WAS IT A FAILURE OF ISLAMIC FINANCE?

Financial institutions are the financial intermediaries that play a key role in the economy of any country by directing the flow of savings of the people towards large corporations and enterprises. The financial institutions provide trust and confidence to the savers of money and bridge the gap between savers and the users of money.

Confidence and trust of the savers on the financial system and intermediaries are critical for the economy and capital formation of a country. Where the element of distrust arises on the financial system it leads to financial crises in the economy and the shattered confidence on a financial institution, resulting in the loss of that institution. In case of failure of any financial institution, people tend to be more cautious about the strength of the financial system and the security of their hard earned money. In the state of distrust, the government or governments' regulatory arms need to play their role of confidence building of the stakeholders and depositors using different regulatory tools which could adequately minimize the risk of loss and ultimately the failure of any financial institution.

When an Islamic Financial Institution (IFI) fails, people rapidly lose trust of the Islamic financial system as compared to the conventional one. The reason being is that the conventional financial industry, due to its long existence, performance and strong regulatory framework, is mature enough to keep the confidence of depositors and answer the causes of failure of any financial institution. On the other side, the modern Islamic financial industry is still considered at its takeoff phase. The failure of any Islamic financial institution raises lots of doubts and questions about the future, viability and adoptability of Islamic finance, especially from its critics. Therefore, it is crucial for the regulators and the users of the Islamic financial products to understand the root causes of the failure of any financial institution. To the larger extent, the causes of failure of IFIs are similar to the conventional counterparts yet the IFIs may also fail if the people realize that they are not working according to the principles of Shari'ah. In general a financial institution fails when:

• It is mismanaged due to greed and carries a huge proportion of infected portfolios.

• It is undercapitalized and fails to fetch low cost funding.

• It lacks competent management.

• The systems, procedures and internal controls do not work as required.

A large number of financial institutions start operations and the majority of the takeoffs achieve a smooth trip toward their ultimate destination but only a few meet an unfortunate fate. Among the failed institutions, the above reasons are common. Now the question is 'can we consider the above factors as key to the failures'? The answer might be 'yes', as in a number of cases the IFIs failed due to multiple factors coupled with the above reasons. Let's take the example of twenty three closed Non-Banking Islamic financial institutions in Pakistan, out of which eight were totally obliterated whereas the rest of the entities were merged with the other existing financial institutions.

In Pakistan, Islamisation of the economy was started in the early 80s and the concept of Modaraba was legalized to conduct the business of Islamic fi nance under the umbrella of Modaraba Management Companies, registered as Mudarib with the Registrar Modaraba, Securities and Exchange Commission of Pakistan. These Management companies manage 'Modarabas' (NBIFIs), which are pooled with the general public's money, who are called certifi cate holders (the Rabb-ul-Maal) of the Modarabas.

The concept and structure of the NBIFIs attracted the major business groups of the country due to a substantial tax incentive which was announced by the Government of Pakistan. These entities provided a very good platform to conduct Shari'ah compliant business and emerged as small and medium sized fi nancial institutions. In the initial fifteen years, a rapid growth in this business of Modaraba was recorded and total numbers of registered MMCs reached 51 and the fl oated NBIFIs were also over 50. In terms of numbers, it was peak time for the NBIFIs whereas their assets had grown to $425 million whereas the total profi ts had touched $108 million.

Unfortunately the NBIFI sector could not continue its growth for a longer period and soon after the 1996 the fall back of NBIFIs started and a large number of closures were witnessed in the country during the next fi fteen years. Twenty three of the NBIFIs stopped their operations in Pakistan and the reasons were heavy losses, mismanagement and misappropriation of the certificate holders' money by the Mudarib. Out of the closed NBIFIs:

1| Fifteen of the NBIFIs were merged into the existing operative NBIFIs to stop further losses and create synergies to give some benefi ts to their certifi cate holders.

2| Seven NBIFIs were wound up due to mismanagement, misappropriation of funds and greed of the Mudaribs.

3| One of the NBIFI was fully involved in the stock market operations and wound up due to heavy losses by investing in the highly volatile scripts.

