The Global Financial Crisis and Its Affect on Islamic Banks in the USA - Research Proposal Example

Research paper The global financial crisis and its affect on Islamic banks in the USA Grade The global crisis has effected institutions all over the world resulting in wiping out of massive wealth. Islamic banks have proved more resilient with almost no closures, profits and asset growth. This paper looks into the different financial measures used to assess the performance of Islamic banks. These different numerical values will give an insight into the performance of Islamic banks in the US before, during and after the crisis. These observations will lead to deductions about how severely these banks were affected by the crisis. Introduction The Islamic banking industry is relatively new but is booming and flourishing. The United States has at least 19 providers of Islamic financial services (Shayesteh, 2009). These range from retail and investment banks to finance providers and mortgage companies. There number is low as compared to the number of Muslims residing in the US but their services are on the rise. The Sub-prime mortgage crises is an ongoing crises; which started in the United States; characterized by evaporating liquidity in the world’s credit markets; declining asset prices specially in the housing sector; high rate of foreclosures on mortgage assets; failure of mortgage backed securities; etc. Although the crises started in the United States (US) its effects have been contagious and have extended to other financial markets around the globe. The crises took everyone by a storm forcing liquidity, reducing credit supplies, reduced asset growth and ratings. There are proofs to suggest that Islamic banks and conventional banks have been affected in different ways. (Maher Hasan, 2010)Their credit and asset growth was better and they got more favorable external ratings than conventional banks. Their business model limited the adverse affect on profitability. Nevertheless Islamic financial institutions like all other financial institutions were affected by the crises though the impact on Islamic banking was lower. The US is home to religious freedom and therefore Islamic finance is allowed to flourish. Islamic finance includes Shariah compliant ways of providing loans, mortgages, credit, insurance and almost everything that conventional banks provide. The only difference is in the terms, conditions, underlying beliefs and laws that form the foundation for Islamic finance. They generally do not invest in toxic investments and therefore the impact of the crises was relatively low. This industry has weathered the crises and the effects will be analyzed by looking at the financial statements and the external credit ratings given to banks. The standards of measurement of any external force on the banking system remain the same for both Islamic and conventional banking. Islamic banking is a balance between capitalism and communism but like all other banking systems have its risks, assets and defaulters. Relevant literature: There is abundance of literature on Islamic finance, Islamic banks and effects of the crises on financial institutions though specific publications related to both Islamic finance in the US and the ongoing crises are limited. The main source of data is the annual reports released by the banks and the external credit ratings given to them by financial institutions. Islamic banking is a very widely published topic. Reports which compare the effects of crises on Islamic banking and conventional banking have been published. One of these is "The effects of the global crisis on Islamic and conventional Banks: A comparative study" by Maher Hassan and Jemma Dridi. This compares the effects of crises on both types of banking using different measures including profitability, credit growth, asset growth and external ratings. These are the measure normally used to analyze a banks performance and the same will be used to find out the effects of the crises on the American banking industry. Another important book which is highly relevant is "Structuring financial requirements" compiled by Prof Dr Saiful Azhar Rosly and Dr Mohd Pisal Zainal and published by INCEIF, the global university in Islamic finance. This book discusses measures used by Islamic financing institutions to structure their financial requirements. (Dr Saiful Azhar Rosly, 2010) Other related reports which help in comparative studies include "The Subprime Crisis and the Effects on the U.S. Banking Industry" by Bo Tiller. (Tiller) This report discusses the effects of Sub Prime financing explaining how the bursting of this bubble led to the crises and how the stick prices of different stocks fell. It describes in detail how Citigroup and the Bank of Americas stock prices fell by 32% and 44% respectively (Economist, 2009) There is also a great deal of data available on Islamic banking in the US. A particularly enlightening article is "Islamic banking in the US: breaking through the barriers" by Abdi Shayesteh published in the New Horizon magazine.(Shayesteh, 2009). It gives a list of the existence and activities of the 19 Islamic banks in the US. The New Horizon magazine is a very important source of data related to Islamic finance. The most important piece of data will be the statistics, financial statements and press releases from Islamic banks in the US. Thus reports from The Bank of Whittier in Southern California (the provider of solely Islamic financial services) and the Islamic bank in Devon will be very important. Financial statements from HSBC and JP Morgan Chases Islamic finance division will also be helpful. These will provide concrete data related to the banks performance. Data related to layoffs and job cuts as released by the banks will be very important. The data from these banks which should be used should be from both the pre-crisis and the post crises times. One example of the resource used is The Bank of Whittiers annual management letter 2009. (Whittier, 