Financial Distress and Bank Failure

1
Islamic Research and Training Institute Islamic
Development Bank
2
Financial Distress and Bank FailureLessons for
Strengthening Islamic Banks

• Salman Syed Ali

3
Bank Failures

• Episodes
• SLs 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

4
Why Banks Fail?

• Structural Reasons
• Asset-Liability Problems
• External Factors
• What Theoretical Models Suggest

5
Can Islamic Banks Fail?

• Stability Theories
• Asset-Liability Link

6
What is the Cost of IB Failure?

• Dead-weight Loss
• Stop to Islamization
• Slow-down in development of new instrument

7
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)

8
Why Islamic Banks Face Problems?

• Structure of Evolution
• Reasons Common to Conventional Banks
• Reasons Unique to Islamic Banks

9
CAUSES OF FINANCIAL DISTRESS
Macroeconomic Factors
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

• Macro-economic Situation

10

• Let us go to Case Study

11
Case Study

• Ihlas Finans House

12
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

13
Background

• Parent Company Ihlas Holdings started as social
  oriented business in 1970s

14
Ihlas Holdings The parent company
15
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)

16

• 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).

17
Table-1 General Information About Special Finance Houses Table-1 General Information About Special Finance Houses Table-1 General Information About Special Finance Houses Table-1 General Information About Special Finance Houses Table-1 General Information About Special Finance Houses
December 31, 1996 Establishment Date Nom. Cap. (Billion TL) No. of Branches (Dec. 31, 1996) No. of Branches (Dec. 31, 2001)
1. Al-Baraka Türk O. F. K. A. S. 1984 750 16 22
2. Faisal Finans Kurumu A. S. 1984 500 11
3. Kuveyt Türk Evkaf O. F. K. A. S. 1988 1,185 10 30
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
18
What Went Wrong
19
We Seek Answers in

• Macroeconomic Factors
• Factors Internal to Banking Sector
• Factors Internal to SFH Sub-sector
• Factors Internal to Ihlas Finans

20
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)

21
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 (82) banks had failed and
  transferred to SDIF
• In Dec. 2000 11th bank failed

22
Banking Sector Factors (Contd.)
Banks Using Interest Rate Arbitrage
Assets in TL
Liabilities in FX
High interest income
Principal Interest in FX
Foreign Investors
Domestic Banks
Govt.
Borrowing in FX
Buying Govt. Securities
23
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)

24
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

25
Banking Sector Factors (Contd.)

• Sharp depreciation worsened the balance sheets of
  the banks including SFH.

26
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.

27
Factors Internal to SFHs Sub-Sector

• 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

28
Factors Internal to SFHs Sub-Sector (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

29
Factors Internal to SFHs Sub-Sector (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.

30
Financial Stability Indicators for SFH Sub-Sector
Cap Adequacy Equity/Total Assets 5.6 in 2000 At par with foreign banks
Asset Usage Loans/Total Assets 70 for (1990-2000) Higher than conventional banks (39)
31
Financial Stability Indicators for SFH Sub-Sector
(contd.)
Asset Quality Non-performing/Total loans Increased during 2000 Higher than foreign but lower than domestic banks
Management Efficiency Employ expenses/Total assets Gradually increased after 1995 Similar to other banks
32
Financial Stability Indicators for SFH Sub-Sector
(contd.)
Earnings (ROA) Net income/Total assets Very low Less than ROA of other private banks
Liquidity Liquid Assets/Total assets Very low Lowest wrt foreign private banks
33
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

34
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

35
Factors Internal to Ihlas Finans (Balance Sheet)

• Capital Adequacy Ratio
• Proxy for CapAd Shareholders Equity/Total
  Assets
• IFH 5.39 lt other SFHs 7 lt 8 recommended by BC
  (as of 31-12-2000)
• IFH followed an expansionary strategy through
  leveraging of capital

36
Factors Internal to Ihlas Finans (Balance Sheet)

• Gross Income to Total Assets Ratio
• Proxy for Survival
• IFH 18.5 gt 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

37
Factors Internal to Ihlas Finans (Balance Sheet)

• Composition of Deposits
• Ratio of Current Deposits to Total Deposits
  3.7 at IFH lt 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

38
Factors Internal to Ihlas Finans (Balance Sheet)

• Liquidity Ratio
• Ratio of Liquid Assets to Total Assets 4.22 at
  IFH lt 11.01 at KTEFH lt 15.8 at AFH in 1999
• During the crisis this ratio sharply went down to
  0.53 for IFH ltlt 7.5 at AFH lt 10.39 at KTEFH in
  2000

39
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 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
gt 1 year 0.4 1.6
40
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) gt DG for KTEFH
  0.261 years (2000)
• Net value of bank will decline in response to
  increase in interest rate

41
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

42
What Next? How Much More?
43
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

44
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

45
Factors Internal to Ihlas Finans (Control
Failures)

• Rubber stamp board of directors
• Board members not-motivated and some lacked
  experience
• Institutional members also passive

46
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

47
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 banks own
  funds in non-financial co.
• Tried to raise cap by retaining dividends for
  2000 and 2001 but it was not sufficient

48
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.

49
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

50
Factors Internal to Ihlas Finans (Strategic
Failures)

• Allowing withdrawals from Investment Accounts
• No rationing
• Lost US200 million cash in few days
• Abrupt stop to convertibility-loss of
  confidence-calls for liquidation-BRSA stepped in
• Other SFHs used better strategy

51
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

52
Other External Factors (Support Failures)

• Lack of Active Support
• Slow response on IFHs application to raise its
  capital (1998-1999)
• Lesser Financial Technical Support than
  Conventional Banks
• Other SFHs survived by foreign help

53
So the Lessons are!
54
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)

55
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

56
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.

57
Lessons for strategy

• Invest through marketassume mutual fund
  management role.
• Offer different services to suit risk-return
  profile of various kinds of depositors and
  customers.

58
Lessons for corporate governance

• Enhance role of institutional investors to
  improve corporate governance.
• Liquidity management is difficult issue for IBs.

59
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.

60
Thank You
61
Task Ahead
62
The End
63
(No Transcript)