WHY THE ISLAMIC FINANCIAL INSTITUTIONS FAILED - MAJOR CAUSES

There are a number of factors which lead to the winding up of eight NBIFIs in Pakistan. A study of the failed NBIFIs reveals that there was no single overriding factor to the failure of these financial institutions. However, some common and major causes for the failure were noticed, which are:

1 INCOMPETENCY OF THE BOARD OF DIRECTORS (BOD) AND SENIOR MANAGEMENT

It is imperative for the success of any business that, the BoD and senior management, who are entrusted to run the operations of the business, must be competent enough. A competent management is expected to perform the following functions for the business, which were never performed by the management of the failed NBIFIs:

a) Provide vision and prudent future planning.

b) Implement proper risk management policies.

c) Sincerely involve in major decision making processes.

d) Ensure effective internal control and regulatory compliance.

Thirty years back, when the NBIFIs were established in Pakistan, there was no fi t and proper criterion from the regulator, for the directors and senior management of the NBIFIs since most of the management companies were headed by the close relatives of the sponsors. The CEOs and directors of the Board were family members of the sponsors and were incompetent to run the business of NBIFIs.

2 UNDER-CAPITALIZATION

Undercapitalization is a state where any institution does not have sufficient funds or access to the required funds to pay its obligations, or to expand and operate business profitably. In many cases, low capital base or under capitalization of the financial institutions may pour cold water on the investment. The financial entities, having a low capital base, are always at high risk of default as they don't have sufficient cash flows to meet their obligations and have resilience against the losses.

Most of the failed NBIFIs were undercapitalized as there was no minimum capital or capital adequacy requirement from the regulator. Soon after the start of business, it was realized that these NBIFIs were undercapitalized and facing the problem of sheer capital inadequacy. The increasing operational costs and losses made the NBIFIs unable to offset their future profits with the present losses. The low capitalization had weakened the shock absorbance capacity of the NBIFIs and had stopped the growth of their business.

3 HIGH RATIO OF INFECTED AND CLASSIFIED PORTFOLIO

Infected or classified portfolio means a pool of investments and facilities which is questionable in terms of the full recovery of principal balances and accrued profit thereon. The high risk facilities, which were extended by the incompetent management, especially to their associates, started defaults which were mostly willful. The management, instead of making recovery efforts, wrote them as bad debts which turned into a huge bad portfolio that reversed the growth of the NBIFIs and the resultant losses eroded all the equity and reserves of NBIFIs. The shocks were so big that the NBIFIs could not bear them and ultimately went into bankruptcies and windups.

4 WEAK INTERNAL CONTROLS, ABSENCE OF RISK MANAGEMENT POLICIES AND RUTHLESS SPENDING

Internal controls are the techniques, methods and procedures which are adopted to safeguard the business assets and to ensure compliance and accuracy of the data and information submitted to the management, stakeholders and the regulator. Weak internal control can never ensure a longer life to any organization; it ultimately opens path to fraud, forgeries and mismanagement of funds.

Weak internal controls and absence of risk management policies were another cause of the failure of those NBIFIs. Inaccuracy in fi nancial statement and data, non-segregation of duties, absence of risk management policies and a one man show attitudes in the business are the sign of weak internal controls and all these issues were common in the failed NBIFIs. For the weak internal controls, which were apparent from the misreporting, presenting false statement of accounts and other regulatory violations, these NBIFIs were penalized by the regulator a number of times.

Effective risk management policies ensure better internal control and security to the investor's money but there were no such policies in those NBIFIs. Without any risk management policies and prudential regulations from the regulator these visionless managers extended facilities to associated undertakings and family businesses of the director and the CEOs without any collateral and put the NBIFIs at a high risk of counterparty default.

The management in these entities was centralized and autocratic and all the decisions were taken by a single person mainly the CEO which remains unchecked and unquestionable as the Rabb-ul-Maal had no right to vote and elect their directors.

This gave a free hand to the CEOs to fix their high remuneration and spent lavishly the hard earned money of the investors on their personal needs of luxurious nature and frivolous activities.

