Bangladesh Islamic banks face higher asset risks with lower loss buffers: Moody’s

Islamic banks in Bangladesh have higher asset risks than conventional private banks during economic downturns because they have rapidly increased corporate exposures that are untested through economic cycles, says Moody's Investors Service in a new report.

At the same time, Islamic banks have weaker loss buffers than conventional peers to withstand a worsening in asset quality, and have weaker capitalisation because of higher financing growth and structurally weaker profitability, the report adds.

"Rapid growth in Islamic financing for corporates in a highly fragmented market could be due to poor underwriting standards. Corporate financing increased to 75% of total Islamic financing as of the end of March 2021 from 52% five years earlier, while the proportion for conventional banks reduced to 71% from 75% during the period," said Tengfu Li, a Moody's analyst.

Explaining the reasons behind Islamic banks' weaker income buffers against financing losses, Moody's says their profitability is structurally weaker, suppressed by higher funding costs and excess liquidity due to a prohibition on holding conventional interest-bearing government bonds and a lack of Shariah-compliant liquid instruments.

Funding costs are higher for Islamic banks than their conventional peers because of their greater reliance on costlier term deposits, the report says, adding that the profitability gap between Islamic banks and their conventional peers will widen if the former's asset quality worsens to a greater degree when existing support measures for borrowers expire.

"Meanwhile, capitalisation at Islamic banks will lag further behind as financing growth accelerates.

"Given their weaker profitability, Islamic banks' internal capital generation is inferior compared with conventional counterparts."

In addition, Islamic financing is growing faster than conventional bank loans. As a result, the capitalisation gap between Islamic banks and their conventional peers will widen as growth in financing will outpace internal capital generation, the report observes.

BB data show contrasting picture

The Bangladesh Bank's latest financial stability report, however, reveals a contrasting picture.  It says, "Islamic banks showed a better performance compared to its conventional peers in terms of both classified-investment-to-total-investment ratio, and net-classified-investment-to-total-investment ratio in the year 2020.

"However, the unclassified-rescheduled-investment-to-total-investments ratio increased slightly last year from the previous year."

Islamic banking in Bangladesh has been attaining marked growth and strong market demand over the period, the Bangladesh Bank says, adding the Shariah-based banking system is receiving growing attention with its 'equity-based and interest-free' banking philosophy.

Besides, this segment of the banking industry has been able to increase its market share over time through innovation and product diversification, it added.

According to the report, a total of eight full-fledged Islamic banks with 1,311 branches were operating in the country's banking sector as of December 2020. Besides, 9 conventional banks were operating 19 Islamic banking branches and 14 conventional banks operating 198 Islamic banking windows were providing Islamic banking services. The present number of full-fledged Islamic banks in the country is 10

As of December 2020, more than one-fifth of the banking sector assets were held by the eight Islamic banks while the top 4 Islamic banks jointly held 14.7% of total assets of the banking sector.

The total asset of the country's Islamic banks amounts to Tk3,70,000 crore, while the total deposits, investments, and liabilities are around Tk3,00,000, Tk2,80,000 and Tk3,50,000 crore, respectively. 

Moreover, the aggregate market share of Islamic banks (excluding Islamic banking windows of conventional banks) saw an increase in 2020 compared to the previous year.

At the end of December 2020, Islamic banks held 20.2% share of total assets, 21.3% share of total deposits and 20.5 % of total liabilities of the overall banking system.