Systemic Risk and Islamic Banks: Lessons from the COVID-19 Pandemic

30 Mar, 2022

Islamic banks had shown stability during the global financial crisis compared to conventional banks. This is attributed to the difference in design and philosophy of the two bank types. Do Islamic banks also show superior stability in the wake of systemic risk? Analysis of the COVID-19 period provides an opportunity to assess the impact of systemic risk on Islamic banks.

The COVID-19 pandemic that started as a serious health crisis and exogenous to the financial system quickly became an economic crisis as lockdowns were implemented worldwide. This created systemic risk for the financial sector. Globally, governments quickly established crisis management plans in response to the immediate challenges of rising unemployment and institution bankruptcies that included short-term debt moratorium and access to credit through government-guaranteed lending programs (IMF Policy Tracker: Policy Responses to COVID-19). These strategies reduce the immediate danger of loan impairment while jeopardizing intermediation norms and resulting in a loss of revenue for the banking sector (S&P Global: COVID-19 Credit Update). Central banks announced many liquidity-supporting measures, including (i) reduced reserve requirements, (ii) reduced regulatory capital buffers, (iii) bond/Sukuk buying programs, and (iv) the availability of central bank credit lines.

The Islamic Development Bank Institute (IsDBI) reports that the first two measures benefit both conventional and Islamic banks; however, Islamic banks have been denied access to the latter two measures, which are critical for liquidity management support. Due to a lack of credit lines or regulatory restrictions, the central bank’s role as a lender of last resort was curtailed for Islamic banks. This complicates liquidity management for Islamic banks even more, particularly considering that loan deferment programs are in place for various jurisdictions that offer Islamic financial services and have systemically important Islamic banks. Furthermore, there are growing concerns that bank borrowers may not be able to service their debts after the end of moratoriums/loan deferment programs. Researchers from the Islamic Development Bank Institute (IsDBI) and National University of Sciences & Technology (NUST), Pakistan have studied the systemic risk implications of the COVID-19 pandemic for Islamic and conventional banks. They found that, in the sample countries, only Bahrain, Bangladesh, Pakistan, and Qatar announced special measures for Islamic banks which highlight the missing attention of regulators to the varying needs of Islamic banks (See Table 1). The choice of sample is determined by the size of Islamic banks in the country. The study has been published in the Emerging Markets Review.

Interconnectedness among financial institutions can spread vulnerability to the network of institutions resulting in an overall heating-up of the financial system. Islamic banks have shown resilience during the global financial crisis owing to the risk-sharing nature of their business model. One of the major differences between the COVID-19 pandemic crisis and the global financial crisis is that COVID-19 is an exogenous shock whereby the overall economy stands still due to extended lockdowns and the adoption of various social distancing measures. Due to the different nature of the shocks, it is expected that Islamic banks would face similar challenges to their sustainability just like conventional banks as the real economy deteriorated. The researchers examine systemic risk (risk of breakdown of the entire financial system) and bank-level spillover measures over the sample period. The spillover measures include spillover to others, which measures the systemic impact of a bank on the financial system, and spillover from others, which measures the systemic impact to a bank from the system.

In the sample countries, the systemic risk increased significantly during the first quarter of 2020, however, recovery was observed during the second half of 2020. A positive association was observed between systematic risk (bank’s risk relative to the market) and the spillover measures suggesting that higher exposure to market risk may increase systemic vulnerabilities. Spillover from others is negatively associated with idiosyncratic risk, which captures institutional-level risk, for conventional and Islamic banks which validates the implementation of macro-prudential regulations in response to the global financial crisis of 2007-09 when micro-prudential regulations were unable to control systemic vulnerabilities. This indicates that managing the idiosyncratic risk of financial institutions does not ensure the financial system’s stability.

Comparatively, the researchers find that Islamic banks trigger similar systemic concerns as their conventional counterparts with their exposures towards market factors during periods of exogenous shocks to the financial system, such as the COVID-19 pandemic, where the real economy is adversely affected. However, compared to the conventional banks, positive abnormal returns of Islamic banks provide systemic stability during such times, which is interesting, as high abnormal returns are usually considered to increase systemic vulnerabilities. This suggests that market risks, such as interest rate risk, foreign exchange rate risk, commodity price risk, and corporate and sovereign credit exposures, increase systemic vulnerabilities during normal periods and can have even more devastating outcomes during periods of exogenous shocks to the financial system. Moreover, smaller banks that are required to pay higher premiums under the capital asset pricing model (CAPM) framework, contribute less spillover to others, while banks exhibiting higher momentum in their stock prices contribute more to systemic risk. Additionally, market capitalization and spillover of banks are negatively associated, suggesting that a decline in a bank’s market value may increase the appetite for risk-taking that, potentially, has adverse consequences for the entire financial system.

The close alignment of Islamic banks’ systemic vulnerability, with conventional banks, during the pandemic, suggests that the real economy was impacted by COVID-19. However, the limited attention of regulators to support Islamic banks during the COVID-19 pandemic may exacerbate their systemic vulnerability. As a result, regulators and lawmakers must put in place the essential support measures to assist Islamic banks in weathering the future events such as the pandemic in the same way that their conventional counterparts have. Furthermore, excessive systematic risk has a significant detrimental influence on systemic stability, implying that regulators should create restrictions that limit banks’ market exposure. In this context, macroprudential policy instruments such as limits on foreign currency exposures and foreign exchange counter-cyclical reserves could be beneficial.

Table 1: Policy responses to the COVID-19 pandemic in the sample countries

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