Limited Purpose Banking: An Alternative That Suits Islamic Finance?

This article was published in Arab Times on July 26th 2011. click Here to read

Following their earlier article on Islamic Finance, Usman Hayat CFA, Director of Islamic finance & Environmental, Social, and Governance (ESG) factors in investing at CFA Institute and Raghu Madagolathur, President of CFA Kuwait, discuss limited purpose banking in the region as an alternative financial system that suits Islamic banking.

The global financial crisis has stirred a search for an alternative financial system. Whilst the Middle East has not been affected as much as some of the Western economies, it has by no means completely recovered. A number of high profile failures as well as continuous provisioning have prevented many banks from a robust recovery and global debate on alternative financial system is also relevant for the Middle East.

Islamic banks in the Middle East are also not immune from problems facing the global banking sector. For instance, they are exposed to speculative financing of real estate. It is worthwhile reviewing some of the issues that follow from our previous article on Islamic finance in the context of alternative financial systems.

The ongoing debate suggests that there are two major expectations from any alternative financial system. First, it should be free of bailouts of private institutions from public money, and second, it should focus on serving the real economy.

One potential alternative that might meet these expectations is limited purpose banking. It is proposed by Laurence Kotlikoff, a prominent economist and a professor at Boston University, who explains it at length in his book “Jimmy Stewart Is Dead” (2011).

As implied by its name, limited purpose banking limits the role of banks. In an audio podcast (2011) that we recorded with him, Kotlikoff explains that “limited purpose banking moves us from trust-me banking to show-me banking”. Simply put, banks will not extend credit themselves but operate like asset management companies offering mutual funds.

These mutual funds that do not borrow to invest will only buy the assets specified in their charters, be they mortgages or corporate bonds. The payment system would function through cash-only mutual funds. Banks will not be able to expand the money supply and the government would have full control of the money supply (M1).

There will be no opaque leveraged speculation through banking and no reason for a contagious run on the bank. Therefore, there will be no need for any bailout, deposit insurance, lender of last resort, and so on.

Unlimited liability will apply to those financial institutions, such as hedge funds, that cannot work as mutual funds. That is, the personal wealth of those who want to speculate on borrowed money will no longer be safe from their actions, cutting the appetite for speculation.

A single financial regulator will take the lead in ensuring safe custody of mutual fund securities and transparency in underlying transactions. This should help prevent fraud as exemplified by Bernie Madoff, “liar loans” and “toxic assets”.

This, in short, is how limited purpose banking seeks to eliminate bailouts and give finance compelling reasons to focus on the real economy.

Does it sound radical? “It’s not radical. What is radical is maintaining the current financial system”, argues Kotlikoff in his video on YouTube (2010).

Limited purpose banking is not without its supporters. Those who have praised “Jimmy Stewart Is Dead” include five Nobel laureates in economics and some known policymakers like George Shultz, former U.S. secretary of the Treasury. Mervyn King, the Governor of the Bank of England, has also talked about Kotlikoff’s “much wider vision of how the financial system can ultimately end”.

Kotlikoff’s alternative may not appeal to high street bankers, but it may find appreciation in some unexpected quarters: Islamic finance.

Islam, it is widely held, prohibits lending money on interest. Literature on Islamic finance tends to discourage the sale of risk and debt financing. Similarly, it encourages profit and risk sharing, it sees as suitable for economic justice. However, observers often note that the Islamic finance industry, usually estimated at around $1 trillion in assets, does not always match this description.

Take, for instance, “Islamic Law and Finance: Religion, Risk, and Return” (1998) by Frank E. Vogel and Samuel L. Hayes III, two professors from Harvard University. In the concluding chapter of this book, they termed it a “legal and financial embarrassment” that Islamic banks “mimic conventional banks” instead of being the profit-and-loss investment intermediaries that Islamic economic theory demands. They went on to suggest that genuine profit sharing through pooled funds could be the solution.

Islamic finance, however, continues to be largely commercial banking within conventional fractional reserve banking. According to the IFSL research report (2010) on Islamic finance, 74 percent of the assets of the industry are in commercial banking and only 5 percent are in funds. Fractional reserve banking is often criticized in Islamic finance.

One of its foremost critics is Tarek El Diwani, a London-based Islamic finance adviser. In his book, “The Problem with Interest” (1997), Diwani makes a detailed economic case against the proliferation of debt and resulting injustice that he sees inherent in fractional reserve banking.

It will soon be four decades since the establishment of the first Islamic commercial bank in 1975. There are many challenges facing the industry but there is a growing realization among reformists that the current financial system is one of the biggest. At the very least, it favors interest-bearing loans and leveraged speculation, making Islamic finance swim against the current.