5 HIGH LEVERAGING, ASSET LIABILITY MISMATCH AND NON-AVAILABILITY OF LOW COST FUNDS

When the bad portfolio of one highly leveraged institution increases it ceases its ability to pay off its obligation toward the other fi nancial institutions at one end and it affects the liquidity of the lending institution on the other. If the lending institution does not prepare any contingency plan for such a situation it hampers its ability to pay off its obligation to its lending institution and so on.

Such a chain creates a systemic risk which threatens the stability of the financial markets.

Sometimes, financial institutions borrow heavily to finance their investments. In such financing the spread is normally very low therefore a small bubble in the investments disturbs the cash flows of the financial institutions. The unplanned institutions do not make any arrangements for such bubbles which lead to the bankruptcy of the institution. This actually happened with the unsuccessful NBIFIs.

Another problem to these entities was the non-availability of low cost funds. Due to disparity between the liabilities and assets, the NBIFIs were forced to recall and stop rollovers of their short term facilities to fund their long term investments but most of the clients were unable to repay the facilities on the call and resultantly the NBIFIs made defaults in repayments of their obligations. The situation was further deteriorated when a huge amount of facilities got stuck up due to non-payment of profits and principles.

6 MORAL HAZARDS - FRAUDS AND GREED

Another major cause of the failure of the NBIFIs was the fraud, corruption and greed of the management. The management intentionally deceived the Rabb-ul-Maal for personal gains. The management breached the trust of certificate holders and looted their money by illegal lending to their associated companies and businesses thereby violating the regulatory provisions. In all such financing they were aware of the facts that this investment will never come back. Consequently most of the associates made both natural and willful defaults and the NBIFIs lost their entire investments. The Management showed inflated Balance Sheets by creating fictitious financial assets without any real economic activity.

They deceived the certificate holders by transferring the real assets of the NBIFIs to their personal businesses. They kept on enjoying the funds of Rabb-ul-Maal by investing them into their personal business and showing continuing losses to the NBIFIs.

Their extreme greed dominated all the ethical considerations and fi nally a large number of NBIFIs were wound up and the certifi cate holders lost their money in these ventures.

7 REGULATORY FAILURE AND NON-COMPLIANCE OF SHARIAH

We must admit that a weak regulatory framework had also played a key role in the failure of a large number of NBIFIs. It provided the opportunity to the Mudarib to play with the money of the general public. Due to the non availability of a Shari'ah compliance mechanism and improper regulatory control, the incompetent and corrupt management of NBIFIs exposed the financial institutions to a high category of regulatory risk.

The excess and deficiency of both types of regulations are dangerous for the financial institutions. In case of excessive regulations, the financial institutions lose their legitimate business due to excessive regulatory requirements like investment in government securities, cash reserves and capital adequacy requirements, restriction on certain types of investments, caps on per party exposure and restrictions on taking exposures on certain types of ventures etc.

But in the case of insufficient regulations the financial institutions lose their money by investing in high risk ventures.

At that time, the NBIFI sector of the country was operating with the insufficient regulation as there was no capital adequacy or minimum equity requirements, no cash reserves, no fi t and proper criteria for the promoters and directors, no Shari'ah compliance, no risk management guidelines and no prudential regulations etc. Taking the benefits of regulatory failure, the management operated the NBIFIs at a high risk and held insufficient, fictitious and low quality assets, showing them as high quality assets in the books. The management of those NBIFIs operated the entities against the injunctions of Islam whereas the money from the public was collected in the name of Islam. This was the cruelest part of the whole picture as due to the un-Islamic practices these NBIFIs lost their trust, reputation and ability to raise further funds as Islamic financial institutions.

It is also true that no institution can survive where the management is greedy, dishonest and corrupt. All risk management and regulations fail before such management. The regulator can only introduce some checks and balances but it is not a guarantee of a fool proof system.

The above seven factors are not the only ones that affect the success or failure of an Islamic fi nancial institution, but in number of studies and reports they appear near or at the top of the list of failures of NBIFIs and the same is true for all financial institutions.

