Mardig Haladjian

With more Islamic institutions looking for ratings, the general manager of the financial institutions group at Moody's in Cyprus explains how the agency rates these names versus conventional credits

Q: What is the extent of Moody's involvement in rating Islamic financial institutions?

A: Moody's has ratings on some banks founded under Islamic principles, such as Al-Rajhi Banking and Investment Corp and Kuwait Finance House, as well as banks that have converted some or all of their operations to be shariah compliant, such as some of the banks in Saudi Arabia. Moody's continues to expand its rating coverage of Islamic financial institutions and has also been involved in rating some of the recent sukuk issues.

Q: Does Moody's have a special approach to rating Islamic financial institutions?

A: Islamic banks' operations, assets and liabilities have special characteristics and risks not found in conventional banks. However, ratings are ratings, in that they are intended to measure expected loss, which is common in any credit.

Moody's follows a generic, 'seven-pillar' approach to rating financial institutions; this same approach is also used in rating Islamic banks. However, Moody's pays particular attention to understanding the underlying risks, which in many areas are different from those seen at conventional banks. Moody's seven-pillar approach involves analysing issues around (i) the operating environment, (ii) ownership and governance, (iii) franchise value, (iv) management strategies, (v) recurring earning power, (vi) risk profile and risk management, and (vii) economic capital. We believe that these seven pillars address all the main credit issues and capture the main risks facing Islamic banks.

These internal and external factors analysed under the seven-pillar approach help us determine a bank's stand-alone financial strength. We then factor in the likelihood of external support, if relevant, from strong shareholders or systemic support for 'too-important-to-fail' institutions, which could push the deposit rating higher. Furthermore, we recognise that in some cases, a deposit rating will be inappropriate, and that the most appropriate rating for an Islamic bank will be an issuer rating where we assess the overall creditworthiness of the entity.

Q: What are examples of issues that you would consider differently under the seven-pillar approach while looking at an Islamic bank?

A: In our effort to understand the operating environment, we assess an Islamic bank's fit in the overall financial market, especially in cases where a system is geared to conventional banking. We look for the existence of a separate Islamic banking law and how this might differ from the law for conventional banks. It is critical for us to understand the mechanism whereby the central bank or lender of last resort would provide shariah-compliant short-term liquidity in case of need. We also assess the legal position of shariah-based contracts and the level of transparency in the bank's reporting and accounting standards. We also appraise the level of competition from other Islamic banks or Islamic banking windows of conventional banks.Under ownership and governance, we assess the shariah board's operating effectiveness, track record and relationship with the bank's management.

We believe that growing competition is a key threat to the Islamic banks' franchise value. Many Islamic banks are very small, even by local standards, and these institutions will be particularly challenged to have a viable future unless they can grow significantly or are party to consolidation.

Recurring earning power is an important pillar of our analysis and an area where we find Islamic banks are often lacking in transparency. The AAOIFI (Accounting and Auditing Organisation for Islamic Financial Institutions) standards are improving levels of financial disclosure, but are still incomplete in coverage and are adopted by only a few regulators of Islamic banks. Essential elements for our evaluation of a bank's earning power are the assessment of the quality of investments, the understanding of the criteria for deciding on profit or loss sharing between shareholders and various investment account holders, and the use of profit equalisation reserves or investment risk reserves. We also review the bank's measurement of its profitability.

We believe that Islamic banks face higher levels of operational and reputation risks than conventional banks, and that they are generally limited in the risk mitigation tools they may employ. The increased operational risks come as a result of the nature of their product offering and the contract-based relationship with customers, bringing documentation risk as well as legal risk. Islamic banks also face greater funding and liquidity risk. Funding risk may arise from the often high reliance on current deposit accounts, while liquidity may be constrained by the limited range of liquid assets that are available for banks. Tough times will come, and so the stronger the risk management foundations of Islamic banks, the better they will be able to weather future storms.

As regards capitalisation, we look at regulatory capitalisation, but pay more attention to economic capital analysis, where we may adjust both capital and risk assets in determining the real capital cushion. For instance, in making our own assessment, we would be strict in the treatment of assets funded by PSIAs (profit-sharing investment accounts) by including such assets in risk-weighted assets.

Q: How qualified is Moody's to rate Islamic banks?

A: Moody's understands credit. Moody's is neither an expert in shariah law, nor are Moody's ratings a judgment on a bank's adherence to the shariah laws. We respect the fact that every bank's shariah board is responsible for shariah adherence, and we are in no position to question their authority. In rating Islamic banks, we make sure that we address all the risks facing a bank, maintain our fair and independent approach and, based on our understanding of credit and long experience in the business of ratings, express a view that is globally comparable in terms of a measure of creditworthiness.

As a general approach, we consider every new bank as being different and unique, and this is particularly true in the case of Islamic banks, where the level of standardisation is low and rapid change is transforming the industry.

Q: What is Moody's general view of the Islamic banking industry?

A: We appreciate that the Islamic banking industry is undergoing dramatic growth and change. In the Arab world, this has been triggered to a certain extent by the recent rise in oil prices and the ensuing increase in demand for banking services in the region. The fall in interest rates and the events of 9/11 may also have caused the channelling of higher levels of Arab wealth to the Arab world. This is reflected in the hike in infrastructure projects, the increased level of consumerism and the unsustainable rise in capital markets and real-estate prices in the Gulf region.

We believe that the range of widely accepted Islamic banking products remains narrow, while the level of standardisation is low, with material differences remaining in shariah interpretation and the approach to Islamic banking among the several schools of shariah law. These are all issues that are being debated and addressed by industry participants.

In our rating approach, we recognise that the Islamic banking industry is young and there are still deficiencies in the legal, regulatory, supervisory, accounting and governance infrastructure. Such issues are further complicated by the global developments taking place in the areas of accounting (International Accounting Standards) and capitalisation (Basel II), where specificities of Islamic banks are not always addressed. Nevertheless, good progress is being made in most areas. The industry is involved in a great deal of internal discussion and coordination, which will undoubtedly lead to its overall improvement and strengthening.


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