Benchmark rates risk management — a 2-edged sword for Islamic banks
Kuwait

A study found that an increasing benchmark rate impacts the economic value of equity and capital base of Islamic banks

By HABHAJAN SINGH / Pic By BLOOMBERG

The benchmark rates risk management has been described as a “two- edged sword” for Islamic banks as they are potentially exposed to risk whether the rates go up or down, according to a recent research paper.

The paper, jointly written by a Kuwait central banker and an industry expert from International Islamic University Malaysia (IIUM), argued that an increasing benchmark rate impacts the economic value of equity and capital base of Islamic banks.

On the converse side, a decreasing benchmark rate regime also exposes the same financial institutions to risk of profitability and non-performing assets as their customers may exit and choose early settlement.

The 26-page paper underlined the “pivotal” need to manage the risk with appropriate tools, irrespective of the direction of the rate and the jurisdiction in which they operate.

“Our empirical results indicate that a persistently low benchmark rates regime carries strategic implications for Islamic banks, including pressure on profitability, excessive risk-taking and distortion in credit allocations.

“On the other hand, in light of the evolving global macroeconomic conditions including a gradual tightening of monetary policy by the US Federal Reserve in the medium to long term, an increasing benchmark rates regime indicates the significant loss of the capital base and emergence of displaced commercial risk, causing early withdrawals by the customers due to higher expectations in dual banking systems,” according to the paper.

The paper, entitled “Risk Management in Changing Benchmark Rates Regime: Prudential Implications for Islamic Banks and Supervisors”, was co-authored by Dr Jamshaid Anwar Chattha and Dr Syed Musa Syed Jaa- far Alhabshi.

Jamshaid is the chief banking researcher and Islamic finance expert at the Central Bank of Kuwait, while Syed Musa is the dean at IIUM Institute of Islamic Banking and Finance. The paper was published in the special issue of the Journal of Islamic Finance.

In the course of their research, the authors analysed data from 50 fully-fledged Islamic commercial banks (ICBs) from 13 countries.

The banks include ABC Islamic Bank and Al Baraka Banking Group from Bahrain; First Security Islami Bank Ltd and Islami Bank Bangldesh Ltd from Bangladesh; PT Bank Shariah Mandiri Tbk and PT Bank Shariah Muamalat Tbk from neighbouring Indonesia; Islamic International Arab Bank plc and Jordan Islamic Bank from Jordon; Boubyan Bank and Ahli United Bank BSC from Kuwait; and Bank Islam Malaysia Bhd and Kuwait Finance House (M) Bhd from Malaysia, among others.

Post-Global Financial Crisis

The authors argued that the post-global financial crisis scenario has presented extraordinary challenges to the global economy in general, and the banking industry, in particular.

One of the new set of challenges to beset the financial industry is the risk management in changing benchmark rates risk for Islamic banks, which the authors argued had received considerable prominence in the banking sector, due to a number of reasons including supervision of banks’ benchmark rates under Basel II Pillar II.

Taking into account the specific features of Islamic banks, the paper intended to theoretically and empirically review the possible prudential implications of lowly and increasing benchmark rates risk, and provide a sturdy risk management and regulatory perspective for Islamic banks and supervisors.

The authors highlighted the importance of appropriate tools such as duration gap, asset-liability management, internal capital adequacy assessment process and stress testing.

“Moreover, in the pursuit of financial stability, supervisors also have to ensure that ICBs continuously safe-guard risk management, as fragile economic and financial environment can eventually transmute a stable banking system into a considerable stress,” they said.