The above factors of failure are interlinked and apparently are not very technical issues but require prudence, experience and training to overcome. Besides the above factors, research and development, review of existing product lines and introduction of new products are also important factors for the promotion and growth of a financial institution. It is necessary that the existing product lines be reviewed and new products be launched to meet the customer needs. The failed NBIFIs never changed themselves according to the needs of fast and ever changing Islamic financial markets of the world.

WAS IT A FAILURE OF ISLAMIC FINANCE?

It is also true that during the 90s the Islamic financial industry of Pakistan was at an evolving stage and the concept of IFIs and Islamic products was new to the people. The entrepreneur failed to correctly understand and implement the NBIFI's model as a vehicle to their business. There is no doubt that a successful institution is the result of untiring hard work of a competent BoD and top management. The top management needs to be involved from the start as their continuous effort is a key throughout the development of an institution. The failed IFIs were actually the failure of the BoD and top management. It is imperative that professional directors set a clear vision, objective and Shariah compliance mechanism for the IFI. Experience showed that the NBIFIs which failed had managements that were incompetent, corrupt and the least concerned towards Shariah compliance and benefit of the certificate holders. This was one of the major causes of their failure.

Most of the failed NBIFIs were also undercapitalized and they were facing the problem of capital inadequacy which had weakened their shock absorbance capacity.

The failed NBIFIs were unable to offset their future profits with the present losses due to undercapitalization which lead to the forced defaults and bankruptcy of the NBIFIs. Had those institutions been properly capitalized the results might have been different.

Absence of risk management policies and weak internal controls were the other causes of failure of those NBIFIs. Weak internal controls open the door to fraud, forgeries and mismanagement of funds which happened with the failed NBIFIs. This was also the failure of the management and not the Islamic financial system.

In financial decisions, a good manager very well knows that lending to someone who is bankrupt and has no collateral to offer, has a high probability of default as compared to a debtor with good standing and acceptable good credit and security. The managers of NBIFIs never followed these principles of lending which created asset liability mismatches.

We must admit that the weak regulations of that era and the non-existence of Shari'ah compliance structure, were also responsible for the defaults but this area has now sufficiently been addressed to strengthen the NBIFIs in Pakistan.

Another major reason of the above failures of NBIFIs was their handsome investment in the listed securities which lost their value due to the stock exchange crash. The stock market performed very well till the year 1995 but in 1995-1996 the stock market lost 27 percent of its value due to political unrest and the discouraging economic outlook of the country.

Due to the above reasons we cannot say that it was the failure of the Islamic financial system but rather it was mismanagement.

We get further support to our conclusion as a large number of Islamic financial institutions which started their operations over 25 years back are still working in Pakistan. The rapid expansion and growth of Islamic Banking and finance in the last decade, with the compound growth rate of around 20 percent in Pakistan and the rest of the world is also a clear indication of the viability of the system and its ability to face the modern challenges of the financial sector. Moreover, the eagerness of the people towards Islam, their hatred to Riba, the inherent strength and roots of the Islamic financial system and untiring hard work of the efficient Mudarib have still kept the twenty six NBIFIs alive in the country. These IFIs are performing and growing day by day. The assets of NBIFIs have touched a high figure of $300 million at the end of March 2012. The Dividend payout history is tremendous and 70 percent of NBIFIs every year pay dividends to their certificate holders and some NBIFIs have a track record of over 20 years of continuous payment of dividends. The dividend payout ratio varies from 2 percent to 70 percent annually on case by case basis. We can hardly find any other sector with such a consistent payout to their shareholders.

In addition to the NBIFIs, the Islamic banking and finance, its outreach and client network is growing in multiple dimensions at a very rapid pace in Pakistan. During the last decade, Islamic banks, Islamic Mutual funds, Islamic Pension Funds, sukuk and Takaful have also started their operations in Pakistan and are growing with a fast pace of over 20 percent per annum. At present, the total Shari'ah compliant assets (Islamic Banking, Non-Banking, Takaful and Sukuk) of Pakistan are over $11 billion.

The regulators have also strengthened the regulatory regime for the Islamic financial institutions as well. Due to the strong regulatory framework now there is not even a single default, except the cases discussed above, in the Banking and non-banking Islamic financial sectors.

© Business Islamica 2012