When benchmark rates change: the case of Islamic banks

Author:Simon Archer, Rifaat Ahmed Abdel Karim
Position:Henley Business School, ICMA Centre, University of Reading, Henley-on-Thames, UK
Pages:197-214
SUMMARY

Purpose This paper aims to examine the issue that arises in the context of benchmark rate (or interest rate) changes made for reasons of monetary policy in a jurisdiction with a significant presence of Islamic banks. Changes, especially increases, in the prevailing interest rate made by central banks raise issues of asset-liability management for banks, which typically have longer... (see full summary)

 
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When benchmark rates change:
the case of Islamic banks
Simon Archer and Rifaat Ahmed Abdel Karim
Henley Business School, ICMA Centre, University of Reading,
Henley-on-Thames, UK
Abstract
Purpose This paper aims to examine the issue that arises in the contextof benchmark rate (or interest
rate) changes made for reasons of monetary policy in a jurisdiction with a signicant presence of Islamic
banks. Changes, especially increases, in the prevailing interest rate made by central banks raise issues of
asset-liability management for banks, which typically have longer maturities on the asset side than on the
liabilities side,resulting in exposure to interest rate risk for conventionalbanks, and what is known as rate of
return (RoR) risk for Islamicbanks, which for reasons of compliance with Islamic religious law(Shariah)do
not use interest in their operations.Islamic banks use various nancial instruments which reect the cost of
funds by means of contractsof sale on credit or of leasing or forms of partnership, which allow themto earn
returns ontheir funds and to pay returns to customers who deposit fundswith them.
Design/methodology/approach The methodology ofthis study consisted of a descriptive analysis of
the relevant characteristicsof Islamic banks and their economic and regulatory environments, illustratedby a
case study approachapplied to two jurisdictions, namely, Sudan and Malaysia.
Findings In jurisdictions where Islamic banks represent a signicant share of the market for nancial
services, if the contracts used in Islamic nancing allowfor periodic adjustments of the prot rate or lease
rental, thiscould result in a signicant impediment to the full implementationof monetary policy and hence to
the maintenanceof nancial stability.
Originality/value This study is (to the best of authorsknowledge) the rst thorough analysis in the
literature of the issues arising from the exposureof Islamic banks to RoR risk and has clear implications for
regulatoryand central bank policy.
Keywords Islamic banking, Central banks, Benchmark (interest) rates
Paper type Research paper
Conventional banks can reect interest rate changes rapidly by using oating rate
instruments, thus mitigatingtheir exposure to interest rate risk. They may also use interest
rate swaps. The instruments used by Islamicbanks are less exible, making the mitigation
of RoR risk more problematic. In thecontracts of sale on credit, the nancier purchases the
asset to be nanced and sells it to the client on credit with a mark-up on the purchaseprice,
which reects the cost of funds and provides the Islamic bank with a commensurate RoR.
However, the selling price cannot be changed subsequently to reects a change in the
market cost of funds. Another instrumentwhich is being used by Islamic banks very often
to provide nancing to customers is Musharakah[1] Mutanaqisah, Diminishing
Musharakah (DM). Given that Islamic banks have shorter maturities on the liabilities or
funding side, the result may be that customers who have deposited funds with them to earn
a return will withdraw themto earn a better return elsewhere. In the case of leasing and DM
contracts, there will be some mitigation of RoR risk if the contract allows for periodic
changes in the rental, but the periodsare typically three or six months.
If Islamic banks have a signicant presencein a jurisdiction and are likely to be impeded
in their effective mitigation of RoR risk, this may havemacro-level implications of systemic
risk and threats to nancial stability. Hence, in addition to the micro levelissue of RoR risk
The case of
Islamic banks
197
Received30 November 2017
Revised24 May 2018
Accepted10 July 2018
Journalof Financial Regulation
andCompliance
Vol.27 No. 2, 2019
pp. 197-214
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-11-2017-0104
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
management for Islamic banks, there is also a macro level issue regarding the policies the
relevant authorities (central bank and banking industry supervisor) should adopt and the
measures they should take in these circumstances. The paper discusses these issues and
provides some examples,with particular reference to Sudan and Malaysia.
1. Introduction the context
Almost 10 years after the global nancial crisis (GFC), the global economy is still
experiencing difcultyin take-off. In a recent report the International MonetaryFund (IMF),
reects that the heightened geopolitical risks and conicts lead to growing concerns about
the future growth trajectories of the global economy (IMF, 2016). In light of the evolving
global macroeconomic conditions, Islamic banks operating alongside conventional banks
are also exposed to broadly the same systemic risk factors and volatilities as their
conventional counterparts,despite their sustained growth momentum (SectionII). It is worth
mentioning that tightening monetary policies have implications for Islamic banks in the
medium to long term as we explain in this paper (Chattha, 2017). In December 2015, the US
Federal Open Market Committee increased the benchmark rate[2] by 25 basis points (bps)
after almost seven years of quantitative easing. A similar 25 bps increase was made in
December 2016, and more recent ones of 25 bps in March 2017 and June 2017, respectively,
so that the US Federal Reserve Bank (Fed) rate reached 1.25 per cent reecting a gradual
increase. This marginalincrease has important implications for the banking industry.
Benchmark rates (or interest rates) play an important role for a central bank in setting
monetary policy, as subsequently these rates are used by the commercial banks as a
reference point in pricing their products and services. Chattha and Alhabshi (2016) stated
that in recent years, the management of benchmark rates has received considerable
prominence in the bankingsector because of various factors, including:
the increasing instability of benchmark rates;
nancial market conditions; including the presence of a at yield curve and the risk
of the yield curve remaining at for a longer period; and
the growing international emphasis on the supervision and control of banks
benchmark rates under Basel II.
Table I.
Breakdown of IFSI
by sector and by
region (USD billion,
2016
a
)
Region Islamic banking Sukūkoutstanding Islamic funds assets Tak
aful contributions
Asia 218.6 182.7 19.8 4.4
GCC 650.8 115.2 23.4 11.7
MENA (ex. GCC) 540.5 16.6 0.2 8.4
Africa (ex-North Africa) 26.6 1.9 1.5 0.6
Others 56.9 2.1 11.2
Total 1,493.4 318.5 56.1 23.2
Notes: Data for SukūkOutstanding and Islamic Funds is for full year 2016; Islamic Banking for six-
months ended June-2016 (1H2016); while that of Takaful as at end-2015
Sources: IFSB IFSI Stability Report 2017; Data are mostly taken from primary sources (regulatory
authoritiesstatistical databases, annual reports and nancial stability reports, ofcial press releases and
speeches, etc. and including IFSBs PSIFI database). Where primary data are unavailable, third-party data
providers have been used including Bloomberg and Thomson Reuters. In only a few instances where there
were still information gaps, data were estimated based on historical growth trends, news reports and
country-specic assumptions. Tak
aful contributions are used as a basis to reect the growth in the Tak
aful
industry. The breakdown of Islamic fundsassets is by domicile of the funds while for SukūkOutstanding
is by domicile of the obligor. The Islamic funds numbers reported for 2016 may not be directly comparable
to previous years due to a change in external database sources.(IFSB, p. 7, 2017)
JFRC
27,2
198

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