Risk-Sharing Financing of Islamic Banks: Better Shielded Against Interest Rate Risk?

Seho, Mirzet and Alaaabed, Alaa and Masih, Mansur (2016): Risk-Sharing Financing of Islamic Banks: Better Shielded Against Interest Rate Risk? Published in: The Journal of Muamalat and Islamic Finance Research , Vol. 13, No. 2 (December 2016): pp. 53-70.

Abstract

In theory, risk sharing based Financing (RSF) is considered a corner stone of Islamic finance. It is argued to render Islamic banks more resilient to shocks. In practice, however thus feature of Islamic financial products is almost negligible. Instead, debt-based instrument, with conventional like features, have overwhelmed the nascent industry. In addition, the framework of present-day economic, regulatory and financial reality inevitable exposes Islamic banks in dual banking systems to problems of conventional banks. This includes, but is not limited to, interest risk rate. Empirical evidence has, thus far, confirmed such exposures, despite Islamic bank’s interest-free operations. This study applies system GMM in modeling the determinants of RSF, and finds that RSF is insensitive to changes in interest rates. Hence, our result provide support to the “stability” view of risk-sharing-based financing. This suggest RSF as the way forward for risk management at Islamic banks, in the absence of widely acceptable Shariah compliant hedging instruments. Further support to the stability view is given by evidence of counter-cyclicality. Unlike debt-based lending that inflates artificial asset bubbles through credit expansion during the upswing of business cycles, RSF is negatively related to GDP growth. Our result also imply a significantly strong relationship between risk- sharing deposits and RSF. However, the pass- through of these deposits to RSF is economically low. About 40 percent of risk-sharing deposits are channeled to risk-sharing financing. This raises questions on the validity of the industry’s claim that depositors accustomed to conventional banking shun away from risk sharing and signals potential for better balance sheet management at Islamic banks. Overall, our findings suggest that, on the one hand, Islamic banks can gain ‘independence’ from conventional banks and interest rates through risk- sharing products, the potential for which is enormous. On the other hand, RSF could enable policy makers to improve systemic stability and restrain excessive credit expansion through its counter cyclical features.

• Item Type: MPRA Paper
• Language: English
• Keywords: Islamic banks, risk-sharing, financing, interest rate, dynamic system GMM.
• Subjects: G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages

References

Abdul Karim, Z., Azman-Saini W.N.W., & Abdul Karim, B. (2011). Bank lending channel of monetary policy: dynamic panel data study of Malaysia. Journal of Asia-Pacific Business, 12(3), 225-243.

Abdul-Rahman, A., Abdul Latif, R., Muda, R. & Abdullah, M.A. (2014). Failure and potential of profit-loss sharing contracts: A perspective of New Institutional, Economic (NIE) Theory. Pacific-Basin Finance Journal, 28, 136–151.

Adebola, S.S.; Yusoff, W.S.W. & Dahalan, J. (2011). The impact of macroeconomic variables on Islamic banks financing in Malaysia. Research Journal of Finance and Accounting, Vol 2, No 4.

Alaabed, A., Masih M., and Mirakhor, A. (2015). Undermining shared prosperity? Risk shifting and Islamic banking. World Bank and Islamic Development Bank Inaugural Annual Symposium on Islamic Finance 2015, Istanbul 9th September 2015.

Anderson, T.W. & Hsiao, C. (1981). Estimation of dynamic models with error components. Journal of the American Statistical Association, 76, 598–606.

Archer, S., Abdel Karim, R.A. & Sundararajan, V. (2010). Supervisory, regulatory, and capital adequacy implications of profit-sharing investment accounts in Islamic finance. Journal of Islamic Accounting and Business Research, 1 (1), 10–31.

Arellano, M. & Bond, S. (1991). Some tests of specification for panel data: Monte Carlo evidence and an application to employment equations. The Review of Economic Studies, 58 (2), 277–297

Arellano, M., Bover, O., (1995). Another look at the instrumental variable estimation of error-components models. Journal of Econometrics, 68, 29–51.

Askari, H. (2012). Islamic finance, risk-sharing, and international financial stability. This article is in part based on a series of recent books the author has co-authored on the subject, in particular, Risk-sharing in Finance: The Islamic Finance Alternative (Singapore: John Wiley & Sons, 2011).

Bacha, O. I. (2004). Dual Banking Systems and Interest Rate Risk for Islamic Banks. MPRA Paper, No. 12763, posted 15. January 2009 15:28 UTC.

Bacha, O. I. (2008). The Islamic inter-bank money market and a dual banking system: the Malaysian experience. MPRA Paper, No. 12699, posted 14. January 2009 09:30 UTC

Blundell, R., Bond, S., (1998). Initial conditions and moment restrictions in dynamic panel data models. Journal of Econometrics, 87, 115–143.

Bond, S.R., (2002). Dynamic panel data models: a guide to micro data methods and practice. Portuguese Economic Journal, 1, 141–162

Chernykh, L & Theodossiou, A. K. (2011). Determinants of bank long-term lending behavior: evidence from Russia. Multinational Finance Journal, 15 (3/4), 193–216.

Chong, B. S. & Liu, M. H. (2009). Islamic banking: Interest-free or interest-based? Pacific-Basin Finance Journal, 17, 125–144.

Constant, F.D. & Ngomsi, A. (2012). Determinants of bank long-term lending behavior in the Central African Economic and Monetary Community (CEMAC). Review of Economics & Finance, ISSNs: 1923-7529; 1923-8401 © 2012 Academic Research Centre of Canada.

