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)
Dead-weight Loss
Diversion of Economic Policy
Slow-down of Islamic Finance
Why Banks Fail?




Structural Reasons
Asset-Liability Problems
External Factors
What Theoretical Models Suggest
Can Islamic Banks Fail?


Stability Theories
Asset-Liability Link
What is the Cost of IB Failure?



Dead-weight Loss
Stop to Islamization
Slow-down in development of new
instrument
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)
Why Islamic Banks Face
Problems?



Structure of Evolution
Reasons Common to Conventional
Banks
Reasons Unique to Islamic Banks
CAUSES OF FINANCIAL DISTRESS
Macroeconomic
Factors
• Macroeconomic
Situation
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
• 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

Let us go to Case Study
Case Study
Ihlas Finans House
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
Background

Parent Company: Ihlas Holdings started as
social oriented business in 1970s
Ihlas Holdings: The parent
company
Ihlas Holdings
(1970s)
Housing
Construction
Electrical Appliances
Media &
Publishing;
Insurance &
many others
Ihlas Finans
(1995)
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)






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).
Table-1: General Information About Special Finance
Houses
Establi
December 31, 1996 shment
Date
Nom.
Cap.
(Billion
TL)
No. of
Branch
es
(Dec.
31,
1996)
No. of
Branch
es
(Dec.
31,
2001)*
1. Al-Baraka Türk O.
F. K. A. S.
1984
750
16
2. Faisal Finans
Kurumu A. S.
1984
500
11
3. Kuveyt Türk
Evkaf O. F. K. A. S.
1988
1,185
10
4. Andolu Finans
Kurumu A. S.
1991
350
13
5. Ihlas Finans
1995
1,000
24
36
6. Asya Finans
Kurumu A. S.
1996
2,000
1
25
22
30
What Went Wrong
We Seek Answers in




Macroeconomic Factors
Factors Internal to Banking Sector
Factors Internal to SFH Sub-sector
Factors Internal to Ihlas Finans
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)
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
Banking Sector Factors (Contd.)
Banks Using Interest Rate Arbitrage
Assets in TL
Govt.
High
interest
income
Liabilities in FX
Principal +
Interest in
Domestic FX
Foreign Investors
Banks
Buying
Govt.
Securities
Borrowing
in FX
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)
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
Banking Sector Factors (Contd.)

Sharp depreciation worsened the balance
sheets of the banks including SFH.
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.
Factors Internal to SFHs SubSector



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
Factors Internal to SFHs SubSector (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
Factors Internal to SFHs SubSector (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.
Financial Stability Indicators for
SFH Sub-Sector
Cap
Adequacy
=Equity/Tot 5.6% in
al Assets
2000
At par with
foreign
banks
Asset
Usage
=Loans/Tot 70% for
al Assets
(19902000)
Higher
than
convention
al banks
(39%)
Financial Stability Indicators for
SFH Sub-Sector (contd.)
Asset
Quality
=Nonperforming/
Total loans
Manageme =Employ
nt Efficiency expenses/T
otal assets
Increased
Higher than
during 2000 foreign but
lower than
domestic
banks
Gradually
increased
after 1995
Similar to
other banks
Financial Stability Indicators for
SFH Sub-Sector (contd.)
Earnings
(ROA)
=Net
Very low
income/Tota
l assets
Less than
ROA of
other private
banks
Liquidity
=Liquid
Very low
Assets/Total
assets
Lowest wrt
foreign &
private
banks
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
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
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
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
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
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
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
Maturity
Gap/Asset
IFH
(1998)
KTEFH
(1999)
0-1
month
-35.7
-30.2
1-3
month
-26.7
-5.7
3-12
month
+33
+26.8
> 1 year
+0.4
+1.6
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
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
What Next? How Much More?
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
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
Factors Internal to Ihlas Finans
(Control Failures)



Rubber stamp board of directors
Board members not-motivated and some
lacked experience
Institutional members also passive
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
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
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.
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
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
Other External Factors
(Regulatory Failures)



First Lax Supervision, then
Drastic Application of Rules
Lacuna in Supervision Law
• Does not specify what to do if SFH violates
•

banking law
Stopped the operations but what next?
Unclear Scope or Confusion on Deposit
Protection Law
Other External Factors (Support
Failures)

Lack of Active Support
• Slow response on IFH’s application to raise its
capital (1998-1999)


Lesser Financial & Technical Support than
Conventional Banks
Other SFHs survived by foreign help
So the Lessons are!
Lessons to be Learned …



Despite their stability Islamic Banks can
fail.
Corporate Governance and Internal
Controls are key issues.
Rethink organizational and institutional
framework of IBs. (representation in BOG/BOD is
not enough)
Lessons to be Learned …
…(contd.)


Multiple subsidiaries in too many lines of
businesses increases the likelihood of
reputation damage.
Diversification is important but without
controlling shares
Lessons to be Learned …
…(contd.)



Increasing monitoring costs limits the
scope for diversification.
Need for business rating companies
which sell monitoring.
Until then focus on diversifying within
few business lines.
Lessons for strategy


Invest through market—assume mutual
fund management role.
Offer different services to suit risk-return
profile of various kinds of depositors and
customers.
Lessons for corporate
governance


Enhance role of institutional investors to
improve corporate governance.
Liquidity management is difficult issue
for IBs.
Lessons for regulation



Need institutions and infrastructure to
handle liquidity crunch.
Laws and Regulations should be clearly
specified without ambiguity.
Insurance of depositors against fraud is
needed.
Thank You
Task Ahead
The End