Back Matter

References

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Appendix I. Sources and Uses of Fund for IBs

Sources of Funds

Profit sharing investment accounts (PSIA) and safekeeping have become the main source of funds for many IBs.31 The expected level of return for PSIA holders would be close to line B in Figure 1 for both Islamic and conventional banking, given that competition in the market would prevent a permanent higher return (Area A) or lower return (Area C). However, positive (negative) market conditions and good (bad) management on the part of the IB could lead to a higher (lower) return, Area A (C), for investors and possibly a higher (lower) future market share for the bank. Safekeeping deposits (current accounts) do not participate in profit sharing because they are not made on the basis of a profit sharing contract (e.g. mudarabah) and are not exposed to loss. See Box 1 for illustration.

Figure 1.
Figure 1.

Potential Return for Banks’ Investors (Depositors)

Citation: IMF Working Papers 2010, 201; 10.5089/9781455205318.001.A999

Uses of Funds

On the investment or financing side, the Shariah principles imply that there must be an agreement to share risk and return on an investment and/or a sale/lease contract and an underlying asset behind financial transactions conducted by IBs. Key Shariah-compliant financial contracts are profit sharing (Mudharabah), joint venture (Musharakah), cost plus sale (Murabahah), and leasing (Ijarah). In line with the justice and risk-sharing principles, Shariah prohibits bayu al-gharar (trading in risk), where the Arabic word gharar is taken to mean excessive uncertainty. Islamic finance also prohibits selling assets not owned, selling someone’s debt, and the use of traditional derivatives. In addition, Islamic finance is restricted to Islam acceptable deals, which exclude investment or financing activities involving alcohol and gambling. Box 2 provides a description of Shariah-compliant contracts.

Figure 3 summarizes the implications of compliance with Shariah on the type of financial contracts that Islamic financial institutions can engage in. While the chart is not comprehensive, as other Islamic and conventional contracts can be included, it covers the most commonly used financial contracts.32 Given some differences among Shariah schools of thought, the borders of Shariah compliance could change to include or exclude some contracts or to encompass differences in the conditions of the contracts.

Figure 2.
Figure 2.

Conventional and Islamic Banks Financial Contracts

Citation: IMF Working Papers 2010, 201; 10.5089/9781455205318.001.A999

Definition of Key Shariah-Compliant Contracts

Sources of Funds (Deposits)

Profit Sharing Investment Account (PSIA) is a contract by which an investor/depositor places an investment fund with an IB on the basis of Mudharabah. The IB could have restricted or full discretionary power in making investment decisions. The IB acts as an entrepreneur while the PSIA holder acts as a capital provider. Both parties agree on a ratio of profit sharing, which must be disclosed and agreed upon at the time of opening the account. Profits generated by the IB are shared with the PSIA holder in accordance with the terms of the Mudharabah agreement while losses are borne solely by the PSIA holder, unless they are due to IB’s misconduct, negligence or breach of the contract terms. Usually the IB’s money (bank capital) is invested in the same income-producing assets or economic activities. Hence, low income (losses) affect the IB through low (negative) return on shareholders’ invested capital and low (zero) income from managing PSIA accounts. This source of revenue is the main one for the IB, and it is used to cover operational expenses.

A Wadiah (deposit) is a contract between the depositor and the IB (custodian) for safekeeping. The depositor grants the IB permission to utilize the funds for whatever purpose permitted by Shariah. The bank in return guarantees the value of the deposit and allows the depositor easy access for withdrawals whenever needed.

Uses of Funds (Financing and Investment)

A Murabahah (Cost-plus financing) contract refers to an agreement whereby the IB sells to a customer, at acquisition cost plus an agreed profit margin, a specified kind of asset that is already in its possession (such as a manufactured good). Following delivery of the asset, a credit risk in respect of the amount receivable from the customer arises. From the perspective of modern finance, a Murabahah facility is similar to an asset-backed risky loan.

A Salam (Purchase with deferred delivery) contract refers to an agreement to purchase, at a predetermined price, a specified kind of commodity (physical product) which is to be delivered on a specified future date in a specified quantity and quality (such as an agricultural or a manufactured product). As the buyer, the IB makes full payment of the purchase price upon execution of the Salam contract. To mitigate price risk, in certain cases, the IB enters into a back-to-back contract, namely Parallel Salam, to sell a commodity with the same specification as the purchased commodity under a Salam contract to a party other than the original seller.

