The document outlines a presentation given by Mahmoud Sami Nabi on the implications of Islamic finance. The presentation discusses the differences between Islamic and conventional banks, including the two-tier Mudaraba business model of Islamic banks. It also analyzes empirical evidence on whether Islamic banks are more stable than conventional banks and concludes that restoring Islamic banking to its original profit and loss sharing principles could help make the sector more resilient.

1. Islamic Finance Conference Series I
“Implications of Participation Model in Finance”
3-4th, March 2014
Islamic banks versus conventional banks
financial stability
Mahmoud Sami Nabi
Associate Professor of Economics
Tunisia Polytechnic School
ERF & IRTI

2. OUTLINE
1. What is financial stability for a bank ?
2. First experiences of Islamic banks
3. Specificity of the Islamic banks’ business model
4. The practice of Islamic banks
5. Are Islamic banks more stable than conventional banks ?
6. Conclusion
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3. 1. What is financial stability for a bank ?
• Financial stability of a given bank reflects its capacity to be solvent and
remain so under difficult economic conditions by means of its capital
and reserve accounts.
• The IMF developed financial soundness indicators (FSIs) including
measures related to bank's capitalization, asset quality, and
profitability in order to provide complementary information about the
“health” of a given bank.
• Maturity transformation is at the core of a bank’s role as a financial
intermediary : depositors (liquid and risk-free/low risk assets) and
borrowers (long-term financing to invest in risky projects).
 Banks are inherently exposed to bank runs (many depositors
attempt to withdraw at once)
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4. 2. First experiences of Islamic Banks
 1950s: in a rural area in Pakistan: a small experimental Interest-Free
Bank founded by a small number of landowners to finance poorer
landowners for agricultural improvements. Failure due to shortage of
funds and problems of specialized staff.
 1963: in Egypt: Mit-Ghamr Islamic Savings Bank (MGISB)
 Adapting the business model of German savings banks to Sharia
rules.
 Within three and a half years, MFISB counted 251,000 depositors
and the deposits grew at higher rates
 Stopped in 1967: the success of the bank created conflicts with the
local social authorities who saw it as interfering in their own area
of authority...
Source: A. Chachi (2005) "Origin and Development of Commercial and Islamic Banking Operations" J.KAU:
Islamic Economics Vol. 18, No. 2.
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5. 3. The specificity of the Islamic Banks’ business model
General principles of Islamic Finance
•
The remuneration of capital is the counterpart of risk inherent to
trade and investment activities based on:
 Profit and Loss Sharing when capital finances investment activities.
 Difference between the selling and buying prices when capital finances trade activities.
• All financial transactions must be backed by real assets.
• Debt (originated from a trade transaction)
traded, rescheduled or discounted for interest.
cannot
be
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6. 3. The specificity of the Islamic Banks’ business model
The “two-tier Mudaraba” model
Assets
Liabilities
Entrepreneurs
PLS modes of financing
(Mudaraba, Musharaka)
Mark-up financing
(Murabaha, Ijara, Istinaa, Salam)
Investment deposits (PSIA)
(restricted or unrestricted)
•Neither the principle nor the
return are guaranteed
• Depositors share the bank’s
net profit according the PLS
ratio stipulated in the contract
PSIA holders
Equity
• Can be withdrawn only on
maturity
100% reserve on the demand
deposits
Demand deposits
•Yield no return and repayable
on demand at par value
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7. 3. The specificity of the Islamic Banks’ business model
• Any loss on the asset side is totally absorbed on the liability side
 IBs maintain their net worth under difficult economic situations.
• Removal of the fulfilling prophecy behind the bank runs in Diamond
and Dybvig (1983) : “During a bank run, depositors rush to withdraw their
deposits because they expect the bank to fail. In fact, the sudden
withdrawals can force the bank to liquidate many of its assets at a loss
and to fail.”
o "An illiquid asset in one in which the proceeds available from physical
liquidation or a sale on some date are less than the present value of its
payoff on some future date“ (Diamond, 2007, p. 190)
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8. 3. The specificity of the Islamic Banks’ business model
Prohibition of Riba and derivatives + linkage with the real economy
principle
•
Source: EIR, october 2008.
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9. 4. The practice of Islamic Banks in a dual banking system
• IBs deviate from their theoretical model on the liabilities side
 Malaysia and Turkey : returns on PLS accounts are dependent
(Granger causality) on CBs deposit rates (Zainol and Kassim, 2010;
Cevik and Charap,2011)
 Malaysia : rate on Islamic deposits mimics the behavior of
conventional interest rates (Chong and Liu, 2009)
• Explantions