2010). This report includes financial highlights from the years 2003 to the year 2009. This includes the crisis period of 2007 to 2009. The statistics include net earnings, return on equity, earning per share, total assets, share holders equity and book value per share. It also includes different ratios which compare a banks efficiency and effectiveness. This includes the efficiency ratio, and returns on assets and equity which are different equity ratios. All these are helpful in determining the banks performance and providing comparisons. Research objectives and variables The primary research objective is to find out the effect of the global financial crisis and its effect on the Islamic banking industry in the US. This paper looks into the different aspects of the Islamic banking industry and measures the quantitative effects of the credit crunch. Islamic banking like all other banking sectors was affected by the crisis but the extent was low as compared to other sectors. The Islamic finance industry has proved more resilient than the conventional banking industry and more stability has been observed (Hamzani, 2008). This relationship is a result of non risky investments and asset based financing. The concurrent results can demonstrate the relationship between less volatility of Islamic banks. Islamic banking is growing rapidly in the US and this research is undertaken to present Islamic banking techniques as a model for banks in need of stability. For this reason, proof that Islamic banking is more stable in times of recession will be needed. Additions: Causes of the subprime crisis The crises started when the US Housing Asset Price Bubble started to burst. The US housing asset prices had risen sharply during the preceding five years up till 2006. During the period of the bubble (2002-2006) the rising housing asset prices more and more people were encouraged to borrow money at low interest rates by various financial institutions. Adjustable Rate Mortgages (ARM) were offered by numerous banks under which mortgage loans at very low initial interest rates were offered; the interest rates were pre-agreed to be increased after a certain period for instance after two to three years. Similarly the mortgage loans were offered at very easy terms or with little credit appraisal requirements. The case of Mortgage Backed Securities (MBS): The Mortgage Backed securities are backed by the earnings or the cash flows of various mortgage loans. The payment, return and the security are all tied up to these mortgage loans. The previous mortgage or lending model envisaged the banks to originate and hold the loan till its maturity; however with the engineering of securitization banks are able to originate and distribute the originated loan to entities by repacking them into securities. This had two detrimental effects on the US financial market; firstly it resulted in availability of excess liquidity to the credit markets. Banks were able to originate the loans through their deposits and then sell these loans by repacking them into securities through out the world thereby releasing their liquidity tied up in the originated for yet further mortgage and loan originations. Secondly the policy of originate and distribute lead to the Moral Hazard problem and encouraged the banks and investment banks to originate high volume of mortgage loans with little emphasis on the credit quality of such loans. The increase in demand for housing and cheap supply of credits resulted in the boom in the construction industry to increase the supply of housing to meet the demand. The increase in supply resulted in the decrease in supply at the start of 2006. With this decrease in prices the real estate housing lost its spark as speculative investment thereby the speculative investors started to withdraw from the market by selling their long positions. This resulted in further increase in the supply of homes to be sold in the market. Thereby further depressing the price of homes throughout the US economy. The depressing of prices was far higher in certain states. This decrease in price was coupled with the increasing in the interest rates of the mortgage loans after the initial lower rates under the Adjustable Rate Mortgage (ARM) schemes. This meant that people with lower or sub prime credit ratings started to default on their periodic mortgage payments. Individuals who had availed such financing with a mindset that they would be able to refinance their ARM loans at lower rates weren’t able to do that once the underlying housing assets started diminishing in value. As a result there were foreclosures on mortgages with sub prime or no credit history; this resulted in more properties available for sale in the economy thereby further decreasing the prices of real estate. With such decreasing in values of houses; defaults in periodic payments by mortgage borrowers and diminishing in values of the underlying mortgage/security the mortgage backed securities whose underlying values were directly related to the cash flows of these mortgaged assets started to feel the pinch of the housing bubble bursting from the core. The value of the MBS started to fall along with the periodic profit payments and the redemption value. The investment banks which had invested heavily in these investments by borrowing extensively from the short term interbank market or through the issuance of bonds were unable to fulfill their repayment requirements under these obligations when these fell due. The liquidity for such investment banks was squeezed to a complete standstill since they were not able to sell their long term MBS assets in the market due to the fallout in the mortgage market and neither were they able to generate enough liquidity through borrowing due to their constantly decaying credit standing and the cautious approach of the other lenders. These institutions also were unable to generate liquidity through further securitizations. As a result such investment banks and non banking financial