A net stable funding ratio for Islamic banks and its impact on financial stability: An international investigation

Journal of Financial Stability 25 (2016) 47–57
Contents lists available at ScienceDirect
Journal of Financial Stability
journal homepage: www.elsevier.com/locate/jfstabil A net stable funding ratio for Islamic banks and its impact on financialstability: An international investigationDawood Ashraf a,∗, Muhammad Suhail Rizwan b , Barbara L’Huillier ca Islamic Research & Training Institute (A member of Islamic Development Bank Group), 8111 King Khalid Street, Jeddah 22332-2444, Kingdom of SaudiArabiab NUST Business School, National University of Sciences and Technology (NUST), Islamabad, Pakistanc College of Business Administration, Prince Mohammad Bin Fahd University, Al Khobar 31952, Kingdom of Saudi Arabiaa r t i c l e i n f oArticle history:Received 25 November 2015Received in revised form 21 June 2016Accepted 29 June 2016Available online 4 July 2016Keywords:Islamic banksNet stable funding ratioFinancial stabilityRegulatory frameworkIFSBa b s t r a c tThe Islamic Financial Services Board (IFSB) is the standard setting body for the Islamic banking industry.The IFSB, while endorsing the Basel III accord, modified the criteria to calculate the Net Stable FundingRatio (NSFR) to cater for the unique aspects of the Islamic banking industry. In this paper, we calculatedthe modified NSFR of 136 Islamic banks from 30 jurisdictions between 2000 and 2013 and explored thepotential impact the requirements of this ratio has on the financial stability of Islamic banks after con-trolling for bank, country, and market-specific variables. The empirical findings suggest that the modifiedNSFR has a positive impact on the financial stability of Islamic banks during the sample period. However,the marginal impact of the NSFR on stability diminishes as the size of the bank increases. The resultsremained robust after applying an alternative measure of stability and using an alternative estimationmodel based on an instrumental variable approach. These results validate the use of the IFSB’s modifiedNSFR for Islamic banks as a regulatory measure.© 2016 Elsevier B.V. All rights reserved.1. IntroductionThe 2007–2009 global financial crisis highlighted weaknesses inthe conventional banking system and drew attention to the successof the Islamic banking model (Hasan and Dridi, 2010). The Islamicbanking sector grew at an exceptional compound annual growthrate of 17% during the period 2008–2013. It now accounts for morethan a quarter of the total banking assets of 10 countries where themajority of the population is Muslim including five of the oil-richmembers of the Gulf Cooperative Council (GCC)1 (Islamic FinancialServices Board, 2015a).In response to weaknesses in the global financial system, theBasel Committee on Banking Supervision (BCBS) introduced twonew regulatory measures in the Basel III regulatory framework. Oneis a liquidity coverage ratio (LCR) that focuses on the short-termliquidity of banks and the other is a net stable funding ratio (NSFR)that aims to monitor the long-term funding stability of banks.∗ Corresponding author.E-mail addresses: [e-mail] (D. Ashraf), [e-mail](M.S. Rizwan), [e-mail] (B. L’Huillier).1 GCC member countries include Saudi Arabia, Kuwait, Qatar, UAE, Bahrain, andOman.Although adoption of the Basel III accord is being phased in,it is expected that by 2019 all requirements will be fully imple-mented. The full impact of these new regulatory requirements onthe banking industry is still unknown. However, there is already agrowing literature assessing the potential impact these new reg-ulatory measures will have on the stability of conventional banks.This literature capitalizes on the argument that the newly intro-duced regulatory measures (NSFR and LCR) can be calculated usingexisting data and their ‘potential’ impact on banks can be exploredretrospectively. Yan et al. (2012), using data from a sample of 11 UKbanks for the period 1997–2010, found that higher regulatory capi-tal requirements not only reduce the probability of a banking crisisbut also reduce the economic loss from a banking crisis. SimilarlyJiraporn et al. (2014), using data from a sample of 68 banks from 11East Asian countries for the period 2005–2009, reported an inverserelationship between the NSFR and risk-taking behavior of banks.King (2013), using data from a sample of banks from 15 countries,suggested that the implementation of the NSFR has adverse con-sequences for the economy due to the shrinking of banks’ balancesheets, changes in the composition of assets or maturity thereof.The business model for Islamic banks is quite different fromthat of conventional banks in terms of their asset-liability struc-ture and product offering. The International Monetary Fund (IMF)(2011) suggested that the business model on which banks base their
http://dx.doi.org/10.1016/j.jfs.2016.06.010
1572-3089/© 2016 Elsevier B.V. All rights reserved.

