Despite the hostile economic environment, there is an air of confidence taking hold of the fledgling Islamic banking industry, with plans being drawn up to create an Islamic megabank with a paid-up capital of $10 billion. "Islamic banking cannot be taken seriously until we have some global Islamic banks" adds Simon Eedle, managing director of Calyon's Islamic banking arm.
As calls for smaller conventional banks grow louder in Europe and the US, Islamic Bankerasks: does size matter?
1980s and 1990s - Years of Consolidation
Whilst the Islamic banking industry took the first steps towards global recognition in the 1980s and 1990s, the conventional industry, driven by limited opportunities for organic growth and increasing deregulation, consolidated rapidly (Berger and Strahan, 1998).
With increasing integration as a result of international money flows, advocates for large conventional banks focused on differences in efficiency levels between large European and US banks and as a result implying that greater efficiency could be achieved with cross-border mergers and growth (Rhoades, 1994).
Today, it has been argued that it was this movement towards rapid consolidation that was the root cause of the credit crisis. As Joseph Stiglitz, the Nobel Prize winning economist puts it: "if it is that big, it should be broken up".
The question is how big is "that big"? And do we break up banks that grow too big or can we manage the size? As calls for smaller banks grow louder in the West, now is the time that we look at the structures of Islamic banks and asks the same tough questions. No doubt, some will contend that since Islamic banks are generally much smaller and because they fared better during the crisis, they should be applauded. This is partly true - we need to recognise success, but as H.G. Wells said "wise men learn by other men's mistakes, fools by their own".
Does size matter? Theory and Practice
In terms of size, the theoretical argument centres on two concepts: economies of scale and economies of scope. The former relates to benefits derived from the production of a large quantity of a product and the latter relates to benefits gained from the production of a variety of products.
Firstly, turning to some evidence in the conventional world, allows us to draw some interesting conclusions. Studies have shown the presence of economies of scale for banks which have assets of $1 billion to $15 billion (Rogers 1998). Anything more than $15 billion leads to diseconomies of scale, that is, inefficiencies from increasing growth in quantities. With regards to economies of scope, most studies show insignificant results.
To our knowledge, only one study, by the IMF, has explored the above concepts for the Islamic banking industry. This IMF paper finds that "small Islamic banks tend to be financially stronger than large Islamic banks." This is mainly due to credit risk monitoring arrangements - for example, monitoring profit-loss schemes (PLS) becomes more complex as the size of Islamic banks increases, which results in adverse selection and moral hazard problems. Interestingly, the authors also point out larger Islamic banks will tend to engage in more PLS arrangements compared to smaller Islamic banks, thereby, compounding the problem.
These findings are particularly potent when compared to the conventional literature on efficiency gains from mergers and acquisitions. It shows that the simple "efficiency gains" argument is not enough when we refer to Islamic banks and other factors need to be taken into account.
Having said this, the jury is still out on the "optimal" size of Islamic banks. We have already established that in the conventional space, studies have shown the presence of economies of scale for banks which have assets of $1 billion to $15 billion. There is a gap in the literature for the Islamic banking industry, which confirms the most efficient size of banks.
With this in mind, it is still imperative for policymakers to manage the risks of larger banks, as the industry continues to grow. We now turn to some solutions.
Managing Size - Solutions for Policymakers
1. Tax bank size
Larger banks tend to be less transparent and take more risks. We recommend taxing the size of banks (size could be determined by a number of factors including balance sheet size). The revenue generated from this scheme would be placed in a fund, to be used during banking failures.
2. Break-up mega-banks
As shown in the IMF study, smaller Islamic banks tend to be financially stronger. How do banks become too big to fail? We can list three main reasons:
Being too-big to fail has become a "competitive-advantage" for some banks and the management have made the most of this reality.
3. Develop a bankruptcy contingency plan
All banks should have a plan in place for bankruptcy, so they can be wound up quickly if they fail. As Mervyn King said "making a will should be as much a part of good housekeeping for banks as it is for the rest of us."
4. Incentivise Long-term Performance
Excessive risks have been taken by banking executives to achieve short-term gain. Therefore, incentives should be based on long-term performance, with bonuses being paid, say, every 5 to 10 years, rather than annually.
5. Enhance regional cooperation
With increasing integration of Islamic banking institutions globally, it is imperative that regulars work together more to manage the resulting risks.
Introducing the above reforms will not prevent a crisis from occurring. The financial markets have a habit of surprising even the most experienced of practitioners. However, adopting the above reforms will ensure that crises of such severity are much less likely. In addition, the intention is to make the impact more manageable.
Notes
1. Berger, A. N., and P. E. Strahan. 1998. The consolidation of the financial services industry: Causes, consequences, and the implications for the future. Working paper, Federal Reserve Bank of New York
2. Rhoades, S. A. 1994. A summary of merger performance studies in banking, 1980-93, and assessment of the ‘‘operating performance'' and ‘‘event study'' methodologies. System staff study no. 167, Board of Governors of the Federal Reserve System.
3. Rogers, K. 1998. Product mix, bank powers, and complementarities at U.S. commercial banks. Journal of Economics and Business 50:205-18.
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