This article is a chapter out of the e-book, "Impacts of the COVID-19 outbreak on Islamic finance in the OIC countries" that is available as a pdf download from HERE. Read the article in the e-book for the complete set of tables, charts and references.
There is a general consensus that the novel coronavirus COVID-19 is gradually leading the global economy into an unprecedented economic recession, second only to the Great Depression. The decline of world GDP is estimated to be 3% in 2020, and an accumulated loss of $9 trillion in 2020 and 2021. The crisis is likely to cripple business enterprises by its recurrent wave of bankruptcies and layoffs. Many industries, including tourism, aviation, catering services, sports, and entertainment, are steadily moving toward an uncharted danger zone. The world’s major stock markets have lost their value significantly, which is merely an indication of what the global economy would look like in the coming days.
The financial sector is likely to receive a blow worse than the 2008/9 global financial crisis (GFC) that was triggered by the financial sector and penetrated the real economy gradually. Back then, regulatory authorities had enough tools to fight the crisis but this current one is utterly different in terms of its genesis, nature, and magnitude of effects. Hence, it is difficult to predict the future effect of the pandemic on financial institutions. Especially, the demand (credit) and supply (deposit) sides of financial institutions are expected to be disrupted seriously. The impact is going to be worse for developing countries like Bangladesh, due to limited available tools to fight the crisis.
COVID-19 struck Bangladesh at a time when the financial system of the country was undergoing a critical phase due to some issues in the banking sector accumulated over the years including liquidity crunch, substantial accumulation of non-performing loans (NPLs), and operational inefficiency. While the credits and deposits of the banking system were starting to show a recovery from an earlier collapse, the pandemic turned the trajectory downward again. Figure 2 shows the latest available monthly data on loans and deposits of the banking system. Compared to December 2019, both credits and deposits declined by 1.28% and 1.53%, respectively, in January 2020.
A similar trend was noted in the leading capital market of Bangladesh. The general index of the Dhaka Stock Exchange (DSE) plunged from its top 5,952 points in January 2019 to its lowest, 4,068 points in January 2020, a loss of more than 31% in just one year. This shows that the financial vulnerability of Bangladesh was already exposed even before the COVID-19 pandemic escalated. The crisis added more damage to the system. For example, between February and March, the DSE general index lost 1,130 points (23%) in just one month.
PROBABLE IMPACT ON THE ISLAMIC FINANCE INDUSTRY
The Islamic finance industry in Bangladesh comprises of banking and non-banking financial institutions. Major non-banking financial institutions include insurance companies and a few other financial service providers. Although the banking sector has absolute dominance over the Islamic finance industry, Shariah-based insurance companies are growing rapidly.
Realizing the importance of Islamic finance in Bangladesh, the DSE decided to launch a separate index comprising of only Shariah-compliant listed firms. The index, the DSE Shariah Index (DSES), was officially launched on January 20, 2014, with the base value of 1,000. About 70 listed companies are included in the index. DSE keeps the names of these confidential but can be purchased.
COVID-19 has affected all sorts of Shariah-compliant firms regardless of sectors. This is reflected in the DSES Index, as illustrated in Figure 3. The graph depicts a one-year daily data of both DSE General and Shariah Indices. DSES index was declining before the COVID-19 affected the market. However, the index was moving upwards at the beginning of 2020 before the virus crushed its recovery. As per the latest available data, DSES tumbled in the first three months of 2020. Between February and March, the index lost 15% of its value.
As mentioned earlier, banks and insurance companies are the major firms constituting the Islamic finance industry in Bangladesh. There are 11 full-fledged takaful companies of which 8 are life and 3 are non-life insurance companies that account for less than 2% of the Islamic financial sector of the country.
No doubt, the insurance sector is expected to suffer a loss of business during the COVID-19 crisis due to the absence of operations. Specifically, property and other insurance, particularly related to businesses such as import and export, will plummet substantially.
Second, the investment value of insurance firms is likely to plunge considerably as most security markets are continuously falling.
Third, due to increased disease and loss of properties, insurance claims will rise rampantly although it is uncertain if COVID-19 will be covered by the general terms and conditions of insurance contracts. Thus, the effect of the pandemic on the liability side remains uncertain.
