Risk Management in Changing Benchmark Rates Regime: Prudential Implications for Islamic Banks and Supervisors
DOI:
https://doi.org/10.31436/jif.v6i0.267Keywords:
Risk management, Low benchmark rates, Increasing benchmark rates, Islamic banks, Duration gap, Stress testing, Financial stabilityAbstract
Post-global financial crisis scenario has presented extraordinary challenges to the global economy, in general, and the banking industry, in particular. This has brought the financial industry to a set of new challenges including risk management in changing benchmark rates risk for Islamic banks. Thus, in recent years, the management of benchmark rates (or interest rates) received considerable prominence in the banking sector due to a number of reasons including supervision of banks’ benchmark rates under Basel II Pillar II. Taking into account the specific features of Islamic banks, the purpose of the paper is to theoretically and empirically review the possible prudential implications of lowly and increasing benchmark rates risk, and provide a sturdy risk management and regulatory perspective for Islamic banks and supervisors. For low rates perspective, policy rates of 12 central banks were collected and analyzed. However, for increasing rates scenario, we used duration gap and stress testing approaches, with a sample of 50 Islamic banks from 13 countries, for the period 2009-2015. Our empirical results indicate that persistently low benchmark rate regime carries strategic implications for Islamic banks including pressure on profitability, excessive risk taking and distortion in credit allocations. On the other hand, an increasing benchmark rate regime indicates the significant loss of the capital base, emergence of displaced commercial risk causing early withdrawals by the customers due to higher expectations in dual banking systems. This study concludes that implications under both scenarios call for a better risk management with appropriate tools and effective supervisory oversight for Islamic banks.
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References
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Zainol, Z., & Kassim, S. H. (2010). An analysis of Islamic banks’ exposure to rate of return risk. Journal of Economic Cooperation and Development, 31(1), 59-84.
Al-Ajmi J., & Hameeda, A.H. (2012). Risk management practices of conventional and Islamic banks in Bahrain. The Journal of Risk Finance, 13(3), 215-239.
Al-Tamimi, H., & Al-Mazrooei (2007). Banks’ risk management: a comparison study of UAE national and foreign banks. The Journal of Risk Finance, 8(4), 394-409.
Alden, L. T. (1983). Gap management: managing interest rate in banks and thrifts. Federal Reserve Bank of San Francisco, Economic Review, (Spr), 20-35.
Arteta, C., Kose, A., Stocker, M., & Taskin, T. (2016). Negative interest rate policies: Sources and implications. Working Paper 52/2016. Centre for Applied Macroeconomic Analysis, the Australian National University.
Ariss, R.T., & Sarieddine, Y. (2007). Challenges in implementing capital adequacy guidelines to the Islamic banks. Journal of Banking Regulation, 9(1), 46-59.
Bacha, O. I. (2004). Dual banking systems and interest rate risk for Islamic banks. International Islamic University Malaysia. Retrieved 2014, from Munich Personal RePEc Archive: http://mpra.ub.uni-muenchen.de/12763/.
Basel Committee on Banking Supervision (BCBS) (June 2006). International convergence of capital measurement and capital standards. Bank for International Settlements, Basel.
BCBS (May 2009). Principles for sound stress testing practices and supervision. Bank for International Settlements, Basel.
BCBS (September 2012). Core principles for effective banking supervision. Bank for International Settlements, Basel.
BCBS (April 2016). Principles for the management and supervision of interest rate risk. Bank for International Settlements, Basel.
Bean, C., Broda, C., Ito, T., & Kroszner, R. (2015). Low for Long? Causes and Consequences of Persistently Low Interest Rates. Geneva Reports on the World Economy, (17).
Bech, M. L., & Malkhozov, A. (2016). How have central banks implemented negative policy rates?. BIS Quarterly Review March. (Basel: Bank for International Settlements)
Ben Selma Mokni, R., Echchabi, A., Azouzi, D., & Rachdi, H. (2014). Risk management tools practiced in Islamic banks: evidence in MENA region. Journal of Islamic Accounting and Business Research, 5(1), 77-97.
Bierwag, G. O. (1987). Duration analysis: managing interest rate risk. Ballinger, Cambridge, mass.
Bierwag, G. O., & Kaufman, G. G. (1992). Duration gaps with futures and swaps for managing interest rate risk at depository institutions. Journal of Financial Services Research, 5(3), 217-234.
Busch, R., & Memmel, C. (2015). Banks' net interest margin and the level of interest rates (No. 16/2015). Deutsche Bundesbank, Research Centre.
Chattha, J. A., & Bacha, O. I. (2010). Duration gaps and net worth risk for Islamic and conventional banks: a comparative cross-country analysis. Review of Islamic Economics, 13(2), 5-33.
Chattha, J. A. (2013). Significance and key challenges in conducting stress testing for Islamic commercial banks. Global Review of Islamic Economics and Business, 1(2), 85-98.
Chattha, J.A. (2016). Risk Management with Stress Testing in Islamic Banks. Islamic Finance Today, Pioneer Publications (PVT) Ltd., pp. 14-20, Colombo, Sri Lanka.
Chattha, J. A., & Archer, S. (2016). Solvency stress testing of Islamic commercial banks: assessing the stability and resilience. Journal of Islamic Accounting and Business Research, 7(2), 112-147.