48 D. Ashraf et al. / Journal of Financial Stability 25 (2016) 47–57
Table 1
Islamic bank assets and liabilities and their conventional counterparts. Comparative haircuts given by Basel III for conventional banks and IFSB for Islamic banks are given in
the last two columns respectively. These haircuts are based on the authors’ understanding of quantitative guidelines for the calculation of the NSFR published by the IFSB
(for Islamic banks) and Basel III for conventional banks.
Islamic product Conventional
counterpart
Nature of the
contract for
Islamic banks
Key features Haircut under
Basel III
Haircut under
IFSB
Qard-al-Hassan or
wadi’ah
Current account Debt Resembles conventional deposits, although
non-interest/return bearing. May receive a gift
(wadiah) from bank capital.
50% 50%
Qard-al-Hassan or
wadi’ah
Saving deposits Debt Safekeeping and profit sharing of Islamic bank
(‘deposit’) contracts.
50% 50%
Profit-sharing
investment accounts
(PSIAs)
Saving and term
deposits
Equity Structured as profit/loss sharing partnerships
(mudarbah or musharaka) or agency (wakalah)
contracts.
95% –
PSIA (Restricted) Saving and term
deposits
Quasi equity Funds provided by investors are invested per account
holder’s instructions and not comingled with banks’
own assets and so easier to trace and transfer to
account holders. However, assets of all such account
holders may be pooled together, so traceability may
still be a challenge.
95% 0%
PSIA (Unrestricted) Saving and term
deposits
Hybrid Account holders give banks’ full discretion to invest in
any Shar ̄ı’ah compliant assets. May be comingled with
bank assets or those of other account holders.
Traceability to specific account holders may be a
challenge.
95% 90–95%
Suk ̄uk Bonds and securitized
loans
Hybrids Islamic equivalent of conventional bonds. Structured
as certificates of participation through securitization of
specific assets/pool of assets.
– 100%
Murabahah Loans and advances Debt A sales contract whereby the institution offering
Islamic financial services sells to a customer a specified
kind of asset that is already in its possession. Selling
price is the sum of the original price and an agreed
profit margin.
85% 85%
Musharaka Loans and advances Equity A contract between the institution offering Islamic
financial services and a customer. Both would
contribute capital to an enterprise. Profits generated
by that enterprise or real estate assets are shared by
the terms of the Musharaka agreement. Losses are
shared in proportion to each partner’s share of capital.
85% 50%
Ijarah Mortgages and leases Equity An agreement made by an institution offering Islamic
financial services to lease an asset to a customer for an
agreed period for a specified rental. An Ijarah contract
commences with a promise to lease that is binding on
the part of the potential lessee before entering the
Ijarah contract.
50%–65% 50%
Qard-al-Hassan Loans and advances Debt An interest-free loan is given by a lender to a borrower
with the stipulation that the latter pays back the
principle only.
85% 0%
Salam and istisna’a Hybrid Hybrid Salam: Agreement to purchase, at a predetermined
price a specified kind of commodity not currently
available to the seller, to be delivered on a specified
future date as per agreed specifications and specified
quality.
– 85%
istisna’a: A contract of sale of specified objects to be
manufactured or constructed, with an obligation on
the part of the manufacturer or builder to deliver the
objects to the customer upon completion.operations has serious consequences for the stability of banks andthat prior to 2008 the NSFR of investment banks declined moresharply as compared to commercial banks. Furthermore, Mergaertsand Vennet (2016) while examining the impact of bank businessmodels on performance and risk of European banks found thatretail banks perform better in terms of profitability and stability andsuggested that business model considerations should be more fun-damentally integrated in the regulatory and supervisory practices.Beck et al. (2013) observed that Islamic banks are generally bettercapitalized compared to conventional banks. The equity-based andrisk-sharing nature of Islamic contracts helps reduce the maturitymismatch of assets and liabilities and enhances financial stability.The Islamic Financial Services Board (IFSB) is the standard-setting body for the Islamic banking industry. The IFSB endorsed theBasel III regulatory framework after making some adjustments forthe difference in the nature of assets and liabilities of Islamic banks.The IFSB issued Guidance Note No. 12 which provides guidelines forthe calculation of the NSFR for Islamic banks.2Why is there a need for a modified NSFR for Islamic banks?Response to this very critical question centers on the treatment of‘risk’ under both banking systems. Under the conventional bankingsystem ‘risk’ transfers from lenders to borrowers while under theIslamic banking system ‘risk’ is shared between the two (Hasan andDridi, 2010). Regulatory requirements under the BCBS’s frameworkare based upon the underlying riskiness of banks and are designed2 Guidance Note 12 on quantitative measures for liquidity risk management ininstitutions offering Islamic financial services [excluding Islamic insurance (Tak ̄aful)institutions and Islamic collective investment schemes] issued by the IslamicFinancial Services Board in 2014. Online: www.ifsb.org.

