Presentation on theme: "Islamic Research and Training Institute"— Presentation transcript:
1 Islamic Research and Training Institute Islamic Development Bank
2 Financial Distress and Bank Failure Lessons for Strengthening Islamic Banks Salman Syed Ali
3 Bank Failures Episodes Costs S&Ls Collapse BCCI Closure Barings East Asian CrisisMany othersCostsFiscal (not a real cost)Dead-weight LossDiversion of Economic PolicySlow-down of Islamic Finance
4 Why Banks Fail? Structural Reasons Asset-Liability Problems External FactorsWhat Theoretical Models SuggestNew Notes: Literature review here
5 Can Islamic Banks Fail?Stability TheoriesAsset-Liability Link
6 What is the Cost of IB Failure? Dead-weight LossStop to IslamizationSlow-down in development of new instrument
7 But Islamic Banks have failed! Experienced Financial DistressClosed DownExamples:Ihlas Finans (Closed)Bank Al-Taqwa (Closed)Faisal Islamic Bank of Egypt (Survived)Dubai Islamic Bank (Survived)
8 Why Islamic Banks Face Problems? Structure of EvolutionReasons Common to Conventional BanksReasons Unique to Islamic Banks
9 CAUSES OF FINANCIAL DISTRESS Macroeconomic FactorsMicroeconomic FactorsExternal to Bank Internal to BankMacro-economic SituationSupervision problemsInadequate infrastructureFinancial liberalization policiesPolitical InterferenceMoral Hazard due to deposit insuranceLack of transparencyFraud and corruptionBanking strategyPoor credit assessmentTaking interest rate or exchange rate exposuresConcentration of lendingConnected lendingEntering in new areas of activityInternal control failuresOperational failures
15 Ihlas Finans (the subsidiary) Started in 1995Objective: to provide interest-free investment opportunitiesRegistered as SFH in TurkeyFour IncumbentsIFH was the only domestically owned SFHIt grew into the largest (40% of) SFH682 Billion TL through IPO (150m shares)Market Cap 6.5 Trillion TL (1996)
16 More branches than all other SFHs Deposits of SFHs not protected by Central BankA banking crisis took place in TurkeyMany banks collapsed and taken over by regulators (BRSA)Ihlas faced run on its deposits (last qrt 2000 & early 2001)License of Ihlas Finans cancelled (Feb 10, 2001).
17 Table-1: General Information About Special Finance Houses December 31, 1996Establishment DateNom. Cap.(Billion TL)No. of Branches (Dec. 31, 1996)No. of Branches (Dec. 31, 2001)*1. Al-Baraka Türk O. F. K. A. S.198475016222. Faisal Finans Kurumu A. S.500113. Kuveyt Türk Evkaf O. F. K. A. S.19881,18510304. Andolu Finans Kurumu A. S.1991350135. Ihlas Finans19951,00024366. Asya Finans Kurumu A. S.19962,000125
19 We Seek Answers in Macroeconomic Factors Factors Internal to Banking SectorFactors Internal to SFH Sub-sectorFactors Internal to Ihlas Finans
20 Macroeconomic Factors (Turkey 2000-2001) Sustained double digit inflationExcessive debt (foreign and domestic). Foreign debt 197% of export earnings, budget deficit 14.5% of GDPDepreciation pressure on TL which was then pegged.Projected GDP growth rate (-ve) 4%Financial liberalization taking placeContractionary fiscal and monetary policies (inflation down from 70% to 40% in one year)
21 Factors Internal to Banking Sector Financial repressionAccumulated bad debtsFinancial liberalization taking placeReduced credit and rising interest rates due to contractionary fiscal and monetary policyBy Nov (8+2) banks had failed and transferred to SDIFIn Dec th bank failed
22 Banking Sector Factors (Contd.) Banks Using Interest Rate ArbitrageAssets in TLLiabilities in FXHigh interest incomePrincipal + Interest in FXForeign InvestorsGovt.DomesticBanksBorrowing in FXBuying Govt. Securities
23 Banking Sector Factors (Contd.) Investigation against the failed banks resulted in arrests of several prominent bankers and businessmenForeign investors started to dump both treasury bills and shares in the marketSqueeze on liquidityOvernight interbank rate went up to 1,950% in one nightMany more banks failed (large ones)
24 Banking Sector Factors (Contd.) Erosion of depositors’ confidenceCB lost over 10 billion dollars trying to maintain crawling peg exchange rate10billion $ IMF rescue package announced but it proved insufficientRow between President and Prime minister over privatization processAnti-inflationary program abandoned and TL left to free float on Feb 22, it depreciated over 40% in just 3 days