institutions which had played a major role in flushing the market with excess liquidity completely dried up their resources to generate the liquidity. This resulted in the shortage of liquidity in the market thereby pushing the interest rates upwards. With the interest rates pushing upwards the housing prices fell more sharply as is the tendency of the assets to move in the opposite direction from the interest rates. This further resulted in failure of mortgage borrowers to get the planned refinancing; the higher rates also resulted in higher profit payments to be made on the loan. The decrease in pricing of homes resulted in negative equity of the mortgaged home owners under the mortgage loan i.e. the value of the underlying asset financed by the loan is less than the amount of the loan outstanding. This situation resulted in encouraging the home owners to default on the loans since the loans were limited recourse mortgages under which the liability of the borrower is restricted to the enforcement value of the security. Lessons for the Islamic finance industry The Islamic Financial Industry (IFI) and its players including the regulators need to learn important lessons from the sub prime crises; especially since the industry at present is in its initial stages and is some what indirectly linked to the global conventional financial system. In the following sections we discuss the various factors to be taken care of and measures to be taken by the industry players to avoid the chaos experienced interest based financial system. Origins of Islamic banking. Islamic banking is a relatively new industry internationally. Works on Islamic finance started as late as 1950s and the first Islamic bank, the Dubai Islamic bank was set up in 1975 by a few Muslim businessmen. Since then there is no turning bank. Though the industry was slow to develop initially but held immense potential due to the large Muslim population around the world. Countries such as Malaysia and Iran with large Muslim populations hold a huge percentage of all Islamic banking assets. They are Shariah compliant and abstain from usury and interest. This makes the working of conventional and Islamic banks very different from each other. Countries such as the UK and the US with a huge Muslim population are also following lead and embracing Islamic banking. Though most banks offering Islamic banking services offer both normal services and Islamic services, The bank of Whittier in California is the sole provider of exclusive Islamic financial services. It is in operation since1982. The bank also has a separate financial services division called Lariba. Other banks which provide Islamic financial services are JP Morgan Chase, Deutsche Bank, HSBC, Devon Bank of Chicago,University Bank of Ann Arbor, Michigan (Where are the Islamic Banks Located In America?: How Can a Muslim Buy a Home in America With No Interest? ) Methodology Since primary banking data is very frequently published and financial publications provide accurate measures for different performance variables, there will be no need for primary research. The data used will be secondary in nature and will be extracted from different sources. Banking is a highly numerical industry and therefore the need for qualitative data is eliminated. Quantitative data will be used to analyze the performance of different banks. Since this is a cause and effect relationship, it will be measured by measuring the effects of the crises on different banking measures. The different variables that a bank uses to announce its performance will be measured and compared. If there is an increment in the positive measures, that will mean that the crises has a beneficial effect. If the result is negative that will mean that the crisis has proved to be a disaster. These results will also be compared to conventional banks in the same area that is the United States so that the relative effect of the crises can be observed. The number of Islamic banks in the US is relatively low therefore normal banking indicators such as the market structure-pricing relationship would not be used. Other indicators such as market concentration of banks also will not be used to represent performance. Instead data from 12 banks from the United States will be taken. This includes annual and interim reports, external ratings and Zawya data base if available. Four key indicators were used to assess the changes during the crisis period. These include 1) Profitability and Capital This will show the internal growth rate of the capital. An increase or no change in the capital over the period of 2007-09 will demonstrate a positive effect on the performance of banks. If the bank has earnings per share in comparison to losses suffered by other organizations, it means that they are not directly hit by this depression. Profitability of banks is measured by return on assets which is the ratio of after tax profits or loss with total assets. Asset growth will also be measured and even a small asset growth is significant as the crisis has led to companies losing assets rather than increasing them. 2) Solvency ratios Returns on equity, capital and equity and debt ratios will be compared. These ratios are solvency ratios and are measures of the banks capital strength. 3) Risk asset ratios. These will provide assessment of adequate capital with respect to assets particularly loans and advances. They include equity to loans ratio and capital to risk assets ratio. These solvency measures can also be calculated from the data provided in the annual reports. 4) Growth ratios These will include asset growth ratios which are the asset growth rate, ratio of the retained profit to share holders equity which determines the internal growth rate of capital and the banks resilience. The Dividend payout ratio will also be measured which is the ratio between dividend payout and after tax profit. 