D. Ashraf et al. / Journal of Financial Stability 25 (2016) 47–57 49to adequately buffer levels of risk. However, this regulatory frame-work cannot remain efficient and effective if its application doesnot take into account the risk-sharing nature of Islamic banks.The IFSB’s modified NSFR takes into account the risk-sharingnature of the underlying contracts of Islamic banks and modi-fies regulatory requirements for the NSFR accordingly. Table 1provides a detailed comparison of the BCBS’s proposed NSFR forconventional banks and the IFSB’s proposed modified NSFR forIslamic banks. Major differences can be seen in regulatory require-ments related to Profit-Sharing Investment Accounts (PSIA) andProfit-Sharing Investment Accounts-Restricted (PSIA-R), Suk ̄uk,Musharaka, Salam, Istisna’a, and Qard-al-Hassan.3Despite the apparent differences in the business models, thereare no studies that have investigated the impact of the NSFR onthe stability of Islamic banks. From the sparse literature related tothe stability of Islamic banks ˇCihák and Hesse (2010) compared thefinancial stability of Islamic banks with that of conventional banksusing a data set of 19 countries and found that small Islamic banksare financially more stable than large Islamic banks. However, theyalso noted the limitations of their research findings regarding lim-ited availability of product-specific data on Islamic banks’ financialstatements. The challenge when using standard harmonized datafor empirical analysis is that it not only assumes that Islamic andconventional banks share the same traits but also that their stabil-ity is affected by similar factors. However, there are clearly somedifferences in the financial indicators of Islamic banks. Examplesmay include the nature of contracts underlying Islamic financialproducts, recognition of income from intermediation activities, andcomputation of capital.This paper explores the potential impact of the IFSB’s new reg-ulatory measures by calculating the NSFR using existing data andlinking it to the financial stability of Islamic banks. It extends thework of ˇCihák and Hesse (2010) on stability and explores whetherthe IFSB’s proposed NSFR has any potential impact on the stabilityof Islamic banks.For empirical estimations, this study utilizes a unique datasetcollected from the financial statements of 136 Islamic banks from30 jurisdictions for the period 2000–2013. This dataset enablesus to capture the financial position of Islamic banks based on theunderlying contracts as per the IFSB’s guidelines. To the best of theauthors’ knowledge there are no published studies that have used adataset based on bank-specific variables, or have utilized the IFSB’sguidelines, to compute the NSFR for Islamic banks.The empirical findings suggest that the NSFR measure intro-duced by the IFSB for Islamic banks has a positive impact on thefinancial stability of Islamic banks during the sample period. How-ever, the marginal impact of the NSFR on stability diminishes asthe size of the bank increases. These findings remained robust afterusing an alternative measure of financial stability and using analternative estimation model based on an instrumental variableapproach.The findings of this study have significant policy implicationsincluding the validation of the new regulatory framework. If Islamicbanks adopt the IFSB’s recommended NSFR their stability will beenhanced. However, our findings also indicate that banks operat-ing under a fully Islamic banking system are less stable comparedto banks in a mixed banking system. We ask that these findingsbe considered cautiously as countries with fully Islamic bankingsystems (Iran and Sudan) were subject to political and economicdifficulties during the time period under examination that mighthave biased the estimation results.3 A detailed discussion on the difference between the BCBS and the IFSB’s pro-posed NSFR measures is provided in Section 2 of this paper. Fig. 1. Islamic banks’ share of total banking assets by jurisdiction.Source: Islamic Financial Services Industry Stability Report (2015b)The rest of this paper is organized as follows. The next sectiondescribes the background, methodology and calculation of the NSFRfor Islamic banks. Section three describes the hypothesis, modeland variable development utilized in this study. Section four pro-vides a rationale and discussion on the sample, data and univariateanalysis used in this research with section five providing regressionresults and section six provides robustness checks of the empiricalfindings. Section seven will provide concluding comments.2. Net stable funding ratio