2015 has been a year of volatility and unexpected price movements in global fixed income markets, much of which have been triggered or exacerbated by government policies. Regulatory changes implemented in the wake of the global financial crisis have made it more onerous for banks to trade bonds, for example, and reduced market liquidity substantially. Fewer active liquidity providers in most markets has meant wider bid-offer spreads and the potential for one large secondary market transaction to dramatically move the price of a security. MICHAEL BENNETT and AKINCHAN JAIN delve further.
Central bank interest rate policies have also added to the volatility. In some cases, expected actions have not occurred. For example, as of October, the market was still waiting for the long expected first interest rate increase by the US Federal Reserve
since 2006. In other cases, actions had the opposite effect from those predicted. For instance, just as the European Central Bank
was stepping up its program of quantitative easing in April 2015, causing many investors to expect even lower yields on core European government bonds, 10-year German government bond yields rocketed from an intraday low of 0.05% in mid-April to a high of 0.8% in just a few weeks.
Financial derivatives and Islamic banks
All of this volatility and uncertainty in the fixed income market exposes banks to significant interest rate risk. One important set of tools that conventional banks use to manage this risk is financial derivatives. Derivative instruments – including swaps, options and futures – provide banks efficient ways to hedge the interest rate exposures that naturally arise from their core activities of lending, borrowing and deposit-taking.
Islamic banks, on the other hand, have many fewer tools available to them to manage this risk. While Shariah
compliant derivative instruments exist, they are fewer in type and much less commonly traded than conventional derivatives. In addition, the acceptance of Islamic derivatives differs by institution. For instance, while profit rate swaps, the Shariah
compliant instrument most similar to a conventional interest rate swap, have become relatively common in the market, some Islamic banks are still prohibited by the opinions of their Shariah
advisors from entering into these contracts. Other institutions are permitted to use profit rate swaps to hedge specifically identified exposures, but may not use them to hedge net exposures on a portfolio basis.
The relative scarcity of Islamic derivatives is not surprising. The prohibitions in Islamic law against the charging of interest (Riba
), speculation (Maysir
) and excessive uncertainty in commercial transactions (Gharar
) raise difficult questions of Shariah
interpretation for Islamic legal scholars when applied to financial derivatives. While their usefulness as risk management tools may be undeniable, usefulness alone obviously is not the only factor in determining Shariah
In addition, Islamic banks’ relative lack of exposure to derivatives at the time of the global financial crisis is frequently cited as one of the reasons they fared better during the crisis than their conventional counterparts. Islamic banks did not, for example, participate in the highly complex, derivative product-based collateralized debt obligation securities that became toxic assets on the balance sheets of many conventional banks. Given the lack of exposure to derivatives has been identified as a strength of the Islamic banking industry in 2008 and 2009, it is not surprising that some banks are reluctant to begin just a few years later to trade in these products.
However, the vast majority of financial derivatives that conventional banks use to hedge their interest rate risk have little, if anything, in common with the complex instruments that contributed to the financial crisis. A swap, for instance, that permits a bank which has a significant percentage of fixed rate assets and is concerned about impending interest rate increases to swap a portion of that fixed rate exposure into a floating rate basis is both a simple and highly effective risk management tool. An Islamic bank that is denied equivalent Shariah
compliant hedging tools will not be able to manage its risks as efficiently as conventional banks in the same market and therefore will be at a competitive disadvantage.
Islamic banks have not been immune to the financial market volatility in 2015. In particular, Islamic banks in the Gulf have been impacted by the continued uncertainty over US interest rates (with the majority of Gulf currencies pegged to the US dollar) and by a significant reduction in their liquidity brought on by the fall in the oil price. Similarly, Islamic banks in Southeast Asia have been hit by the dramatic decline in the value of the Malaysian ringgit as well as the general widening of emerging market credit spreads. At the same time, Islamic banks, like their conventional counterparts, are increasingly subject to stricter prudential regulation. Given this difficult market and regulatory backdrop, it is increasingly important for Islamic banks to have access to a full range of tools to hedge interest rate and other risks.
The findings, interpretations and conclusions expressed herein are those of the authors and do not necessarily reflect the views of the World Bank
or its affiliated organizations.
Michael Bennett is the head of derivatives and structured finance in the Capital Markets Department of the World Bank and Akinchan Jain is a senior financial officer in the same department. They can be contacted at [email protected] and [email protected] respectively.