 The holders of unrestricted PSIA tend to behave similarly to
depositors rather than investors  withdrawal risk  liquidity
crisis .
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10. 4. The practice of Islamic Banks in a dual banking system
 Archer and Abdelkarim (2010): …In Jordan, Malaysia and
Qatar, Central Banks require the U-PSIA to be managed in order to
avoid passing losses to holders of this type of accounts and
smoothing the periodic returns
 Profit Equalization Reserve (PER) + Investment Risk Reserve 
Lack of Transparency, …
In Bahrain, there is no regulation imposing these requirements but
IBS are using them.
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11. 4. The practice of Islamic Banks in a dual banking system
• IBs deviate from their theoretical model on the liabilities side
 Ihlas Finance House (Turkish Islamic financial institution) was
closed during the financial crisis of 2000-2001 due to liquidity
problems and financial distress that originated from its strategic
error to allow withdrawals from Investment Accounts.
 “On the contrary other SFHs (Islamic financial institutions) which
survived the crisis did not en-cash the investment deposits and
advised their clients to hold them to maturity.”
Source: Syed A.S. (2007) Financial Distress and Bank Failure: Lessons from Closure from
Ihlas Finans in Turkey. Islamic Economic Studies, 14 (1-2), 1-52. )
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12. 4. The practice of Islamic Banks in a dual banking system
IBs deviate from their theoretical model on the assets side
 Low use of the PLS modes of finance relatively to “mark-up”
financing … Dominance of less risky, low return assets  deprives
IBs of the benefits of the portfolio diversification, as PLS contracts
are more profitable (El- Hawary, 2007; Greuning and Iqbal, 2008)
Explantions
 The PLS financing generate agency problems (moral hazard and
adverse selection) and “bankers ascribe the problem of moral
hazard or asymmetric information to be an important explanation
for individual preference for short-term liquidity.” (Ul Haque and
Mirakhor, 1987 - p161) …
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13. 4. The practice of Islamic Banks in a dual banking system
Islamic Modes of Finance for 63 Banks: 2012 (Billion US Dollar)
Source: Islamic Banking and Finance Information System (IBFIS) - IRTI
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14. 5. Are Islamic banks more stable than conventional banks ?
 Cihak and Hesse (2010) : compare the stability of IBs relatively to CBs
in a cross-country analysis during the period 1993-2004 :
 small IBs > small CBs
 large CBs > large IBs
 small IBs > large IBs
 Resilience to the recent global crisis : “…Although IBs have illustrated
a degree of resilience and stability, they have been impacted by the crisis
because of their higher exposure to real estate and their limited reliance
on risk sharing or equity based transactions…” (Shamshad Akhtar
(2009), Speech during the “Symposium on Islamic Finance in Roma: Developments in MENA
region”, Bank Italia, Rome, Italy, November, 11th, 2009)
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15. 5. Are Islamic banks more stable than conventional banks ?
Study
Sample
Hasan and Dridi (2010) 120 IBs (~25%) and
CBs (~75%) in 8
countries over
2007-2010
Beck et al. (2013)
(+)
IBs’ more resilient in early IBs’ profitability has
stages of the crisis.
steeply declined
relatively to the CBs
in 2009 (crisis moved
to the real economy)
2956 banks (99
IBs are more efficient
IBs) in 141 countries than CBs with higher
capitalisation
over 2005-2009
Better stock performance
of listed Islamic banks
during the recent crisis
due to their higher
capitalization and better
asset quality.
Bourkhis and Nabi
(2013)
matched sample of
34 IBs and 34 CBs
in 16 countries over
1998–2009
(-)
Some evidence that IBs
were in average 19982009 are more sound (in
regards of the Z-score)
IBs Not
distinguishable from
CBs in term of
stability, business
models and asset
quality
No significant
difference in terms of
the effect of the crisis
on the stability (Zscore and Capital
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ratio)

16. 5. Are Islamic banks more stable than conventional banks ?
Source: Bourkhis and Nabi (2013)
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17. 5. Conclusion
 The recent global financial Crisis has generated new initiatives to
rethink economics and to restore the ethics to finance …Freeman
(2010): “…Restoring finance to its role as a productive force in the
economy will require new institutions and modes of compensation, as
part of a general overhaul of the relation between finance and the real
economy”.
 Restoring Islamic Banking to its initial “philosophy”…Moving towards
equity-based financing :
• New set of technical and risk management capabilities
• Institutional development (Supervisory and prudential regulatory
framework, Accounting and auditing standards, credit bureau, judicial
procedure, etc.)
• Balance sheet size and economies of scale.
• Innovating in products and services to meet the customer needs and
expectations in presence of fierce Competition.
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18. Thank you
msaminabi@gmail.com
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