But does limited purpose banking suit Islamic finance better?

Dr. Volker Nienhaus, an economist from Germany, thinks it does. In a video podcast (2011) that we recorded with him, he suggests that ending financing via banking and routing financing through mutual funds will lead to genuine and transparent risk sharing between contracting parties. According to Nienhaus, this structure will make finance serve the real economy and it “puts into practice what is promised” in Islamic finance. Nienhaus is of the view that Islamic financial sector should adopt this structure even if global banking reform does not mandate it.

In the past, a similar proposal, but with a limited scope, was narrow banking. This was part of the Chicago Plan of 1930s. Interestingly, the Chicago Plan predates modern Islamic finance but some see it as a fit. In a research paper (2004), Valeriano García, Vicente Fretes Cibils, and Rodolfo Maino suggested that narrow banking and equity financing are “what Chicago and Islam have in common”.

Some practitioners in Islamic finance—such as Iqbal Khan, the founding CEO of HSBC Amanah—have also spoken in favor of a mix of narrow banking and asset management for Islamic finance.

The Chicago Plan was never implemented despite the support of leading economists. Time will tell if limited purpose banking enjoys better luck. But it would probably enjoy support among reformists in both conventional and Islamic finance by meeting their expectations from an alternative financial system.

Managing Counterparty Risk

This article was originally published in Arab Times

Corporate failures caused about by the financial crisis has brought to the fore an important topic i.e., counter party risk. In the GCC, credit risk is normally not strongly evaluated due to lack of data. Also, there is a concentration of risk among major banks which leads to spillover risk in case of failures. Absence of strong regulatory structures in this area in GCC is a major impediment in handling this key risk for investors. Also, due to weaker legal structures, enforcement of credit rights is rendered more difficult in the GCC region.   Following an earlier article in the Financial Times (FTfm supplement) Mr. Raghu Mandagolathur, President of CFA Kuwait and Stephen M. Horan, head of professional education content and private wealth at CFA Institute discuss how institutions manage counterparty risk. 

 

Q: What is counterparty risk?

In derivatives contracts, parties agree to exchange cash flows based on the price of an underlying assets.  A corn farmer wishing to lock in the price he receives for his crop, for example, may sell a futures contract that will pay him more as the price of his corn falls, locking in his financial outcome.  Counterparty risk is the risk that the hedger or speculator, who buys the futures contract from the farmer, fails to pay if the price of corn falls. 

In organized derivative securities exchange, a clearinghouse acts as an intermediary, serving as the counterparty to each side of a transaction and insuring performance if one party fails to perform on its contractual obligations.  This arrangement allows investors to trade with confidence.
 

Q: Why is a clearinghouse a less risky counterparty?

As an intermediary, the exchange-based clearinghouse has offsetting long and short positions managing its net exposure to the value of the contract to near zero.  Its main exposure is that a party may default on their obligations.  To protect against these losses, the clearinghouse monitors its member’s positions each day and collects small fees on each trade for capitalization. 

It also requires trading partners to meet certain capital requirements and to deposit funds to insure contract performance.  As security prices fluctuate, counterparties are required to realize their losses on a daily basis or risk having their positions liquidated, a process called marked-to-market.   This arrangement requires contracts to be standardized and actively traded so that clearinghouses have the necessary information to mark-to-market. 
 

Q: How is the over-the-counter (OTC) derivative market different?

In OTC markets, trades are negotiated between counterparties such as broker dealers, corporations and hedge funds.  The negotiation process allows parties to customize contracts, which prevents them from being traded on organized exchanges.  Without a clearinghouse, counterparties assume each other’s credit risk.  Many would suggest these differences mean there is really not a market, simply a series of private negotiations. 

Assessing the risk of a particular counterparty is complicated by the opaqueness of their financial position.  Although large financial institutions may publish quarterly or semi-annual financial statements, estimating the risk of their positions from that information is challenging.

 

Q: How is counterparty risk related to the current financial market instability?

When a large party defaults, it can jeopardize the financial strength of their counterparties, which in turn increases the risk that their default and so on.  Because the notional value of derivatives markets dwarfs the cash markets (sometime by more than ten times), this cascade effect can cripple the financial system. 

OTC derivatives markets absorb small idiosyncratic defaults quite well.  The impact of major counterparty defaults is less clear.  Lehman Brothers was a significant player in derivatives, but it was not one of the largest counterparties.  AIG is one of the largest counterparties and was taken under the wing of the U.S. Treasury out of fear for the systemic effects of a default.

