Moody's Investors Service says that the ratings of entities in the fast-growing Islamic banking sector are stable, largely thanks to their ample liquidity, high profit margins and conservative leveraging. Nevertheless, Moody's cautions in its latest report on the sector that future upgrades
may be constrained by issues relating to Islamic banks' under-utilised excessive liquidity, inadequate corporate governance and weak risk management, particularly in terms of the handling of asset-liability maturity mismatches.
Moody's new Special Comment, entitled "The Liquidity/Leverage Trade-Off for Islamic Banks", evaluates the liquidity and leverage trade-offs for Islamic financial institutions (IFIs) in a changing environment and assesses the impact that this exchange will have on their ratings. "IFIs have traditionally demonstrated low leverage for religious reasons, but also because of their very profitable assets, cheap deposits and high levels of core capital. However, the resulting reliance on concentrated short-term liquid assets to finance liabilities means that Islamic banks' balance sheets are deficient in medium- to long-term funding instruments," explains Anouar Hassoune, a Moody's Vice President -- Senior Credit Officer Analyst.
The Moody's-rated Islamic banks that are based in Gulf Co-operation Council (GCC) typically have C to E+ bank financial strength ratings (BFSRs) and A1 to Baa1 global local currency deposit ratings. The relatively low BFSRs reflect the banks' strong dependence on qualitative, or non-financial, factors, the scores for which capture the IFIs'unsteady operating environment, constrained risk positioning and weak franchise value in comparison with those of peers.IFIs AWASH WITH CASH AND LIQUID ASSETS
"IFIs benefit from abundant liquidity, which is a very positive factor in an economic downturn. However, if such excessive liquidity is left underutilised, the lack of an innovative range of assets could slow growth during an economic boom," says Mr. Hassoune. In the context of Moody's ratings, liquidity is usually a credit strength because it provides a financial institution with surplus cash to use as a shock absorber against potential future shortages relating to obligations and investments.
Most IFIs in the GCC region have been able to use their surplus liquidity to aggressively boost deposit volumes and thus swell their market shares by growing lending volumes, while also maintaining their focus on the retail and corporate sectors. Moody's notes that securing funding has been relatively easy for IFIs because of the market perception that they will be more resilient to the global credit turmoil than their conventional peers, largely because Shari'ah supervisors forbid investment in highly leveraged structured instruments or global investment banks' shares.
However, the ample liquidity of Islamic banks is not without its drawbacks. IFIs are grappling with risks associated with liquidity, balance sheet management and overall risk monitoring, all of which represent constraints on their ratings. Most IFIs have been unable to introduce new products to help them handle their high liquidity levels and address the asset-liability discrepancies on their balance sheets. Moody's regards the latter issue as especially crucial in today's capital markets because of the rising frequency of asset write-downs.
"This awkward situation is largely due to the fragmentation of the Islamic finance industry and the varying opinions among Islamic scholars on the legitimacy of Shari'ah-compliant products, although there are some efforts underway to introduce new offerings to clients, especially in rapidly developing countries like Malaysia and Bahrain," explains Mr. Hassoune.LIQUIDITY RISK ISSUES WILL PERSIST
Moody's expects most IFIs to survive the decline in property prices and to rebound with the help of government support and the resurgence of global markets.
However, the liquidity-related issues will likely persist unless they are addressed with innovative solutions such as the introduction of a range of Shari'ah-compliant instruments and the management of asset-liability mismatches, which originate from the shortage of long-term funds. Moody's regards progress in this area as essential because the IFIs' underdeveloped funding portfolios are not nearly sufficient to maintain their performance and allow them to develop into a dominant regional financial industry.Global Arab Network