Cihak, M., & Hesse, H. (2008). The Islamic banks and ï¬nancial stability: an empirical analysis. Working Paper No. WP/08/16, International Monetary Fund, Washington.
Daniel C. Hardy and Philipp Hochreiter (2014), A Simple Macroprudential Liquidity Buffer, IMF Working Paper, WP/14/235.
Genay, H., & Podjasek, R. (2014). What is the impact of a low interest rate environment on bank profitability?. Chicago Fed Letter, (Jul).
Gup, B. E., Lambert, R., Avram, K. J., Kolari, J. W., & Diana, B. (2007). Commercial banking: the management of risk. Jon Wiley & Sons.
Fauziah, H. T., Abdul Rahman, R., & Omar, N. (2011). Empirical evidence on the risk management tools practiced in Islamic and conventional banks. Qualitative Research in Financial Markets, 3(2), 86-104.
Fooladi, I. J., & Roberts, G. S. (2000). Risk management with duration analysis. Managerial Finance, 26(3), 18-28.
Hussain, A. A., & Naysary, B. (2014). Risk management practices in Islamic banks in Kuwait. Journal of Islamic Banking and Finance, 2(1), 123–148.
How, J., Abdul Karim, M., & Verhoeven, P. (2005). The Islamic ï¬nancing and bank risks: the case of Malaysia. Thunderbird International Business Review, 47(1), 75-94.
Islamic Financial Services Board (IFSB). (2005, December). IFSB-1: Guiding principles on risk management for IIFS. Kuala Lumpur, Malaysia.
IFSB (2007, December). IFSB-4: Disclosures to promote transparency and market discipline for IIFS. Kuala Lumpur, Malaysia.
IFSB (2010, December). IFSB GN-2: Guidance note in connection with the risk management and capital adequacy standards: CMT. Kuala Lumpur, Malaysia.
IFSB (2011, January). IFSB GN-4: Guidance note in connection with the IFSB capital adequacy standard: the determination of alpha in the capital adequacy ratio for IIFSs. Kuala Lumpur, Malaysia.
IFSB (2012, March). IFSB-13: Guiding Principles on Stress Testing For IIFS. Kuala Lumpur, Malaysia.
IFSB (2014, March). IFSB-16: Revised guidance on key elements in the supervisory review process for IIFS. Kuala Lumpur, Malaysia.
IFSB (2015, April). IFSB-17: Core principles for Islamic finance regulation (banking segment). Kuala Lumpur, Malaysia.
IFSB (2015, 2016, 2017). Islamic financial services industry stability report. Kuala Lumpur, Malaysia.
International Monetary Fund (IMF) (2016, April). Global financial stability report. (Washington, D.C.: International Monetary Fund)
International Monetary Fund (2017). Ensuring Financial Stability in Countries with Islamic Banking. International Monetary Fund, Washington.
Jobst, A., & Lin, H. (2016). Negative Interest Rate Policy (NIRP); Implications for Monetary Transmission and Bank Profitability in the Euro Area (No. 16/172). International Monetary Fund.
Khan, T., & Ahmed, H. (2001). Risk management: an analysis of issues in Islamic financial industry. Islamic Development Bank, Islamic Research and Training Institute, Jeddah.
Koch, T.W., & MacDonald, S.S. (2009), Bank Management (7th Edn.). Cengage Learning.
Linnemann, M. (2016). How have central banks implemented negative policy rates?. BIS Quarterly Review.
Macaulay, F. R. (1938). The movements of interest rates, bond yields and stock prices in the United States since 1856. National Bureau of Economic Research, New York.
Mohd. Ariffin, N., Archer, S., & Abdel Karim, R.A. (2009). Risks in Islamic banks: evidence from empirical research. Journal of Banking Regulation, 10(2), 153-163.
Omar, M., Mohd Noor, A., Meera, A. K. M., Abdul Manap, T. A., Majid, M. S. A., ... & Sarif, M. A. (2010). Islamic pricing benchmarking. ISRA research paper, (17).
Romzie, R. & Abdul Rahim, A. R. (2015). The practice of IFSB guiding principles of risk management by Islamic banks: International Evidence. Journal of Islamic Accounting and Business Research, 6(2), 150-172.
Ruprecht, B., Entrop, O., Kick, T. & Wilkens, M. (2013). Market timing, maturity mismatch, and risk management: evidence from the banking industry. Discussion Paper No 56/2013. Deutsche Bundesbank.
Standard and Poor (2016, September). Islamic Finance in 2017: Modest Growth and Amid Oil-Prices Woes. www.standardandpoort.com/ratingsdirect.
Usman, M., Akhtar, M., & Ahmed, N. (2011). Risk management practices and Islamic banks: an empirical investigation from Pakistan. Interdisciplinary Journal of Research in Business, 1(6), 50-57.
Zainol, Z., & Kassim, S. H. (2010). An analysis of Islamic banks’ exposure to rate of return risk. Journal of Economic Cooperation and Development, 31(1), 59-84.
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Published
2017-12-31
How to Cite
Chattha, J. A., & Alhabshi, S. M. S. J. (2017). Risk Management in Changing Benchmark Rates Regime: Prudential Implications for Islamic Banks and Supervisors. Journal of Islamic Finance, 6, 205–230. https://doi.org/10.31436/jif.v6i0.267
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