4 lessons that western banks can learn from Islamic counterparts

Perhaps, Islamic banks can teach its western counterparts some basic principles very much linked to common sense which could enhance their financial stability three years after the credit crisis.

During 2008, UK accountants joked Dabout   the   balance   sheet   of   their banks:   “On   the   left   side   there   is nothing right; on the right side there is nothing left.” Languages in other countries did not offer the same potential when referring to the balance sheet of banks, yet the under- lying situation was more or less the same. However, it is remarkable the strength that Islamic banks (those subject to Islamic fi – nance) have shown over these years. Three years after the ignition of the crisis, several lessons can be learned from these banks, but the four most important are:

First: Islamic banks can stabilise credit growth. A major danger for an economy lies in excessive credit growth. Central banks can influence this inter alia through interest rates, but sometimes this tool is ineffective, banks lend too much in good years and too little in bad years, creating  Hyman Minsky’s credit cycles that can worsen economic cycles. In “good” years non performing loans come down, there is plenty of liquidity and it is very easy to obtain credit, which in turn further drives down NPLs (non-performing loans). The opposite occurs during “bad” years. We have learned from this crisis that (a) incentives drive human behavior, and (b) an incorrect incentive scheme can lead to exponential credit growth that creates the basis for future banking and economic damage. As Islamic finance only allows financing to happen as long as it is linked to the value-creating real transactions, ultimately “credit growth” (although under Islamic finance “credit” should be read as “coinvestment”) is very much restricted by growth in productivity and income, creating a natural brake for credit growth in “good” years. Structural reforms in the western banking system point towards creating similar “brakes” for credit growth normally linked to incentive schemes.

Second: One bank can lose most of its investment in a “complex” to value synthetic product, such as a CDO (Collateralized debt obligation), a CDO squared or a CLO (Collateralized loan obligation), yet if the investment is a physical asset (property, infrastructure, energy) the risk of losing 100% of the position is almost nil. As Islamic banks are only allowed to invest in physical assets generating free cash flow, valuation of these instruments is more transparent; as a consequence financial stability is intuitively reduced compared to that of an investment in a theoretically   risk-limited   AAA   rating CDO squared. Indeed, reforms in Basel II and III in general penalize in capital consumption the holding of positions without underlying physical assets.

Third: Systemic risk is reduced if risk-managing instruments are used in tandem with wealth creating activities rather than trading risk independent of economic productive transactions. Comparing the replacement value of global derivatives with global GDP shows how side-betting can grow to almost reach world production of goods and services mostly through over-the-counter (OTC) transactions which enhance systemic risk. Islamic finance allows risk-taking   only   if   it   is   integrated   with wealth creation, rather than pure zero-sum side-betting (betting would be forbidden under the principle of gharar). This has produced the fact that Islamic banks were much less affected by the OTC derivatives meltdown that followed the demise of Lehman Brothers. The recent US reforms of the financial system which seriously limit proprietary trading could illustrate this vision. Continue reading