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Islamic Research and Training Institute Islamic Development Bank

Islamic Research and Training Institute Islamic Development Bank. Financial Distress and Bank Failure Lessons for Strengthening Islamic Banks. Salman Syed Ali. Bank Failures. Episodes S&Ls Collapse BCCI Closure Barings East Asian Crisis Many others Costs Fiscal (not a real cost)

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Islamic Research and Training Institute Islamic Development Bank

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  1. Islamic Research and Training Institute Islamic Development Bank

  2. Financial Distress and Bank FailureLessons for Strengthening Islamic Banks Salman Syed Ali

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

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

  5. Can Islamic Banks Fail? • Stability Theories • Asset-Liability Link

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

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

  8. Why Islamic Banks Face Problems? • Structure of Evolution • Reasons Common to Conventional Banks • Reasons Unique to Islamic Banks

  9. CAUSES OF FINANCIAL DISTRESS Macroeconomic Factors 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 • Macro-economic Situation • 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

  10. Let us go to Case Study

  11. Case Study Ihlas Finans House

  12. Contents • Background • Macroeconomic Factors • 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

  13. Background • Parent Company: Ihlas Holdings started as social oriented business in 1970s

  14. Ihlas Holdings: The parent company

  15. Ihlas Finans (the subsidiary) • 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 (150m shares) • Market Cap 6.5 Trillion TL (1996)

  16. 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).

  17. What Went Wrong

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

  19. Macroeconomic Factors (Turkey 2000-2001) • 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)

  20. Factors Internal to Banking Sector • 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 11th bank failed

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

  22. Banking Sector Factors (Contd.) • 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)

  23. Banking Sector Factors (Contd.) • Erosion of depositors’ confidence • CB lost over 10 billion dollars trying to maintain crawling peg exchange rate • 10billion $ 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

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

  25. Summary of Banking Sector Factors • 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.

  26. Factors Internal to SFHs Sub-Sector • 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

  27. Factors Internal to SFHs Sub-Sector (Contd.) • 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

  28. Factors Internal to SFHs Sub-Sector (Contd.) • 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.

  29. Financial Stability Indicators for SFH Sub-Sector

  30. Financial Stability Indicators for SFH Sub-Sector (contd.)

  31. Financial Stability Indicators for SFH Sub-Sector (contd.)

  32. Summary of Financial Stability Indicators for SFH Sub-Sector • 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

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

  34. Factors Internal to Ihlas Finans (Balance Sheet) • Capital Adequacy Ratio • Proxy for CapAd = 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

  35. Factors Internal to Ihlas Finans (Balance Sheet) • 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

  36. Factors Internal to Ihlas Finans (Balance Sheet) • 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

  37. Factors Internal to Ihlas Finans (Balance Sheet) • 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

  38. Factors Internal to Ihlas Finans (Balance Sheet) • Maturity Mismatch • There has been a significant maturity mismatch long before the crisis • Short-term liabilities exceeded short-term assets

  39. Factors Internal to Ihlas Finans (Balance Sheet) • 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

  40. Factors Internal to Ihlas Finans (Balance Sheet) • 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

  41. What Next? How Much More?

  42. Factors Internal to Ihlas Finans (Role of Ownership) • 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

  43. Factors Internal to Ihlas Finans (Role of Ownership) • 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

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

  45. Factors Internal to Ihlas Finans (Management Failures) • 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

  46. Factors Internal to Ihlas Finans (Management Failures) • 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. • Tried to raise cap by retaining dividends for 2000 and 2001 but it was not sufficient

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

  48. Factors Internal to Ihlas Finans (Fraud) • 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

  49. Factors Internal to Ihlas Finans (Strategic Failures) • 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

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