 

Q:  How is counterparty risk managed without a clearinghouse?

Risk is managed by selecting and monitoring counterparties.  Credit ratings can be an important part of this monitoring process.  Lehman Brothers was rated “A” just prior to bankruptcy, however.  So ratings may be slow to capture sudden changes in financial health and are inadequate alone. 

The fund manager must perform an independent credit risk analysis of their counterparties.  Contracts often include procedures for requiring initial margin on trades and subsequent adjustments to margin as positions fluctuate, as well, similar to a clearinghouse but on a less frequent basis.  Risk is also managed by limiting exposure to any single counterparty, diversifying credit exposure.  These measures are limited, however, is the face of a systemic collapse of confidence in capital markets. 
 

Q:  Is it feasible to transition the OTC market to a clearinghouse model?

Much of the OTC derivatives markets is characterized by customized, illiquid contracts.  This lack of standardization is inconsistent with an actively traded market, and illiquidity makes it difficult to mark positions to market. 

A dealer-based clearinghouse would require appropriate capitalization and customized risk management techniques.  Otherwise, risk may simply be transferred from individual dealers and concentrated in a single place at the clearinghouse.  A more limited clearinghouse focusing on liquid and standardized derivatives could be a partial solution. 

 

Q:  What are the implications for fund managers?

Current market failures may prompt more regulation, but OTC derivative contracts are a challenging instrument to regulate.  Fund managers trading OTC derivatives are well advised to approach counterparty risk management as rigorously as any other investment management activity, including an analysis of extreme scenarios on counterparties’ risk profiles.  Those investing in financial services firms may take the opportunity to question management thoroughly and call for greater transparency. 

After the crisis-Hurdles remain for gulf banks

The GCC banking sector is an important segment of GCC financial sector. From a modest asset base of $314b as of end of 2003, the total assets for the sector grew to an astonishing $ 966 b by the end of 2009, implying an annual growth of 20%. The banking sector is dominated by domestic players due to regulatory protection. The sector enjoys a large market opportunity set primarily due to absence of non-bank finance companies. Hence, one can find banks actively pursuing asset management, investment banking, stock broking ,etc. GCC banking sector is inherently helped by certain fundamental advantages like benign demographics that is not only young but also wealthy. The region is still under penetrated when benchmarked with western banks. While the sector cruised along nicely all these years, a major brake occurred during the fourth quarter of 2008, after which the sector continued to witness tremendous challenges.

Asset quality deterioration has led to unprecedented levels of provisioning during the last two years which dented the profitability, especially that of Islamic banks. Exposure to troubled sectors (like real estate, construction and financial services) coupled with bad corporate governance can stand as main reasons. While the sector was hit by the global financial crisis, the general assessment is that it has shown more resilience than expected. As per IMF assessment, regional banks withstood the onslaught better due to their low exposure to structured products and derivatives (both on and off balance sheet). On an average, banks in GCC held 18% of their portfolios in securities as of end-2008 of which exposure to equities/derivatives is just 1%. Also, regional banks enjoyed high capital and profit leading to larger buffers. In addition, timely help from central banks reduced the impact.

However, looking forward, the days of easy money (through high spreads) are gone with high level of risk aversion setting in among banks. This will lead to lower credit growth. While credit grew by an astonishing 30% during the last few years, it will be prudent to assume that this rate will atleast halve going forward. With other avenues for capital deployment being weak, deposit growth will continue to be strong adding further pressure. The potential for fee income has also reduced. Ambition to foray beyond borders will also be reviewed in this challenging time.

GCC banks were laid back in the past in a protected environment leading to poor customer service and product offering. On an average, the ratio of product-per-customer ratio is two to three in the GCC compared to eight or nine in the western retail banks as per AT Kearney study. The banking sector faces large competition with limited potential in the domestic market and the gradual relaxation of regulatory restrictions. Most banks operated within their country of operations and had limited branch network thereby keeping a control on infrastructure costs. Also, through expat hiring banks kept its costs low even in areas like information technology. All this enabled GCC banks to enjoy a low cost-to-income ratio compared to other banks in the western world. Also, GCC banks enjoyed high capital cover and a stable shareholder base which in some countries could be the respective government providing cheap and stable capital and deposits. But going forward, GCC banks may have to face some change in paradigm leading to vanishing of these advantages. The WTO would bring in more pressure for the local regulators to allow entry of foreign banks. Also, post financial crisis, regulators will lay more emphasis on encouraging the development of local capital markets as depending only on the banking sector could be dangerous. This is likely to reduce the overall dependence and importance of banks as the main financial intermediary.Click here for the original article