Islamic lenders’ profits are lower due to higher overheads and structural costs according to a recent report by the International Monetary Fund (IMF).

“The Islamic banks’ lower profitability could be attributed to the higher overhead cost-to-revenue ratios due to start-up costs of foreign full-fledged Islamic banks. The cost structure of some standalone Islamic banks is slightly higher relative to Islamic banks within groups, as the latter reap the benefits of shared platforms,” it said.

The multi-country report, entitled “Ensuring Financial Stability in Countries with Islamic Banking”, said with low oil prices persisting and given prospects of the US normalising its monetary policy and potential for capital outflows, macro-financial risks for both Islamic and conventional banks are increasing.

However, it said Malaysia’s Islamic banks are well-capitalised with good and improving asset quality, but profitability and liquidity ratios are low and macro-financial risks from low oil prices are increasing.

Islamic banks’ aggregate capital adequacy ratio is above the statutory requirements and the non-performing financing ratio is low and declining.

The rate of return risk in the Islamic banking sector continues to be reasonably well-managed, underpinned by active risk reduction strategies pursued by Islamic banks, it added.

On the asset side, the report noted that banks hold variable rate assets in the financing book, mainly in the form of musyarakah, ijarah and variable murabahah contracts.

On the liability side, Islamic banks issued more fixed rate funding instruments such as tawarruq with longer contractual maturities to narrow the re-pricing gap against IBs’ fixed rate assets.

The shift towards tawarruq, it said, was also partly in response to the regulatory requirement to clearly differentiate between deposit and investment account products in accordance with the Islamic Financial Services Act 2013. This increased demand for deposit products that are principal-guaranteed.

It defined tawarruq as a multi-step transaction heavily used for interbank financing and liquidity management, often based on commodities traded on the London Metal Exchange.

In a 2015 Bank Negara Malaysia (BNM) policy document, tawarruq is said to consist of two sale and purchase contracts. The first involves the sale of an asset by a seller to a purchaser on a deferred basis. Subsequently, the purchaser of the first sale will sell the same asset to a third party on a cash and spot basis.

In contrast, the 102-page report said mudarabah-based general and specific investment deposits declined by 84% to account for 3.1% of the funding base compared to 19.7% in 2014.

The report also noted that Malaysia’s Islamic banking sector is supported by highly developed financial markets and infrastructure that enable the banks to manage various risks. These include a well-developed sukuk market and interbank markets between the Islamic banks and conventional banks.

It said the country’s sukuk market has gained breadth and depth, although banks are players as subscribers and not issuers. The market comprises both government and corporate issues with a broad range of tenures, including short-term sukuk.

“The decision in 2015 to discontinue the short-term liquidity management programme has been rescinded. It is understood that BNM has switched to other instruments for liquidity management that cater specifically to the Islamic banks it regulates.

“The previous sukuk programme was being subscribed to by a broad array of investors, preventing the sukuk from reaching their intended end-users (primarily Malaysian Islamic banks for liquidity management purposes),” the report said.

The IMF paper serves as a supplement to the board paper on “Ensuring Financial Stability in Countries with Islamic Banking Sectors”.

It aimed to present country experiences with reforms to strengthen regulatory oversight of the Islamic banking sector. It also reviews experiences with and the progress made in adapting prudential, safety nets and resolution frameworks to the specifics of Islamic banking.