis, while their credit and assets remained strong. The IBs’ higher solvency has helped them meet their healthy demand for Islamic finance as well as maintaining healthy external ratings. Furthermore, lending to the consumers who are less affected has strengthened the IBs asset growth and strong credit (Aziz, 2009). Figure 3: IBs experienced steep decline after 2009 Conclusion This paper has revealed the Islamic Banks as one of the fastest growing segments of the world financial market, and as a very influential industry that many countries cannot afford to ignore. The distinctive features that differentiates IBs from CBs banks have been highlighted, especially those that influences the manner in which IBs performs better than CBs during a financial crisis. The most outstanding feature of the IBs business model, which shield them from the adverse impacts of financial classes that largely affects the CBs, is in relation to Shariah law, which prohibits Islamic financial institutions from operating on the basis of interest. The fundamental principle in Islamic banking and finance is justice, which is fulfilled largely through the sharing of risk. On the other hand, the conventional intermediation is debt based, which allows for risk transfer, and which contributes most to its risk exposure during a financial crisis (Qutub, 2008). References Aziz, Z. A. (2009). Islamic Finance: During and after the global financial crisis. Istanbul: sage. Choong, B. S., & Ming-Hua, L. (2006). Islamic Banking: Interest-Free or Interest- Based?‖ Retrieved from http://ssrn.com/abstract=868567. Čihák, M., & Hesse H. (2008). Islamic Banks and Financial Stability: An Empirical Analysis,‖ IMF Working Paper 08/16. Washington: International Monetary Fund. Imam P., & Kangni, K. (2010). Islamic Banking: How Has it Spread?‖, IMF Working Paper, forthcoming . Washington: International Monetary Fund. Qutub, H. (2008). An Islamic view on loans and interest. Christian Science Monitor, 100 (195), 8–8. Read More