Islamic Research and Training Institute Islamic Development Bank

Financial Distress and Bank Failure Lessons for Strengthening Islamic Banks Salman Syed Ali

Bank Failures l l Episodes • • • S&Ls Collapse BCCI Closure Barings East Asian Crisis Many others • • Fiscal (not a real cost) Dead-weight Loss Diversion of Economic Policy Slow-down of Islamic Finance Costs

Why Banks Fail? l l Structural Reasons Asset-Liability Problems External Factors What Theoretical Models Suggest

Can Islamic Banks Fail? l l Stability Theories Asset-Liability Link

What is the Cost of IB Failure? l l l Dead-weight Loss Stop to Islamization Slow-down in development of new instrument

But Islamic Banks have failed! l l Experienced Financial Distress Closed Down • Examples: • Ihlas Finans (Closed) • Bank Al-Taqwa (Closed) • Faisal Islamic Bank of Egypt (Survived) • Dubai Islamic Bank (Survived)

Why Islamic Banks Face Problems? l l l Structure of Evolution Reasons Common to Conventional Banks Reasons Unique to Islamic Banks

CAUSES OF FINANCIAL DISTRESS Macroeconomic Factors • Macroeconomic Situation Microeconomic Factors External to Bank Internal to Bank • Supervision problems • Inadequate infrastructure • Financial liberalization policies • Political Interference • Moral Hazard due to deposit insurance • Lack of transparency • Fraud and corruption • Banking strategy • Poor credit assessment • Taking interest rate or exchange rate exposures • Concentration of lending • Connected lending • Entering in new areas of activity • Internal control failures • Operational failures

l Let us go to Case Study

Case Study Ihlas Finans House

Contents l l l Background Macroeconomic Factors Internal to Banking Sector Factors Internal to SFH Sub-sector Factors Internal to Ihlas Finans • • Balance Sheet Analysis Role of Ownership Structure Control Failures Management Failures Fraud Strategic Failures Regulatory Failures Support Failures Lessons

Background l Parent Company: Ihlas Holdings started as social oriented business in 1970 s

Ihlas Holdings: The parent company Ihlas Holdings (1970 s) Housing Construction Electrical Appliances Media & Publishing; Insurance & many others Ihlas Finans (1995)

Ihlas Finans (the subsidiary) l l l l Started in 1995 Objective: to provide interest-free investment opportunities Registered as SFH in Turkey Four Incumbents IFH was the only domestically owned SFH It grew into the largest (40% of) SFH 682 Billion TL through IPO (150 m shares) Market Cap 6. 5 Trillion TL (1996)

l l l More branches than all other SFHs Deposits of SFHs not protected by Central Bank A banking crisis took place in Turkey Many banks collapsed and taken over by regulators (BRSA) Ihlas faced run on its deposits (last qrt 2000 & early 2001) License of Ihlas Finans cancelled (Feb 10, 2001).

Table-1: General Information About Special Finance Houses Nom. Establis Cap. December 31, 1996 hment (Billion Date TL) No. of Branch es (Dec. 31, 1996) 2001)* 1. Al-Baraka Türk O. F. K. A. S. 1984 750 16 2. Faisal Finans Kurumu A. S. 1984 500 11 3. Kuveyt Türk Evkaf O. F. K. A. S. 1988 1, 185 10 4. Andolu Finans Kurumu A. S. 1991 350 13 5. Ihlas Finans 1995 1, 000 24 36 6. Asya Finans Kurumu A. S. 1996 2, 000 1 25 22 30

What Went Wrong

We Seek Answers in l l Macroeconomic Factors Internal to Banking Sector Factors Internal to SFH Sub-sector Factors Internal to Ihlas Finans

Macroeconomic Factors (Turkey 2000 -2001) l l l Sustained double digit inflation Excessive debt (foreign and domestic). Foreign debt 197% of export earnings, budget deficit 14. 5% of GDP Depreciation pressure on TL which was then pegged. Projected GDP growth rate (-ve) 4% Financial liberalization taking place Contractionary fiscal and monetary policies (inflation down from 70% to 40% in one year)

Factors Internal to Banking Sector l l l Financial repression Accumulated bad debts Financial liberalization taking place Reduced credit and rising interest rates due to contractionary fiscal and monetary policy By Nov. 2000 (8+2) banks had failed and transferred to SDIF In Dec. 2000 11 th bank failed

Banking Sector Factors (Contd. ) Banks Using Interest Rate Arbitrage Assets in TL Govt. High interest income Liabilities in FX Principal + Interest in Domestic FX Foreign Investors Banks Buying Govt. Securities Borrowing in FX

Banking Sector Factors (Contd. ) l l l Investigation against the failed banks resulted in arrests of several prominent bankers and businessmen Foreign investors started to dump both treasury bills and shares in the market Squeeze on liquidity Overnight interbank rate went up to 1, 950% in one night Many more banks failed (large ones)

Banking Sector Factors (Contd. ) l l l Erosion of depositors’ confidence CB lost over 10 billion dollars trying to maintain crawling peg exchange rate 10 billion $ IMF rescue package announced but it proved insufficient Row between President and Prime minister over privatization process Anti-inflationary program abandoned and TL left to free float on Feb 22, it depreciated over 40% in just 3 days

Banking Sector Factors (Contd. ) l Sharp depreciation worsened the balance sheets of the banks including SFH.