for Islamic banksIn 2014, almost 80 percent (USD 1.63 trillion) of the globalIslamic finance industry’s assets were Islamic banking assets(Thomson Reuters, 2015). The Islamic banking industry grew atabout 17 percent annually between 2008 and 2013. In compari-son, the top 1000 global banks grew by only 4.9 percent in 2012and 0.6 percent in 2013. With such rapid growth, several Islamicbanks have become systemically important banks especially inthose economies where Islamic banks account for over 10 percentof total bank assets.4Fig. 1 depicts the share of Islamic banking assets as compared tototal banking assets in countries where the Islamic banking sectorhas a sizeable presence. Iran and Sudan have a fully Islamic bank-ing sector and thus 100 percent of bank assets are with Islamicbanks. Other countries with a significant Islamic banking sectorinclude: Saudi Arabia with 51.3%, Brunei with 41%, Kuwait with38%, Yemen with 27.4%, Qatar with 25.1%, Malaysia with 24%, andthe UAE with 17.4% of total domestic banking assets invested withIslamic banks. Bangladesh, Jordan, and Pakistan are also in dou-ble figures in terms of the percentage of total domestic bank assetsinvested with Islamic banks. These figures highlight the importanceof the Islamic banking sector in countries where the majority of thepopulation is faith-adhering Muslims.To support the Islamic banking sector legal and regulatoryframeworks specifically designed to cater the needs of Islamicbanks have been created. Examples include the Malaysian IslamicFinancial Services Act 2013 which provides a legal foundation forthe Islamic banking system to shift towards a regulatory frame-work that caters to the needs of specific types of Shar ̄ı’ah contracts.4 Islamic Financial Services Industry Stability Report (2015b).

50 D. Ashraf et al. / Journal of Financial Stability 25 (2016) 47–57Likewise, the State Bank of Pakistan launched a five-year strate-gic plan and is finalizing details on an Islamic liquidity frameworkconsisting of an Islamic inter-bank money market (IIMM) and amudarbah-based placement facility run by the central bank. Omanand Qatar recently set up a separate banking system for Islamicbanks that does not allow conventional banks to offer Islamic finan-cial products through Islamic windows. Turkey is also in the processof developing legal and regulatory frameworks to enhance theIslamic banking industry.One of the major differences between conventional banks andIslamic banks is the way assets and liabilities are structured. Theassets and liabilities of conventional banks are structured as debtinstruments while the assets and liabilities of Islamic banks arestructured in more equity-like instruments. Aside from benevolentloans (Qard-al-Hassan) the assets of Islamic banks can be dividedinto three broad categories:• Equity-like assets including partnership instruments (Musharakaand Mudarbah),• Leases (Ijarah) and,• Debt-like instruments including deferred delivery-of-products(salam for basic products and istisna’a for manufactured or con-struction projects) and sale plus markup (Murabahah).The major difference between conventional and Islamic banksin terms of liabilities is in the nature of deposits. In comparisonwith conventional banks, deposits of Islamic banks have guar-anteed Shar ̄ı’ah safekeeping deposit contracts (Qard-al-Hassanand Wadi’ah), non-guaranteed Shar ̄ı’ah contracts for investment(Mudarbah and Wakalah), profit sharing investment accounts(restricted and unrestricted), and suk ̄uk (Islamic equivalent of con-ventional bonds). The nature of profit sharing investment accounts(PSIAs) also differs from that of conventional bank deposits. PSIAsare more like mutual fund investments where investors bear theloss when there is a deterioration in the value of an investment forreasons other than management negligence. This equity-like struc-ture of liabilities provides an extra layer of protection to Islamicbanks especially during market down turns.To cater for the specific regulatory needs of Islamic banks,the IFSB provides a regulatory framework for the Islamic bank-ing industry. To remain aligned with the global banking industrythe IFSB endorsed the Basel III regulatory framework after mak-ing adjustments for the different nature of assets and liabilities ofIslamic banks. The IFSB issued several standards including the Cap-ital Adequacy Framework (IFSB-15), and the Guiding Principles onLiquidity Risk Management (IFSB-12) for Islamic banks.Like its conventional counterpart, the NSFR requirement underthe IFSB’s guidelines is the ratio of available stable funding (ASF)to required stable funding (RSF). However, there are clear differ-ences in the computation of ASF and RSF between Islamic andconventional banks. Table 1 presents the major differences in thetreatment of assets and liabilities under both approaches and theirrespective haircuts for the calculation of the NSFR.The difference in treatment of various categories of assets andliabilities under the IFSB-NSFR and the BCBS-NSFR is due to thedistinctive nature of assets and liabilities of Islamic banks. On theliabilities side of an Islamic bank, current account deposits anddeposits under Qardal-Hassan or wadi’ah are debt in nature similarto their conventional counterparts and hence need similar RSF tomeet both the IFSB and the BCBS’s requirements. However, depositsunder profit sharing arrangements have clear differences undereach banking systems.Islamic banks’ ‘Profit Sharing Investment Accounts (PSIA)’ havetwo categories. One is restricted under which funds are provided byinvestors and are invested per the account holder’s instructions andhence are quasi equity. The second category of PSIA is unrestictedin which account holders give banks full discretion to invest in anyShar ̄ı’ah-compliant assets and these accounts may be comingledwith shareholders’ capital. The IFSB requires a haircut of 90%–95%for unrestricted PSIA. The BCBS for conventional banks however,does not differentiate savings deposits and requires a flat haircutof 95% when calculating the NSFR.A major source of difference between the BCBS and the IFSB’sNSFR is in regard to the treatment of assets. There are productsoffered by Islamic banks which are so unique that there are nocounterparts offered by conventional banks. One such example isMusharaka products which are based on partnership principles.These are not the same as conventional banks’ loans and advances.Under the BCBS conventional banks are required to provide 85%stable funding against such loans and advances but due to thepartnership nature of the Musharaka Islamic banks are requiredto provide just 50% stable funding as it partially qualifies as equity(risk-sharing feature).Another major difference under loans and advances is Qard-al-Hassan. It is rare for conventional banks to offer such loans andadvances to customers. However, if it does then the BCBS requires85% stable funding. Islamic banks offer Qard-al-Hassan more fre-quently and these loans are based upon Hassana’h and the IFSBrequires no stable funding against these loans. Suk ̄uk, Salam andistisna’a are unique products provided by Islamic banks. The BCBSdoes not have any rules regarding these products but the IFSB pro-vides for an 85% haircut for these products. Ijarah contracts are likemortgages and leases offered in the conventional banking system.The BCBS allows for a 50%–65% haircut while the IFSB requires 50%stable funding for all Ijarah contracts.For the calculation of RSF utilizing the IFSB guidelines, assets andliabilities are categorized into ‘buckets’ depending on their liquid-ity. Every ‘bucket’ has a haircut depending on the relative liquidityof the asset. These haircuts range from 0% for cash (highly liquid) to100% for fixed assets (highly illiquid). On the other hand, haircutsalso apply to funding sources to calculate ASF. These haircuts rangefrom 100% for regulatory capital (non-returnable equity financing)to 0% for Shar ̄ı’ah -compliant hedging instruments.Although quantitative guidelines issued by the IFSB are compre-hensive, there are clear limitations in calculating the NSFR usingpublically available data. The International Monetary Fund, in itsApril 2011 Global Financial Stability Report, highlights data issuesthat are challenging when calculating the NSFR. Most of the stud-ies analyzing the impact of NSFRs usually apply an approximationsapproach on the application of haircuts to various components ofthe balance sheet when calculating the NSFR under Basel III (King,2013; Distinguin et al., 2013; Yan et al., 2012). These assumptionsare generally in line with the broader interpretation of various bal-ance sheet items and are based on the liquidity and maturity ofassets and liabilities. Similar to the conventional approach, we usea modified IFSB approach for the computation of the NSFR thattakes into consideration several assumptions about maturity andliquidity in assigning haircuts as shown below:
NSFR it = ASF it
RSFit(1)where ASFit is the sum of• 100% values of total shareholders’ capital (tcapit ) and mudarbahinvestment accounts (mud invit ), and• 50% of Mudarbah savings (mud savit ), current savings (cnsacit )and other accounts (oth depit ) that are not profit and loss sharing.RSFit is the sum of