An Ijarah (Lease) contract refers to an agreement whereby the IB leases to a customer an asset (such as a ship, aircraft, or telecom equipment) for an agreed period against specified installments of lease rental. The contract commences with an agreement to lease that is binding on the part of the potential lessee and requires the IB to purchase or lease an asset prior to entering the contract. An Ijarah contract could offer the lessee the option to purchase the asset either at the end of the lease period by means of a gift or a token consideration, or by installments of a specified amount during the lease period.

A Musharakah (Equity financing) contract is an agreement whereby the IB and a customer contribute capital to an enterprise, whether existing or new, or to the ownership of real estate or a moveable asset, either on a permanent basis or on a diminishing basis where the customer progressively buys out the share of the IB (“diminishing Musharakah”). 3 Profits generated by the enterprise or the asset/real estate are shared in accordance with the terms of the Musharakah agreement while losses are shared in proportion to the respective contribution to capital.

A Mudharabah (Participation or trust financing) contract is an agreement whereby the IB contributes capital to an enterprise or activity which is to be managed by the customer/investor. Profits generated by that enterprise or activity are shared in accordance with the terms of the Mudharabah agreement, while losses are to be borne solely by the IB unless they are due to the customer/investor’s misconduct, negligence, or breach of the contract terms.

1 This box follows closely the Islamic Financial Services Board (IFSB) definition of contracts.2 In the case of lease-to-buy contracts, the asset backing the lease is strictly not collateral as it remains the property of the lessor. It may be described as quasi-collateral (see the IFSB Capital Adequacy standard).3Diminishing Musharakah is a means of providing financing on a profit and loss sharing basis.

Appendix II. Empirical Results for Change in Credit and Change in Assets

Figure 1.
Figure 1.

Change in credit

(In percent)

Citation: IMF Working Papers 2010, 201; 10.5089/9781455205318.001.A999

Sources: Zawya Dow Jones; bank annual reports; and author’s calculations.
Figure 2.
Figure 2.

Growth in Assets

(In percent)

Citation: IMF Working Papers 2010, 201; 10.5089/9781455205318.001.A999

Sources: Zawya Dow Jones; bank annual reports; and author’s calculations.
Figure 3a.
Figure 3a.

Bahrain_Offshore: Change in credit

(In percent)

Citation: IMF Working Papers 2010, 201; 10.5089/9781455205318.001.A999

Sources: Zawya Dow Jones; bank annual reports; and author’s calculations.
Figure 3b.
Figure 3b.

Bahrain_Offshore: Change in Assets

(In percent)

Citation: IMF Working Papers 2010, 201; 10.5089/9781455205318.001.A999

Sources: Zawya Dow Jones; bank annual reports; and author’s calculations.

Appendix III. Description of the Database

Bank-level data were collected for CBs and IBs in five GCC countries (Bahrain, Kuwait, Qatar, Bahrain, Saudi Arabia, and the UAE), three non-GCC countries, (Jordan, Turkey, and Malaysia) and the Bahrain offshore banks. The dataset includes 120 CBs and IBs, of which about one-fourth are Islamic (Annex I).

For the GCC countries and Jordan, Zawya Dow Jones was the main data source, covering financial statements and interim accounts of most of the banks in these countries, both in local currency and U.S. dollars. However, data on risk-weighted assets, regulatory capital and nonperforming loans were obtained from individual bank annual reports for end-of-year reporting and from the Basel Capital Disclosures statements for interim data.

In the case of Turkey, data were mostly obtained from the Turkish Banking Association. However, individual bank annual reports were used for some series, such as nonperforming loans. In the case of Malaysia, individual bank annual reports/interim reports were used for all the data included in the study.

Annex I. List of Banks

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1

We would like to thank Hassan Al-Atrash for his valuable support and for guiding this research. We are grateful to Abbas Mirakhor, Adnan Mazarei, Daniel Hardy, Gabriel Sensenbrenner, Ghiath Shabsigh, Juan Carlos Di Tata, Khaled Sakr, Mahmoud El-Gamal, May Khamis, Mohsin Khan, Patrick Imam, Rifaat Ahmed Abdel Karim, and Simon Archer for their helpful comments on an earlier draft. We would also like to thank participants of the Middle East and Central Asia Department seminar for their helpful suggestions. Special thanks to Anna Maripuu, Yuliya Makarova, Arthur Ribeiro da Silva, and Patricia Poggi for valuable assistance.

2

The establishment of modern Islamic financial institutions started three decades ago. Currently, there are at least 70 countries that have some form of Islamic financial services; almost all major multinational banks are offering these services. See Imam and Kpodar (2010) for more details on how Islamic banking spread.

3

Oman is excluded since it does not have Islamic banks.

4

See IFSB et al (2010) for such a comparison.