This sums up what insurance companies are going to suffer, and it appears that the market has already started to adjust to the looming future as reflected in the stock price of listed takaful companies, as seen in figure 4.
However, as the major partner of the Islamic finance industry in Bangladesh, the banking sector should brace itself to face the worst blow.
The pandemic will, first, undermine the current growing trend of the Islamic banking sector of the country, which consists of 11 full-fledged Islamic banks, 19 Islamic banking branches of 9 conventional commercial banks, and 88 Islamic banking windows of 8 conventional commercial banks. The Islamic banking sector constitutes a quarter of the total banking sector of the country in terms of deposits and investments, as illustrated in Table 1.
Since takaful accounts for only a tiny fraction (less than 2%) of the total assets of the Islamic financial sector, the impact assessment and recommendations thereof, reflect mainly the banking sector.
For the banking sector, the impact of COVID-19 can be assessed through balance sheets. The balance sheet approach, although it tells the inside story of a bank, provides the necessary clues to signal the future trajectory. For instance, the quality lending capacity, operational efficiency, liquidity position, and equity capital strength signal the buffer a bank possesses to fight adverse economic conditions. Islamic banks in Bangladesh are going to be affected almost in the same fashion as their conventional counterparts because of their similar exposure to risk.
Figure 5 shows that more than 90% of the investment of Islamic banks takes the form of murabahah (mark-up or cost-plus investment) which includes bai murabahah, bai muajjal, and ijarah. Profit and loss sharing modes of finance such as musharakah and mudarabah constitute only a small percentage of total investments.
THE DEMAND-SIDE VIEW OF THE IMPACT
Let us turn to where Islamic banks might be hit hard by the COVID-19 outbreak.
Figure 6 shows the sectoral distribution of investment of Islamic banks. About two-thirds of Islamic banking sector assets are concentrated in trade and commerce and working capital for industries. The majority of them are invested in the ready-made garments industry, which is severely disrupted by the pandemic. According to Bangladesh Garment Manufacturers and Exporters Association (BGMEA), work orders of about 634.8 million pieces of garment items from 729 registered garment factories, with an estimated value of $1.51 billion, were cancelled as of March 23, 20209. Islamic banks should be ready to embrace a serious financial blow from this sector.
On the other hand, 7.39% of the banks’ portfolios are doled to the cottage, small, and medium enterprises (CSMEs) while 1.53% is disbursed to the transport sector. These two sectors combine to make up about 10% of Islamic banks’ investment and are likely to be hit hard by the upcoming recession. Their operations have been completely shut down and cash inflows dwindled to almost zero. Islamic banks are likely to receive another blow from these sectors.
HIT TO FUTURE INVESTMENTS
The setbacks for Islamic banks resulting from COVID-19 are not limited to the assets which are already invested. Their future investment is also in jeopardy. For instance, about 30% of Islamic banks’ investments are allocated to meet the working capital needs of industries. The ongoing lockdown of major cities and the suspension of industrial production for an uncertain period result in limited demand for bank finance at present (figure 1) and the future.
On the other hand, banks’ operations have been reduced through closures of branches in high-risk areas, limiting operating hours, and restricting service provision. Moreover, neither the banks’ infrastructure nor their customer base is equipped with advanced technologies so that a significant portion of operations can be kept running. These constraints seriously diminish Bangladesh’s bank’s current and future earnings. Since banks cannot adjust their operating expenses temporarily in commensuration with the declining revenue, their bottom line is expected to turn red.
THE SUPPLY-SIDE VIEW OF THE IMPACT
While the demand (asset) side remains a great concern, banks are also not immune from supply (liability) side shock. In general, the saving capacity of the people of Bangladesh, like in other developing countries, is very limited due to low per capita income. The current crisis will narrow the existing low savings capacity further down. Households will hardly find savings to deposit in the banking system. Also, during the time of crisis households and businesses tend to turn their short-term and marketable assets (securities) into cash for a precautionary purpose10. These scenarios, along with banks limited deposit collection infrastructure are likely to create a negative pressure on banks’ deposits.
HOW FAST AND HOW FAR?
It is thus obvious that the Islamic financial sector is going to be badly affected. However, the questions are: how fast and how far?
