By Dr. Ullas Rao, Programme Leader, London School of Business & Finance
History may well look at 2022 through the prism of prophecy in the conferment of the Sveriges Riksbank Prize in Economics Sciences on Diamond & Dybvig (1983) along with Ben Bernanke for their path-breaking work on ‘Bank Runs’. It appears to have caught the imagination of the world in the last few days with at least four banks falling off the cliff leaving a fifth teetering on the fringes of bankruptcy. The saga started with the Silicon Valley Bank (SVB) with depositors reclaiming deposits when panic ran amok as it became evident SVB made a ‘distressed’ call for recapitalisation of at least USD 2.7 billion. What followed was a spell of financial tsunami claiming SVB, Signature Bank, and First Republic in the United States as its first victims. It didn’t take too much time for the contagion to cross the Atlantic, leading to last-ditch efforts by the Swiss regulators to rescue the almost 165-year-old Credit Suisse from eventually losing its identity in a merger with UBS, orchestrated under the careful lens of the regulators.
Implicit in the above, is the case of panic spreading faster than pain, evident in the beeline of depositors reclaiming their deposits to safety out of banks. Curiously, Diamond & Dybvig capture this panic in their intellectually arousing model by distinctly identifying the bank’s depositors as ‘late’ (patient) and ‘unique late’ (impatient). Evidently, the bank faces a mortal crisis, revealed in the transition of its depositors from patient to impatient, leaving a trail of panic as information asymmetry expands at an explosive rate. Deriving inspiration from the famed Game Theory lies the intuitive idea exquisitely encapsulated in the 2×2 Nash Equilibria determining two distinct outcomes: Run or Don’t run!
It doesn’t take too much of an effort to trace the underlying risks afflicting banks ever eager to bolster their balance sheets with risky assets. At least in the instance of SVB, it was clear the bank benefited significantly with flush deposits – in the peak of the pandemic – making its way to the close confines of the bank serving primarily as a safe haven for the trailblazing clientele of Silicon Valley in California. A combination of factors including poor asset-liability management (ALM), deteriorating standards of corporate governance, and duration risks marking on bond holdings played a catalyst in bringing the curtains down.
It comes as little surprise to witness common remnants of reclusion of confidence traced to the tyranny of the 2008 global financial crisis (GFC) bringing an entire world economy to its knees. The crisis precipitated as a direct consequence of the collapse of ‘too-big-to-fail’ investment banks – Lehman Brothers and Bear Sterns – touting unabashed investment gains traced to inflated prices of mortgage-backed securities (MBS) long before the implosion on the back of sub-prime lending morphing into bad loans. The fall of the proverbial house-of-cards came crashing….
At the heart of the financial crisis discussed above lies the perverse incentive on part of interest-bearing, henceforth, conventional banks to assume excessive risk with scant regard to prudential norms exacerbated by moral hazard in deriving a license to splurge at the expense of the lender-of-last-resort (central bank). In contrast, the banking system founded on the fundamental tenets of Sharia’ – prohibition of ‘Riba’ (interest) and ‘Gharrar’ (excessive uncertainty) – popularly known as Islamic Banks, are precisely designed to disdain these perverse incentives afflicting conventional counterparts. Islamic Finance in essence reposes a significant degree of importance on generating returns from underlying assets churning economic activity or usufruct. With the edifice of Islamic Banks built on risk mitigation, there is a compelling argument to view the model from a constructivist perspective.
Islamic Banks provide an important alternative in limiting the wedge between a lender and borrower as the latter is exposed to excessive risk even as the rewards remain skewed towards the former. It is also pertinent to trace the symptomatic association of Islamic Finance with the Relationship-based financial system dominant in South-East Asian countries – notably in Indonesia and Malaysia. In a relationship-based system, during times of economic prosperity, the borrower wouldn’t hesitate from paying a higher profit rate, whilst in times of economic distress, the lender would be willing to settle for a lower profit rate.
Implicit in the system is mutual understanding between the lender and borrower as agents within an economic ecosystem. With its insistence on strictly contractual norms surrounding risk-reward sharing, Conventional-banks operating within the ecosystem of transaction or arms-length financials are inhibited by design to view the relationship between lender and borrower in a beneficence way. It is therefore not inconceivable to defend the inherent resilience of Islamic Banks by the evidence they were significantly well insulated from the vagaries of economic crises during the height of the mortgage crisis.
Products and services offered by Islamic Banks necessitate approval under the close vigil of the Sharia’ Supervisory Board (SSB) ensuring compliance with the edicts of Sharia’ to preserve prohibition of Riba and Gharrar. ‘Murabaha’ (cost plus markup) for instance is one of the most popular products offered by Islamic Banks constituting almost 70% of the operating income. Under this model, an Islamic Bank performs the role of financial intermediation by maintaining the ownership of the asset until all the lease payments (combination of principal and profit) are made by the lessee (borrower) to the lessor (Islamic Bank). As an illustration, say a customer willing to buy the latest model of Tesla approaches an Islamic Bank for financing. Here, the Islamic Bank will buy the asset from the vendor for X amount and lease the same to the borrower at (X+Y). Until the lease payments are settled by the lessee, the Islamic Bank retains legal ownership of the asset thereby hedging against the possibility of default. Note, in conventional banks, this arrangement remains in place only indirectly as the loan is sanctioned against the asset offered as collateral impeding real ownership of the asset.
From a critiquing perspective, one might argue it is the precedence of form over substance inherently evident in Islamic Financial contracts as interest is disguised as profit. However, in deriving this inference, there is a potential to miss the wood for the tree. Even as dichotomous opinions continue to dominate discussions surrounding Islamic Finance, the implicit requirement to pass the test of usufruct offers one of the foundational pillars in achieving harmony between profit and purpose.