Islamic banking is slowly moving to become an integral part of the traditional banking industry. As it grows in significance and as regulations change, there are increasing challenges to risk management which DENNIS COX addresses in this article.
Review of 2016
2016 has been an unusual year in many respects and the impact on risk management has been a consequence of this. We continue to implement slowly the regulations drafted rapidly after the last financial crisis. There is also the long-term continuation of the low interest rate environment. Indeed, during 2016 most interest rates did not vary and this was an advantage for Islamic banks.
In an environment when interest rates do not vary, floating rate and fixed rate facilities look much the same. Of course, a fixed rate of interest can also be considered as a fee since it is the same amount paid or received over the lifetime of an asset or liability. That resulted in the potential rate issue for an Islamic bank being of less significance and indeed many Islamic banks are increasingly offering similar products to what might be termed traditional banks.
With Islamic banks coming of age, there is increasing regulatory focus. Too often, regulations emerging from Basel do not really consider the impact that they might have on Islamic finance. In the course of 2016, we have seen a greater recognition that regulations need to address the entire banking industry, not just traditional banks.
One other trend we have identified during the year has been the integration of the Shariah board and internal audit into the mainstream of the Islamic bank. Too often, internally the banks appeared identical to traditional banks with Shariah appearing as an add-on. Shariah is fundamental to the operation of an Islamic bank and should be at its core and we have noted greater integration in this respect.
Preview of 2017
2017 will be in the post-US election environment which would suggest an increasing funding requirement for the US economy. Why is this relevant for the risk management function in an Islamic bank? The US debt continues to increase at an alarming rate and everything that the new regime in the US is currently proposing would exacerbate this. Rising interest rates are already being priced into the yield curve.
There is a realistic expectation that interest rates will start to rise significantly during the course of 2017. Rising interest rates are a challenge for all banks but in particular for banks that have what is essentially a fixed rate book, such as Islamic banks although the fixed rate is effectively disguised as either a fee or a profit share. Rising interest rates will increase the cost of funding and accordingly would need to be passed on to customers in some way. The challenge for the Islamic bank is that there are limited options available to it to offset this risk.
We are expecting the Islamic ISDA to be reissued in early 2017, but this is mostly due to the requirement to refer directly to the central counterparty rules. What will be needed is a new style of instrument which has some insurance-based characteristics and will be inherent in many of the instruments that are to be sold.
Another key concern is volatility. 2017 will lead to the creation of a new upward interest rate trend, but the road to its creation will not be smooth. Islamic banking has never operated in a rising interest rate environment and it is difficult to assess the likely impact on behavioral analysis of depositors and investors. It is likely that Islamic banks will lag in the market in reflecting the new funding paradigm.
While it is always clear that interest rates are not directly reflected within Islamic finance, the indirect impact and probable attractiveness of traditional banking over Islamic banking will be significant.
The excess liquidity environment which has been both an advantage and a challenge for Islamic banks will also come to an end. The changing regulatory requirements will require additional capital and liquidity to be held to support increasing business activity. The sophistication of the risk management functions will also need to be enhanced to meet this challenge.
Finally, we are expecting a greater focus on corporate governance within the Islamic banks. The requirement to enhance the senior management team and incorporate additional quality risk management independent advisors will become clear during the year as will the need to upskill existing executive and non-executive directors.
We conclude that 2017 is likely to be a year of significant challenges to Islamic banks and to their risk management. The perfect storm of rising interest rates, increased volatility, increasing capital requirements, changing liquidity and increasing regulatory and customer expectations provides the backdrop for the year. Since much of this is new to Islamic banking, risk managers will need greater foresight and modeling to adequately support the needs of the business and to ensure that Islamic banking continues to flourish through 2017 and beyond.