25 Banking Sector Factors (Contd.) Sharp depreciation worsened the balance sheets of the banks including SFH.
26 Summary of Banking Sector Factors Exchange rate shock coupled with liquidity crunch eroded depositor confidence in the banking system.These were the factors external to SFH sub-sector that affected IFH not by rendering it insolvent but by creating liquidity crunch and run on its deposits.
27 Factors Internal to SFHs Sub-Sector SFHs were not affected in the previous crisis of 1994In 2001 SFHs constituted3.1% of total banking deposits4.7% of total banking investmentThe small size implied limited scope of shock absorbing capacityDeposits of SFHs were not protected by SDFI
28 Factors Internal to SFHs Sub-Sector (Contd.) SFHs were not affected in the beginning because they did not have govt. securities in their portfolioHowever, they suffered the domino affect of collapse of so many conventional banks
29 Factors Internal to SFHs Sub-Sector (Contd.) Two observations to support domino affect hypothesisConventional banks withdrew their deposits from SFHs between Sep and Nov. 2000Big fall in deposits of SFHs came about in Jan 2001 two month after that of conventional banks when SFHs lost 900 trillion TL deposits.
30 Financial Stability Indicators for SFH Sub-Sector Cap Adequacy=Equity/Total Assets5.6% in 2000At par with foreign banksAsset Usage=Loans/Total Assets70% for ( )Higher than conventional banks (39%)
31 Financial Stability Indicators for SFH Sub-Sector (contd.) Asset Quality=Non-performing/Total loansIncreased during 2000Higher than foreign but lower than domestic banksManagement Efficiency=Employ expenses/Total assetsGradually increased after 1995Similar to other banks
32 Financial Stability Indicators for SFH Sub-Sector (contd.) Earnings(ROA)=Net income/Total assetsVery lowLess than ROA of other private banksLiquidity=Liquid Assets/Total assetsLowest wrt foreign & private banks
33 Summary of Financial Stability Indicators for SFH Sub-Sector Cap Adequacy : At par with foreign banksAsset Usage: Higher than conventional banks (almost double)Asset Quality: Poorer than foreign but better than domestic banksManagement Efficiency: Similar to other banksEarnings: Less than ROA of other private banksLiquidity: Lowest w.r.t. foreign & private banks
34 Factors Internal to Ihlas Finans Balance Sheet AnalysisRole of Ownership StructureControl FailuresManagement FailuresFraudStrategic FailuresRegulatory FailuresSupport FailuresLessons
35 Factors Internal to Ihlas Finans (Balance Sheet) Capital Adequacy RatioProxy for CapAd = Shareholders’ Equity/Total AssetsIFH 5.39% < other SFHs 7% < 8% recommended by BC (as of )IFH followed an expansionary strategy through leveraging of capital
36 Factors Internal to Ihlas Finans (Balance Sheet) Gross Income to Total Assets RatioProxy for SurvivalIFH 18.5% > all other SFHs except for Asya FH = 20.6% (as of )In past years too this ratio for IFH was not badIn isolation it does not tell why IFH collapsed while others survived
37 Factors Internal to Ihlas Finans (Balance Sheet) Composition of DepositsRatio of Current Deposits to Total Deposits = 3.7% at IFH < 8% to 13% at other SFHsIn order to give returns IFH needed to maintain high fund utilization ratioIncrease in liquidity-, credit-, and economic risk by over investment in limited investment opportunities
38 Factors Internal to Ihlas Finans (Balance Sheet) Liquidity RatioRatio of Liquid Assets to Total Assets = 4.22% at IFH < 11.01% at KTEFH < 15.8% at AFH in 1999During the crisis this ratio sharply went down to 0.53% for IFH << 7.5% at AFH < 10.39% at KTEFH in 2000
39 Factors Internal to Ihlas Finans (Balance Sheet) Maturity MismatchThere has been a significant maturity mismatch long before the crisisShort-term liabilities exceeded short-term assetsMaturityGap/AssetIFH(1998)KTEFH (1999)0-1 month-35.7-30.21-3 month-26.7-5.73-12 month+33+26.8> 1 year+0.4+1.6
40 Factors Internal to Ihlas Finans (Balance Sheet) Duration AnalysisIn theory it measures timing of cash flows. For lack of data we assumed cash flows are timed to maturity. Therefore it gives maturity gap in number of yearsDG for IFH = years (1998) > DG for KTEFH = years (2000)Net value of bank will decline in response to increase in interest rate