Any sensible prediction at this point is not feasible as the effect of the pandemic depends clearly on how fast the virus can be exterminated.
On a positive note it can be said that unlike other business entities, the strike in the banking system is not likely to be immediate. The banks’ real scenario is expected to be revealed during the second quarter of the year. On the other hand, banks’ internal capacity, as well as the external regulatory and policy environment in which banks operate, will determine how far COVID-19 can damage the Islamic finance industry in Bangladesh.
WAYS TO WEATHER THE STORM
Unlike the 2008/9 global financial crisis, the financial sector has neither triggered the economic crisis nor can it do a lot to ameliorate the current worrisome situation. Still, it has to prompt some actions from within and then wait for suitable policy interventions from the state. Also, banks can appeal by their institutional capacity or with the cooperation of the state for international assistance.
EFFORTS FROM WITHIN
First, banks, as well as insurance companies, shall continue their normal operation as much as possible. However, the scope for insurance companies to operate during the crisis is much smaller than the banking sector because insurance in Bangladesh is still not extensively utilized as a risk-socializing strategy. As a result, the size of this sector is still very small.
These sectors have the opportunity to serve their customers without coming into physical contact. Here comes the role of technology.
Many service organizations are increasingly relying on technology for delivering their services. Banks can try to capitalize on this opportunity. In particular, mobile banking technology shall be highly encouraged. The mobile phone is widely used even in developing countries. Bangladesh can mobilize this particular device to render banking services. In so doing, they can request the government to increase the internet infrastructure to facilitate enough technological enablement. On a positive note, Islamic banks’ investment to deposit ratio is about 94% (table 1), which exceeds the allowable limit of 90%. Thus, a temporary halt of investment will drop the investment-deposit ratio to a recommended level.
Second, banks’ internal determinants such as equity capital, liquidity buffer, and the quality of assets are going to provide a lifeline for their survival during this tough time.
Bangladesh Bank, the central bank, has revised the statutory reserves requirements for both conventional and Islamic banks. According to the revised policy, Islamic banks are required to maintain an 11% statutory liquidity ratio (SLR) and cash reserve requirement (CRR). As of December 2019, the excess liquidity (total liquid assets – provision for SLR and CRR) of Islamic banks accounted for 48% of the required provision. On the other hand, the capital adequacy ratio (CAR) of six Islamic banks, which account for 90% of Islamic market share, averages 12.3%, which is close to 12.5% required by Bangladesh Bank to meet the BASEL III requirement.
These statistics show that the overall liquidity conditions of the Islamic banking sector in Bangladesh would provide it some buffer to absorb a short to medium-term shock of moderate level. Of course, not all Islamic banks are equally strong, and smaller banks are more fragile than larger ones. However, a long-term crisis will drain income away and seriously impair the asset side of balance sheets that may trigger a systemic bank run.
THE ROLE OF NATIONAL GOVERNMENT
Appropriate policy responses by the national government are considered the preconditions for mitigating the effect of the current uncertain economic situation.
Regulatory intervention, as far as the banking sector is concerned, should focus primarily on the asset side of the banks. The reduced economic activities have led to a substantial drop in income for households and businesses. For banks, this may mean an abnormal level of their investment may turn non-performing due to customers’ inability to pay their dues in time or not paying at all. Since banks only have adequate provisions for managing the average level of non-performing assets (NPA), the abnormal rise in NPA will create a tremendous burden.
Moreover, banks are unlikely to receive their regular income owing to the potential failure of many businesses or reduced scope of business activities. Until the normal flow of economic activities is restored, banks are certainly going to suffer.
Hence, government intervention should focus on returning to business-as-usual for business entities. In particular, business enterprises, especially SMEs, manufacturing, and export-oriented industries, should receive loans from the state at a substantially reduced rate and flexible terms. As the data shows, Islamic banks’ health is tightly tied to the ready-made garment industry, which is basically export-dependent.
In addition, the government should devise policies so that banks can adjust their balance sheets for unusual changes in assets. For example, a new NPA means that banks should maintain an additional amount with the central bank as a statutory reserve. This, in turn, will create a negative pressure on banks’ liquidity as well as their capacity to invest. In this circumstance, the central bank can allow Islamic banks with the privilege to reschedule the NPA until the crisis subsides.