Summary of Banking Sector Factors l l Exchange rate shock coupled with liquidity crunch eroded depositor confidence in the banking system. These were the factors external to SFH sub-sector that affected IFH not by rendering it insolvent but by creating liquidity crunch and run on its deposits.

Factors Internal to SFHs Sub. Sector l l l SFHs were not affected in the previous crisis of 1994 In 2001 SFHs constituted 3. 1% of total banking deposits 4. 7% of total banking investment The small size implied limited scope of shock absorbing capacity Deposits of SFHs were not protected by SDFI

Factors Internal to SFHs Sub. Sector (Contd. ) l l SFHs were not affected in the beginning because they did not have govt. securities in their portfolio However, they suffered the domino affect of collapse of so many conventional banks

Factors Internal to SFHs Sub. Sector (Contd. ) l Two observations to support domino affect hypothesis • Conventional banks withdrew their deposits • from SFHs between Sep and Nov. 2000 Big fall in deposits of SFHs came about in Jan 2001 two month after that of conventional banks when SFHs lost 900 trillion TL deposits.

Financial Stability Indicators for SFH Sub-Sector Cap =Equity/ Adequac Total y Assets 5. 6% in 2000 Asset Usage 70% for (19902000) =Loans/ Total Assets At par with foreign banks Higher than conventi onal banks (39%)

Financial Stability Indicators for SFH Sub-Sector (contd. ) Asset Quality =Nonperforming/ Total loans Increased Higher than during 2000 foreign but lower than domestic banks Managemen =Employ Gradually t Efficiency expenses/T increased otal assets after 1995 Similar to other banks

Financial Stability Indicators for SFH Sub-Sector (contd. ) Earnings (ROA) =Net Very low income/Tot al assets Less than ROA of other private banks Liquidity =Liquid Assets/Tot al assets Lowest wrt foreign & private banks Very low

Summary of Financial Stability Indicators for SFH Sub-Sector l l l Cap Adequacy : At par with foreign banks Asset Usage: Higher than conventional banks (almost double) Asset Quality: Poorer than foreign but better than domestic banks Management Efficiency: Similar to other banks Earnings: Less than ROA of other private banks Liquidity: Lowest w. r. t. foreign & private banks

Factors Internal to Ihlas Finans l l Factors Internal to Ihlas Finans • • Balance Sheet Analysis Role of Ownership Structure Control Failures Management Failures Fraud Strategic Failures Regulatory Failures Support Failures Lessons

Factors Internal to Ihlas Finans (Balance Sheet) l Capital Adequacy Ratio • Proxy for Cap. Ad = Shareholders’ Equity/Total • • Assets IFH 5. 39% < other SFHs 7% < 8% recommended by BC (as of 31 -12 -2000) IFH followed an expansionary strategy through leveraging of capital

Factors Internal to Ihlas Finans (Balance Sheet) l Gross Income to Total Assets Ratio • Proxy for Survival • IFH 18. 5% > all other SFHs except for Asya FH = 20. 6% (as of 31 -12 -2000) • In past years too this ratio for IFH was not bad In isolation it does not tell why IFH collapsed while others survived

Factors Internal to Ihlas Finans (Balance Sheet) l Composition of Deposits • Ratio of Current Deposits to Total Deposits = 3. 7% at IFH < 8% to 13% at other SFHs In order to give returns IFH needed to maintain high fund utilization ratio Increase in liquidity-, credit-, and economic risk by over investment in limited investment opportunities

Factors Internal to Ihlas Finans (Balance Sheet) l Liquidity Ratio • Ratio of Liquid Assets to Total Assets = 4. 22% • at IFH < 11. 01% at KTEFH < 15. 8% at AFH in 1999 During the crisis this ratio sharply went down to 0. 53% for IFH << 7. 5% at AFH < 10. 39% at KTEFH in 2000

