Mandelbrot set image very small MohammedAmin.com
Serious writing for
serious readers
Follow @Mohammed_Amin
Join my
email list

Search this site

Custom Search
Tap here for MENU

The Royal Bank of Scotland disaster: its lessons for Islamic finance

Summary

21 January 2012

After the FSA report on RBS was issued, I was asked about the implications for Islamic finance. I wrote this article which was first published in the18 January 2012 issue of the magazine Islamic Finance News.

On 1 January 2007, the Royal Bank of Scotland Group plc (RBS) was a giant of international finance, with a market capitalisation of £62.8 billion. Although based in the UK, it had a major presence in the USA and significant operations in many other countries. Its consolidated balance sheet showed total assets of £871 billion, more than all the Islamic banks in the world combined, then or today. In the next twelve months to 31 December 2007 RBS made a profit of £7.7 billion after tax.

Only 10 months after that, in October 2008 RBS needed emergency liquidity funding from the Bank of England in its capacity of UK lender of last resort, alongside emergency capital injections from the UK Government in December 2008 and January 2009 totalling £45.5 billion. Without that emergency funding and capital, RBS would clearly have failed; it reported a loss after tax for the year ended 31 December 2008 of £34.3 billion.

This was the greatest disaster that has ever befallen a UK bank.

What went wrong?

UK banks are regulated by the Financial Services Authority (FSA), and since RBS’s near collapse (being saved only by the Bank of England and UK Government interventions) many have asked whether the FSA’s regulation was adequate. Accordingly, in December 2011 the FSA published its report “The failure of the Royal Bank of Scotland” explaining what happened and laying out the FSA’s shortcomings in its regulation of RBS.

The FSA identified six key factors which led to RBS’s failure:

  1. significant weaknesses in RBS’s capital position during the Review Period, as a result of management decisions;
  2. over-reliance on risky short-term wholesale funding;
  3. concerns and uncertainties about RBS’s underlying asset quality;
  4. substantial losses in credit trading activities, which eroded market confidence;
  5. the ABN AMRO acquisition, on which RBS proceeded without appropriate heed to the risks involved and with inadequate due diligence; and
  6. an overall systemic crisis in which the banks in worse relative positions were extremely vulnerable to failure. RBS was one such bank.

Is any of this relevant to Islamic finance?

The easy but wrong answer would be to say that because Islamic finance is different, it is not exposed to the same risks as conventional finance. However Islamic banks fulfil essentially the same function as conventional banks, namely channelling money from one set of customers (called depositors in conventional finance) to another set of customers (called borrowers in conventional finance).

While an Islamic bank would not engage in some of RBS’s business lines (for example trading in derivatives), most of the above causes of RBS’s failure are also exposures within in Islamic finance. Some key ones are discussed below.

Weak capital position

Fundamentally, the owners of a bank always want to minimise the amount of capital they deploy in the business. The lower the capital deployed for a particular level of total business, the greater the return on equity (profits divided by equity). There are only two constraints on minimising the capital:

  1. External rules created and enforced by regulators.
  2. The common sense of the shareholders, since the lower the capital deployed the greater the risk of the total failure of the bank. Furthermore if a bank is perceived to have low capital, customers will be reluctant to supply it with money.

It is sometimes argued that Islamic banks have lower capital requirements than conventional banks, due to a significant proportion of their assets being financed by profit sharing investment accounts (PSIA). In those jurisdictions where PSIA are offered, PSIA holders are not guaranteed full repayment of their account balances and in principle suffer the loss if the assets being financed underperform. The Islamic Financial Services Board standard “Capital Adequacy Standard for Institutions (Other Than Insurance Institutions) Offering Only Islamic Financial Services December 2005” accepts this argument in principle. However it points out in paragraphs 70-79 that, for the reasons explained in those paragraphs, regulators have discretion to require Islamic banks to recognise a proportion of the assets financed by PSIA when computing the required amount of capital.

Over-reliance on risky short-term wholesale funding

As well as funding from customers holding current accounts and PSIA, Islamic banks also fund themselves via the Islamic money market using commodity murabaha contracts, or sometimes wakala contracts. Reliance on such wholesale Islamic money market funding carries the same risks of sudden unavailability of fresh funds that RBS faced in the period running up to its needing Bank of England lender of last resort facilities.

Concerns and uncertainties about underlying asset quality

Islamic banks do not lend money to customers, but they do provide finance in other ways, such as leasing, murabaha or diminishing musharaka contracts over tangible assets, commodity murabaha contracts, etc. Such financings are just as exposed to the customer’s inability to continue making payments as are conventional loans.

While there will usually be an underlying asset which the Islamic bank can (subject to legal enforceability of the contracts) reclaim  and sell, there is no assurance that the Islamic bank will realise any more in a default situation than would a conventional bank that had made a loan secured on a similar asset.

If anything, Islamic banks are more exposed to asset concentration risk than conventional banks, since they will finance a narrower range of assets than will conventional banks. All types of banks periodically experience distress from financing real estate after a major fall in real estate values, and Islamic banks’ risk exposure is no less than that of conventional banks.

The ABN AMRO acquisition

The specific details of the acquisition of ABN AMRO (a Dutch bank with significant international operations) need not concern us. What matters are the following aspects of the acquisition:

Corporate governance generally

The FSA report does not list corporate governance as one of its six key causes of RBS’s failure and does not reach a definitive conclusion on RBS’s corporate governance. However part of paragraph 593 of the FSA report is worth reproducing:

Why the Review Team was able to identify little significant disagreement on major issues during the Review Period in a Board containing tough and experienced individuals with successful track records (see paragraph 647). Clearly constant disagreement would be debilitating for a board, but some divergence from consensus would not be unhealthy.

My experience from membership of various boards indicates that board members are often unwilling to appear awkward by challenging more senior board members (such as the chairman or chief executive) and often unwilling to resist an apparent board consensus by speaking up or demanding a vote. Accordingly there is a significant risk in most organisations of individual board members “going with the flow” and failing to ask challenging questions or vote against proposed actions. The risk is amplified in cultures that place particular emphasis on consensus and on respect for more senior people.

Conclusion

Islamic bankers should not regard financial disasters of the type that befell RBS as particular to conventional finance. Instead they should study RBS and similar situations closely, as many of the reasons that led to RBS’s failure are also risks in Islamic banking.

 

The Disqus comments facility below allows you to comment on this page. Please respect others when commenting.
You can login using any of your Twitter, Facebook, Google+ or Disqus identities.
Even if you are not registered on any of these, you can still post a comment.
comments powered by Disqus

 

Custom Search

Follow @Mohammed_Amin

Tap for top of page