the global financial crisis: can islamic finance help? - Institute of ...

ANALYSIS
NEWHORIZON January–March 2009
Balance sheet analysis:
Islamic vs. conventional
Hennie van Greuning (left) and Zamir Iqbal (right), senior advisor and lead investment officer
respectively at The World Bank Treasury in the US, and the authors of ‘Risk Analysis for Islamic
Banks’, compare the balance sheet structures of Islamic banks and their conventional counterparts.
The goal of financial risk management
is to maximise the value of a financial institution
as determined by its level of profitability
and risk. Since risk is inherent in
banking and unavoidable, the task of the
risk manager is to manage the different
types of risk at acceptable levels to achieve
optimal profitability. Doing so requires the
continual identification, quantification,
and monitoring of risk exposures, which
in turn demands sound policies, adequate
organisation, efficient processes, skilled
analysts and elaborate computerised information
systems. In addition, risk management
requires the capacity to anticipate
changes and to act in such a way that a
bank’s business can be structured and
restructured to profit from the changes
or at least to minimise losses. Regulatory
authorities should not prescribe how
business is conducted; instead, they should
maintain prudent oversight of a bank by
evaluating the risk composition of its assets
and by insisting that an adequate amount
of capital and reserves is available to safeguard
solvency.
Although the approaches to risk management
are diverse, a good starting point is
to undertake a top-down approach starting
with the balance sheet. One cannot underestimate
the importance of understanding the
structure and composition of the balance
sheet of a financial institution.
It is critical to assess the ways in which a
bank’s risk managers and analysts can
analyse the structure of balance sheets and
income statements, as well as individual
balance sheet items with specific risk aspects
so that the interaction between various
types of risk is understood to ensure that
they are not evaluated in isolation. The
relative share of various balance sheet
components – assets and liabilities – is a
good indication of the levels and types of
risk to which a bank is exposed.
Table 1 below shows stylised balance sheet
of a conventional commercial bank. On the
liability side, it accepts demand and saving
deposits, issues term certificates such as
certificate of deposits (CD), and has capital.
On the asset side, there is much more
diversity and options in the form of
marketable securities, trading accounts,
lending to corporations and to consumers.
From the risk point of view, two observations
can be made. First, the deposits create
instantaneous pre-determined liabilities
irrespective of the outcome of the usage of
the funds on the asset side, thus creating an
asset-liability mismatch. Second, medium- to
long-term assets are financed by the stream of
short-term liabilities, exposing the bank to a
maturity mismatch risk and discouraging the
bank from investing in long-term non-liquid
projects. An increase in the level of non-retail
deposits or funding could expose a conventional
bank to greater volatility in satisfying
its funding requirements, requiring increasingly
sophisticated liquidity risk management.
Certain funding instruments also expose a
bank to market risk.
Table 1 Stylised balance sheet of a conventional bank – based on functionality
Assets
Loans and advances to customers
Cash and cash balances with other banks
Investments in associates, subsidiaries and joint ventures
Financial assets held for trading
Cash and cash balances with the central bank
For Islamic financial institutions, the nature
of financial intermediation, including the
function of banking, is different from that
of conventional financial institutions. This
is the key to understanding the difference
in the nature of risks in conventional and
Islamic banking. For Islamic banks, the
mudarabah contract is the cornerstone of
financial intermediation and thus of banking.
The basic concept is that both the mobilisation
and (in theory) the use of funds are based
on some form of profit sharing among the
Liabilities
Customers’ deposits
Due to banks and other financial institutions
Other liabilities
Sundry creditors
Equity and reserves
16 IIBI www.newhorizon-islamicbanking.com