Factors Internal to Ihlas Finans (Balance Sheet) l Maturity Mismatch • • There has been a significant maturity mismatch long before the crisis Short-term liabilities exceeded short-term assets Maturity Gap/Asset IFH (1998) KTEFH (1999) 0 -1 month -35. 7 -30. 2 1 -3 month -26. 7 -5. 7 3 -12 month +33 +26. 8 > 1 year +0. 4 +1. 6

Factors Internal to Ihlas Finans (Balance Sheet) l Duration Analysis • In theory it measures timing of cash flows. For lack • of data we assumed cash flows are timed to maturity. Therefore it gives maturity gap in number of years DG for IFH = +0. 452 years (1998) > DG for KTEFH = +0. 261 years (2000) Net value of bank will decline in response to increase in interest rate

Factors Internal to Ihlas Finans (Balance Sheet) l Currency Risk • • • Exact data is not available We expect exposure to forex risk since considerable investment existed in construction & vacation housing sectors which are sensitive to economic uncertainty and exchange rate movements. Gap between US$ denominated payables and receivables became 39. 33 million US$ in 2000 for Ihlas Holdings

What Next? How Much More?

Factors Internal to Ihlas Finans (Role of Ownership) l Ownership Structure: • • • Most diversified of all SFH 36% shares publicly held IDB had 10% share Parent Ihlas Holdings had 50. 27% • But ownership of the Parent Co Ihlas Holdings was skewed in favor of one individual with 40. 85% shares, 54. 94% were publicly traded and 4. 2% held by other minority holders This makes one person influential

Factors Internal to Ihlas Finans (Role of Ownership) l Local Ownership: • Ihlas Finans was domestically owned while • other SFHs were foreign owned Other SFHs had better internal reporting and control system as they were predominantly controlled from abroad

Factors Internal to Ihlas Finans (Control Failures) l l l Rubber stamp board of directors Board members not-motivated and some lacked experience Institutional members also passive

Factors Internal to Ihlas Finans (Management Failures) l Not prepared for changing regulations • • • Required SFHs to increase their capital to 20 trillion TL in 2 years from 1999. Req to pay 10% of min req cap towards the insurance Fund Min Cap-Adq raised to 8% from 2% for SFHs Investment in subsidiaries limited to 10% Lending limit to a single party = 25% of equity New disaggregated reporting system

Factors Internal to Ihlas Finans (Management Failures) l Given the existing allocation of funds/investments of IFH it was unable to abide by new limits on connected financing and concentration • E. g. , New reg permitted max 15% of bank’s own funds in non-financial co. l Tried to raise cap by retaining dividends for 2000 and 2001 but it was not sufficient

Factors Internal to Ihlas Finans (Management Failures) l Hired an executive from previously failed bank. • The executive came under BRSA scrutiny thus affected the customer confidence when it was needed most.

Factors Internal to Ihlas Finans (Fraud) l Tried to hide financial problems by fraudulent practices, hoping to rectify them in due course • Example: Agency financing done in the name of fictitious parties in order to address the internal financial problems

Factors Internal to Ihlas Finans (Strategic Failures) l Allowing withdrawals from Investment Accounts • No rationing • Lost US$200 million cash in few days • Abrupt stop to convertibility-loss of confidence • calls for liquidation-BRSA stepped in Other SFHs used better strategy

Other External Factors (Regulatory Failures) l l l First Lax Supervision, then Drastic Application of Rules Lacuna in Supervision Law • Does not specify what to do if SFH violates • l banking law Stopped the operations but what next? Unclear Scope or Confusion on Deposit Protection Law

Other External Factors (Support Failures) l Lack of Active Support • Slow response on IFH’s application to raise its capital (1998 -1999) l l Lesser Financial & Technical Support than Conventional Banks Other SFHs survived by foreign help

So the Lessons are!

Lessons to be Learned … l l l Despite their stability Islamic Banks can fail. Corporate Governance and Internal Controls are key issues. Rethink organizational and institutional framework of IBs. (representation in BOG/BOD is not enough)

Lessons to be Learned … …(contd. ) l l Multiple subsidiaries in too many lines of businesses increases the likelihood of reputation damage. Diversification is important but without controlling shares

Lessons to be Learned … …(contd. ) l l l Increasing monitoring costs limits the scope for diversification. Need for business rating companies which sell monitoring. Until then focus on diversifying within few business lines.

Lessons for strategy l l Invest through market—assume mutual fund management role. Offer different services to suit risk-return profile of various kinds of depositors and customers.

Lessons for corporate governance l l Enhance role of institutional investors to improve corporate governance. Liquidity management is difficult issue for IBs.

Lessons for regulation l l l Need institutions and infrastructure to handle liquidity crunch. Laws and Regulations should be clearly specified without ambiguity. Insurance of depositors against fraud is needed.

Thank You

Task Ahead

The End