NEWHORIZON

ANALYSIS
NEWHORIZON Jamatul Thani - Sha’ban 1434
behaviour was the belief that
housing prices would not fall
over the long term. This belief
flew in the face of the age-old
risk management lesson ‘do not
put all your eggs in one basket’
and once the housing market did
fall the financial institutions were
heavily exposed to one sector. As
a lesson the IFI and its players
must diversify their asset base
across sectors and industries so
that a reversal in one sector does
not affect the overall health of
any given institution and it is able
to survive the losses by banking
on its other assets.
Diversification of the Funding
Sources
Similarly funding sources should
be diversified not only for the
Islamic non-banking financial
institutions, but also for Islamic
banks; since, as the crisis has
shown, some institutions had
relied very heavily on wholesale
sources or the short-term
interbank market to get cheap
funding. The failure of Northern
Rock is a classic case of limited
funding sources. The bank relied
heavily on the wholesale and
money markets for generating
liquidity. (About 75 % of their
total funding came from this
source.) Since the bank was in a
high growth mode, increasing its
market share in 2007 to 18.9%
in the mortgage market from
14.5%, reliance on this mode of
funding increased. The bank had
changed its funding strategy from
‘originate to hold’ to ‘originate to
distribute’ by packaging a pool
of mortgage loans and selling
the securities to other investors,
thereby creating instant liquidity
for the bank. This process of
securitisation was done through
an independent special purpose
vehicle (SPV) called ‘Granite’,
which issued these securities,
thereby enabling Northern Rock
to manage its risk by passing it on
to the SPV.
Similarly the wholesale funding
also included the direct issuance
of bonds against the security
of mortgage loans without
involving the SPV and in this
case the risk remained with
Northern Rock. Other sources
of wholesale borrowing were
the interbank money market for
mainly short-term funding. While
the bank was in a high-growth
mode and increased its funding
from the wholesale markets to
finance that growth, the bank
continued to decrease its reliance
on retail funding sources. The
proportion of deposit and retail
funds to the total liabilities and
equity of Northern Rock fell
from 62.7 % in 1997 to 22.4 %
in 2006 according to the House
of Commons Treasury Select
Committee. This was not only
a massive decrease in itself, but
also when compared to that of
other banks. These figures show
the extent of the increasing
reliance that the bank was
placing on wholesale sources of
funding. This strategy of high,
expansionary growth through
increasing reliance on wholesale
markets had the potential to
lead to a severe crisis once
there was a liquidity shortage
in these markets. That is just
how things turned out when
the US mortgage markets hit
troubled waters due to defaults
and foreclosures in the subprime
mortgage market. Increasingly
the wholesale institutional
investors became averse to
investing in the mortgage-based
sector.
Generally, against the backdrop
of concerns regarding the
slowdown in the US economy
due to the subprime mortgage
crisis, the confidence of lenders
in the wholesale and money
markets was low and unfavourable
to taking big exposures, especially
in institutions heavily reliant upon
mortgage assets. The result was the
failure of Northern Rock’s funding
policy of generating sufficient
liquidity at competitive prices. The
availability of a healthy level of
retail deposits or a retail-fundingoriented
policy would have helped
the bank weather the crisis in which
almost all banks were feeling the
liquidity pinch. This is particularly
true in the case of Northern Rock,
which always had sufficient assets
to cover its liabilities, but found
it hard to convert its assets to
generate liquidity, since they were
largely based on declining quality
mortgages. Banks with high levels
of retail funding were able to
survive the storm.
Relying too heavily on retail
deposits such as current accounts
and savings deposits, however, is
an equally bad strategy, since these
deposits normally do not have
any restrictions on withdrawals by
customers. The lesson is clear –
the Islamic finance industry and
its players need to maintain an
efficient mix of wholesale and
retail deposits to manage both sides
of the risk.
Corporate Governance and the
Moral Hazard Problem
Slack corporate governance also
played its role in contributing
to triggering the crisis. Bank
managers and investment banking
executives were more concerned
with the short-term goals of
high volume originations of
mortgage assets pursuant to the
policy of ‘originate and distribute’
through various SPVs. Similarly,
investment banks were also
more concerned with the shortterm
goals of devising complex
structured financial derivatives and
MBS, which would bring them
structuring and advising fees. All
this short-term focus meant that
the originating and structuring
entities were less concerned
with long-term quality. By
focusing on short-term originate
and distribute strategies
managers were able to inflate
their short-term performance
in the hope of enjoying fat
bonuses. Larry Tabb, founder
and chief executive of the
TABB Group, a capital markets
research and advisory firm,
sums this up in the following
words: ‘In the record year of
2006, Wall Street executives
took home bonuses totalling
$23.9 billion, according to the
New York State Comptroller’s
Office. Wall Street traders were
thinking of the bonus at the end
of the year, not the long-term
health of their firm’ (Business
Week, October 2008).
Islamic banks and financial
institutions need to be wary
of such factors and need to
build appropriate corporate
governance measures to restrict
behaviour directed at earning
short-term profits at the cost
of long-term losses for the
investors, customers and
the financial system at large.
Bonuses and appraisals should
be linked to the long-term
performance of the underlying
structure and products,
especially in cases where such
products are financial in nature
and can pose systemic risk for
the financial system at large. In
this regard the bonuses could
be announced on deferred
terms, i.e. the amount of the
bonus is announced based
on short- term performance,
but is payable on a deferred
basis based on the long-term
performance of the employee
and the structured product.
Appropriate accountability
measures are, therefore,
necessary in Islamic financial
18 IIBI
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