Du, W. (2011). The investigation on the relationship between the problem of long‐term loan and economic growth. China Finance Review International, Vol. 1(2), 187 – 198.

Ergec, E. H. & Arslan, B. G. (2013). Impact of interest rates on Islamic and conventional banks: the case of Turkey. Applied Economics, 45(17), 2381-2388

Farooq, M. & Zaheer, S. (2015). Are Islamic banks more resilient during financial panics? Pacific Economic Review, 20(1), 101-124.

Farook, S., Hassan, M.K. & Clinch, G. (2012). Profit distribution by Islamic banks: an empirical investigation. The Quarterly Review of Economics and Finance, 52, 333–347.

Gerrard, P. & Cunningham, J. B. (1997). Islamic banking: a Study in Singapore. International Journal of Bank Marketing, 15(6).

Haneef, R. & Mirakhor, A. (2014). Islamic finance: legal and institutional challenges. ISRA International Journal of Islamic Finance, 6 (1).

Hossain M.B., Bhuiyan, M. A. H. & Rahman, H. (2013). Deposit behavior and its impact on loan: a case study on Rajshahi Krishi Unnayan Bank (RAKUB), Bangladesh. Journal of Economic Cooperation and Development, 34 (4), 47-60.

Ibrahim, Mansor H. (2006). Stock Prices and Bank Loan Dynamics in a Developing Country: The Case of Malaysia. Journal of Applied Economics. Vol IX, No. 1, 71-89.

Ibrahim, M. H. and Sukmana, R. (2011). Dynamics of Islamic financing in Malaysia: causality and innovation accounting. Journal of Asia-Pacific Business, 12 (1), 4-19.

Ibrahim, M. H. and Sufian, F. (2014). A Structural VAR analysis of Islamic Financing in Malaysia. Studies in Economics and Finance, Vol. 31 (4), 371 – 386.

Ibrahim, M. H. (2016). Business cycle and bank lending procyclicality in a dual banking system. Economic Modelling, 55, 127-134.

Iqbal, Z. & Mirakhor, A. (2013). Economic Development and Islamic Finance. World Bank Publications, The World Bank, No. 15787.

Kader, R.A. & Leong, Y.K. (2009). The impact of interest rate changes on Islamic bank financing. International Review of Business Research Papers, 5 (3), 189-201.

Karim, M. A., Hassan, M. K., Hassan, T. & Mohamad, S. (2014). Capital adequacy and lending and deposit behaviors of conventional and Islamic banks. Pacific-Basin Finance Journal, 28, 58–75.

Kim, S. B. & Moreno, R. (1994). Stock prices and bank lending behaviour in Japan. Economic Review, Federal Reserve Bank of San Francisco, No. 1.

Kuala Lumpur Declaration (2012). Available from ISRA’s website (20th September, 2012).

Minsky, H. P. (1984). Central banking and money market changes: a reprise. Working Paper, Washington University, Department of Economics, No. 72.

Mirakhor, A. (2009). Islamic economics and finance: an institutional perspective. MPRA Paper, No. 56017, posted 20. May 2014 18:29 UTC.

Mirakhor, Abbas (2010). Whither Islamic finance? Risk sharing in an age of crises. MPRA Paper, No. 56341, posted 31. May 2014 18:12 UTC.

Pruteanu-Podpiera, A. M. (2007). The role of banks in the Czech monetary policy transmission mechanism. Economics of Transition, 15 (2), 393–428.

Rama, A. & Kassim, S. H. (2013). Analyzing determinants of assets and liabilities in Islamic banks: evidence from Indonesia. Review of Islamic Economics, Finance, and Banking, 1 (1), 34-53.

Roodman, D. (2009). A note on the theme of too many instruments. Oxford Bulletin of Economics and Statistics, 71 (1), 135–158.

Rosly, S.A. (1999). Al-bay’ bithaman ajil financing: Impacts of Islamic banking performance. Thunderbird International Business Review, 41, 461–480.

Sarafidis, V., Yamagata, T. & Robertson, D. (2009). A test of cross section dependence for a linear dynamic panel model with regressors. Journal of Econometrics, 148, 149–161.

Sargan, J.D. (1976). Testing for misspecification after estimating using instrumental variables. London School of Economics Working Paper.

Shaikh, S. A. (2010). An ideal Islamic economic system: a gone case. MPRA Paper, No. 26701, posted 17. November 2010 06:28 UTC.

Windmeijer, F. (2005). A finite sample correction for the variance of linear efficient two-step GMM estimators. Journal of Econometrics, 126, 25–51.

Industry Reports:

Earnst & Young (2013-2014). World Islamic Banking Competitiveness Report 2013–14.

Earnst & Young (2014-2015). World Islamic Banking Competitiveness Report 2014–15.

IFSB (2013). Islamic Financial Services Industry Stability Report.

KFH (2014). Islamic Finance Outlook 2014. Kuwait Finance House.

World Bank (2015). World Bank Annual Report 2015. Available at: http://www.worldbank.org/en/about/annual-report

Websites:

Lagarde, C. (2015). Unlocking the Promise of Islamic Finance. Islamic Finance Conference, Kuwait City. Retrieved on Nov 16th, 2015 from http://www.imf.org/external/np/speeches/2015/111115.htm

NBR. The National Bureau of Asian Research. http://www.nbr.org/research/activity.aspx?id=370