5) Credit growth Credit growth determines macro environmental stability and the credit increment of Islamic banks in the US will be analyzed both during the pre and the post crisis period. Normal financial institutions have cut down on credit so stable credit or an increase in credit will be an indicator of efficiency and positive activity. 6) Loan quality and quantity. The sub-prime mortgage crisis was a result of easy lending terms and as a consequence banks decreased the number of loans. Loan conditions became more stringent and some banks stopped lending all together. Credit quality of loan portfolios also determines a banks profitability. (Jim Wong, 2007)A ratio of loan loss provision to assets will determine how much the bank earns. The higher the banks loan provision to asset ratio, the less its profitability and net income. Lending spreads or flight to quality will also determine a banks response to the crisis. (Giovanni Dell’Ariccia, 2004). Almost all banks raised their banking spreads to discourage creditors but since Islamic banks do not function on the basis of credit or interest, their performance stayed stable thus eliminating this variable. Another important variable which measures a banks efficiency and will also be used to measure Islamic banks profitability is the number of defaulters. It is customary for a bank to have a large number of defaulters who are unable to repay their loans during times of recession. Though this is not greatly applicable as loans of Islamic banks are asset based but it is still a reliable measure of a banks performance. 7) External ratings. External ratings are awarded by rating companies to organizations. These represent the non riskiness of investment with that company in the stock market. The more stable a company is the higher and better its external rating is. As a result of the crisis, the external ratings of many banks dropped significantly. These credit ratings are normally given by external rating agencies foreg Fitch, Moodys and S&P. the effects of the crisis can be seen by using pre crisis ratings foreg from before September 2008 and April 2010. An AAA will mean that the bank is highly reliable and stable and investing in it is non risky. On the contrary a low rating foreg a B or a C will mean that the banks stock cannot be bought or money invested in the bank can be lost because of the extremely volatile nature of the bank. 8) Lay-offs and closures Another significant effect of the crisis has been closure of bank branches, mergers and acquisitions of banks and laying off employees by all major banks. The crisis has also resulted in drastic job and pay cuts. This data will be collected from Islamic banks all over the US and the number of lay-offs and bank closures if any will give a significant insight into the effects of the Sub-prime crisis. All these ratios will be calculated from the years 2006 to the year 2009 and the credit growth, profitability and external ratings will also be analyzed in the same time frame. The financial crises caused a crunch in all sectors, and greatly affected banking, mortgage and industrial sectors. The 2007-09 crises has reportedly wiped out nearly 45%wealth of the world (Partnoy) Regression analysis of the data will be done and graphs and bar charts will be drawn to compare pre and post crisis data. This will make the comparison easier and more graphic. Since the profitability and net income of most financial institutions was nil and in some cases zero, a stable environment with no growth will also indicate that these banks have withstood the recession and suffered indirect effects. An increase in assets and profits will symbolize that these banks were less affected by recession whereas a sharp decline in profits and layoffs will mean that these Islamic banks have also been hit by recession, the way conventional financial industries like Lehman brothers are. Conclusion Islamic banking is a relatively new but an extremely fast growth industry. Different financial measures analyzed are used to prove that this industry has withstood the test of recession and difficult times. This is more because Islamic financing is more asset based. The disadvantage is that it is more illiquid (review, 2008). Financial measures such as growth, liquidity, profit and solvency ratios are benchmark ratios for any organizations performance and these ratios were used to assess the performance of Islamic banks and to observe the effects of the crisis. Though profitability and credit growth of Islamic banks was affected but the profitability remained consistent and their asset and credit growth was twice that of conventional banks. (Zawya) These measures once determined by calculations from interim and annual reports will indicate the performance. The difference between measures in Islamic banking and conventional banking will be the simple fact that no interest rates or lending spreads will be including, rather profits will be based on the fixed prices of mortgages. INCEIF stands for the International centre for education in Islamic finance. It is located in Malaysia. References Where are the Islamic Banks Located In America?: (online)How Can a Muslim Buy a Home in America With No Interest? . (n.d.)., from suite101: http://www.suite101.com/content/buying-a-home-in-the-usa-the-islamic-way-a194970#ixzz165QipRB1 Retrieved November 23, 2010 Banks under stress. (2009, Feb 23)(online), from Economist: www.economist.com/finance/displaystory. Retrieved November 19, 2010 Dr Saiful Azhar Rosly, D. M. (2010). Structuring financial requirements. Kuala Lampur: INCEIF. Giovanni Dell’Ariccia, E. D. (2004). The Real Effect of Banking Crises. IMF. Hamzani, M. A.(online) (2008, September 30). islamic banks unaffected by global finacial crisis., from asharq-e: http://www.asharq-e.com/news.asp?section=6&id=14245 Retrieved November 20, 2010 Jim Wong, T. F.-f. (2007). DETERMINANTS OF THE PERFORMANCE OF BANKS IN HONG KONG. HongKong: HongKong monetary authority. Maher Hasan, J. D. (2010). The Effects of the Global Crisis on Islamic and Conventional Banks:. IMF. 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