5

While IBs dominate the banking sectors in Iran and Sudan, these countries were not included in the analysis because the focus of this paper is on comparing the performance of the two groups of banks in the same country.

6

Asymmetric information occurs when buyers or sellers are not equally informed about the quality of what they are buying and selling. The asymmetry always runs in the same direction, with the security issuer (borrower or party receiving financing) having more information than the investor (lender or party providing financing) about the issuer’s (borrower or receiver of financing) future performance.

7

The discussion here refers to justice in economic sense and not just to the exploitation of poor debtors by rich creditors. For more details, see El-Gamal (2001).

8

See Subbarao (2009), pp. 4–5.

9

This means that an investment is structured on exchange or ownership of assets, placing Islamic banks closer to the real economy compared to conventional banks that can structure products that are mainly notional or virtual within an infinite range.

10

More information about the IFSB is available on www.ifsb.org.

11

The term toxic assets refers to certain financial assets whose value has fallen significantly and for which there is no longer a functioning market, so that such assets cannot be sold at a price satisfactory to the holder. The term has become common during the financial crisis of 2007–10, in which they played a major role (Wikipedia). Complicated financial assets such as some collateralized debt obligations and credit default swaps falls in this category. These assets are not Shariah compliant and hence IBs cannot invest in them

12

The main sources used in building the database include banks’ annual and interim reports, Zawya database, and information from rating agencies.

13

*, ** and *** indicate that the hypothesis that the difference between IBs’ weighted average and CBs’ weighted average is greater than zero is significant at 10, 5, and 1 percent significance levels, respectively.

14

CBs receive higher share of public sector deposits in many countries. For example, public sector deposits in Jordan Islamic banks (largest IBs in Jordan) where about 1.5 percent of total deposits while public sector deposits averaged 8 percent in the banking system deposits in 2008.

15

CBs have more flexibility in debt restructuring given that they can provide their customers with cash (liquidity), which facilitates compliance with regulatory requirements for debt rescheduling/restructuring. Turkey relaxed the classification and provisioning requirements during the crisis.

16

We also examined the impact of the exposure to the household and trade sectors, capital adequacy ratios, growth in credit, and interaction (real estate and construction x country dummies) variables, which proved to be insignificant

17

The omitted category (country) is Bahrain offshore.

18

This helps in providing more stable sources of funds. It remains the case that in several countries one or two IBs dominate the market. This contributes to the stability of funds.

19

They defined large banks as banks with assets exceeding US$1 billion while we define large banks based on the median of bank assets in each country.

20

While the IBs dummy is not significant at 10 percent significant level, it is very close to be significant.

21

GIB is owned by the six Gulf Arab states.

22

See GIB’s 2008 Annual Report for more details. The analysis does not account for the potential reduction losses due to the purchase of these assets.

23

Islamic financial institutions carry 40 percent more liquidity than their conventional counterparts and commit about 95 percent of their funds to short-term Ijarah, Murabahah and Musharakah instruments (Khan et al, 2008).

24

A Liquidity Management Task Force was formed in early 2009 by the IFSB and the Islamic Development Bank to find ways to address this problem.

25

This includes the default of East Cameron Gas Company sukuk (US$167 million), Kuwait Investment Dar sukuk (US$100 million) and the Saad Group US$650 million Golden Built Sukuk. Given that these will represent the first cases to work-out sukuk default or restructuring, they will set a precedent for future restructuring. See Sukuk, Interrupted (Deutsche Bank; 2009) for further discussion.

26

While Nakheel sukuk holders did not face any losses while conventional loans and bond were restructured with losses to lender/holders, the legal uncertainty remains an issue that needs to be addressed.

27

Some Shariah scholars are reluctant about full and total harmonization of Shariah standards. In their view, the standardization of Shariah may be against the fundamental premise of Ijtihad, the process of deducting Shariah rules from their authentic sources. If rules become standard, and imposed by legal authorities, then Ijtihad cannot be applied anymore. This will eventually damage the very reason why Shariah can be applied in all circumstances, times and places.

28

Securing minimum features in the contracts, including approval by an appropriate Shariah board, would facilitate product innovation.

29

Islamic products tend to be more complicated than their conventional counterparts since they usually involve more than one concept and non-standard transaction structures

30

In the UAE some IBs exceeded the 25 percent limit on lending to real estate sector.

31

See Box 2 for the definition for these accounts.

32

For a description of various Islamic financial contracts, see http://en.wikipedia.org/wiki/Islamic_banking#Mudarabah_.28profit_sharing.29.

The Effects of the Global Crisison Islamic and Conventional Banks: A Comparative Study
Author: Mr. Jemma Dridi and Maher Hasan