41 Factors Internal to Ihlas Finans (Balance Sheet) Currency RiskExact data is not availableWe expect exposure to forex risk since considerable investment existed in construction & vacation housing sectors which are sensitive to economic uncertainty and exchange rate movements.Gap between US$ denominated payables and receivables became million US$ in 2000 for Ihlas Holdings
43 Factors Internal to Ihlas Finans (Role of Ownership) Ownership Structure:Most diversified of all SFH36% shares publicly heldIDB had 10% shareParent Ihlas Holdings had 50.27%But ownership of the Parent Co Ihlas Holdings was skewed in favor of one individual with 40.85% shares, 54.94% were publicly traded and 4.2% held by other minority holdersThis makes one person influential
44 Factors Internal to Ihlas Finans (Role of Ownership) Local Ownership:Ihlas Finans was domestically owned while other SFHs were foreign ownedOther SFHs had better internal reporting and control system as they were predominantly controlled from abroad
45 Factors Internal to Ihlas Finans (Control Failures) Rubber stamp board of directorsBoard members not-motivated and some lacked experienceInstitutional members also passive
46 Factors Internal to Ihlas Finans (Management Failures) Not prepared for changing regulationsRequired SFHs to increase their capital to 20 trillion TL in 2 years from 1999.Req to pay 10% of min req cap towards the insurance FundMin Cap-Adq raised to 8% from 2% for SFHsInvestment in subsidiaries limited to 10%Lending limit to a single party = 25% of equityNew disaggregated reporting system
47 Factors Internal to Ihlas Finans (Management Failures) Given the existing allocation of funds/investments of IFH it was unable to abide by new limits on connected financing and concentrationE.g., New reg permitted max 15% of bank’s own funds in non-financial co.Tried to raise cap by retaining dividends for 2000 and 2001 but it was not sufficient
48 Factors Internal to Ihlas Finans (Management Failures) Hired an executive from previously failed bank.The executive came under BRSA scrutiny thus affected the customer confidence when it was needed most.
49 Factors Internal to Ihlas Finans (Fraud) Tried to hide financial problems by fraudulent practices, hoping to rectify them in due courseExample: Agency financing done in the name of fictitious parties in order to address the internal financial problems
50 Factors Internal to Ihlas Finans (Strategic Failures) Allowing withdrawals from Investment AccountsNo rationingLost US$200 million cash in few daysAbrupt stop to convertibility-loss of confidence-calls for liquidation-BRSA stepped inOther SFHs used better strategy
51 Other External Factors (Regulatory Failures) First Lax Supervision, thenDrastic Application of RulesLacuna in Supervision LawDoes not specify what to do if SFH violates banking lawStopped the operations but what next?Unclear Scope or Confusion on Deposit Protection Law
52 Other External Factors (Support Failures) Lack of Active SupportSlow response on IFH’s application to raise its capital ( )Lesser Financial & Technical Support than Conventional BanksOther SFHs survived by foreign help
54 Lessons to be Learned …Despite their stability Islamic Banks can fail.Corporate Governance and Internal Controls are key issues.Rethink organizational and institutional framework of IBs. (representation in BOG/BOD is not enough)
55 Lessons to be Learned … …(contd.) Multiple subsidiaries in too many lines of businesses increases the likelihood of reputation damage.Diversification is important but without controlling shares
56 Lessons to be Learned … …(contd.) Increasing monitoring costs limits the scope for diversification.Need for business rating companies which sell monitoring.Until then focus on diversifying within few business lines.
57 Lessons for strategyInvest through market—assume mutual fund management role.Offer different services to suit risk-return profile of various kinds of depositors and customers.
58 Lessons for corporate governance Enhance role of institutional investors to improve corporate governance.Liquidity management is difficult issue for IBs.
59 Lessons for regulation Need institutions and infrastructure to handle liquidity crunch.Laws and Regulations should be clearly specified without ambiguity.Insurance of depositors against fraud is needed.