Also, it is important for banks’ smooth operations that they hold enough liquidity and flow of funds. When households are left with barely any income during the time of COVID-19, they tend to exhaust deposit balances. Depository institutions are going to experience the squeeze of household deposits. Thus, to avoid a total disruption of the deposit channel, fiscal policy is likely to play a critical role. The government should earmark funds for households in dire need of cash. Also, the government should sponsor other developmental activities, especially where it is safe to work, so that circulation of money increases in the economy.
SEEKING ASSISTANCE FROM INTERNATIONAL DEVELOPMENT AGENCIES
We may prescribe various initiatives to be undertaken by the national government. However, the government’s capacity is constrained by limited available resources.
Fiscal deficit accounts for about 5% of the annual budget of Bangladesh. The deficit is financed through borrowing nationally and internationally. As per the recent statistics, the debt to GDP ratio of Bangladesh is not alarming, about 34%. Of the total debt, about 20% comes from domestic sources, mostly from the national banking system. The remaining 14% is borrowed from external sources.
For the fiscal year 2019-2020, a borrowing target of 773.63 billion takas ($9.1 billion) was set, of which 490.20 billion takas ($5.8 billion) (63%) was borrowed during the first half of the fiscal year, mostly from commercial banks. This proves that the local market is incapable of supplying huge resources required for tackling the impact of COVID-19.
Thus, the government should convince bilateral partners and international development organizations and donor agencies to extend their help. The International Monetary Fund, the World Bank, the Islamic Development Bank, and the Asian Development Bank can provide loans at zero or near-zero rates to developing nations to fight COVID-19 together. Also, some development assistance would be highly appreciated. It is to be noted that the crisis is global, not local; hence global coordination is quite essential.
The coronavirus outbreak is an extraordinary situation that has already affected economic activities so much that the resulting economic recession is ‘similar to none’.
It is almost impossible to predict the economic consequences of the pandemic because of its sheer uncertainty. Like other sectors in the economy, the Islamic financial sector is also going to be affected seriously, and the concern is more for banks because they are highly leveraged. Thus, regulatory authorities and policymakers should adopt necessary policies to alleviate the gravity of the impact. This article has attempted to project, in the context of the Islamic financial sector in Bangladesh, the possible ways and means available to financial institutions, regulatory authorities, and the international community that can be furnished for taming the impact of the crisis. Based on the discussion, the following recommendations can be offered:
- Islamic banks and takaful should keep rendering their valuable services as much as the on-going circumstance permits. Of course, this will require to draw a cautionary line of safety for employees and customers. As mentioned earlier, banks and insurance companies should utilize the available technology and infrastructure to materialize their full benefits. If the additional infrastructure is required that can be provided in the short run, in particular strengthening internet facilities, banks can appeal to the government to provide the required infrastructure.
Due to some issues that had plagued the financial sector before the pandemic hit Bangladesh, some regulatory changes and banks’ efforts facilitated the building up of Islamic banks’ capital buffers and liquidity cushions that will surely help banks to withstand the storm to some extent. However, banks have to be very cautious in utilizing these assets. They have to properly preserve liquid assets as new NPAs are expected to rise. If necessary, they should suspend paying cash dividends for the recent accounting year.
The immediate asset-side impact for insurance companies will be the loss of investment value due to the decline of major securities markets. An early assessment of potential risk-exposure will help them to strategize future moves. Like banks, insurance companies should also think of deferring cash dividends because failure to honor the policyholders, in case the stated incident happens, will create a ripple effect in the economy and lead to bankruptcy.
Given the nature of the problem, the government’s monetary and fiscal incentives are very essential. Since the impact is not confined to any specific sector or area, monetary and fiscal policies are the prerequisite for fighting the crisis. Among monetary policies, conventional tools including a rate cut, quantitative easing, and tax rebate are to be put in place. At the same time, fiscal stimulus, to increase the circulation of money in the economy, should be planned.
Banks should be allowed to reschedule impaired investments until the situation becomes normal. This will reduce the pressure from banks, in particular, from classifying new NPA and maintaining additional risk-adjusted reserves. At the same time, it will buy additional time for banks’ customers to repay their dues.
In a dire situation, if depositors flock to withdraw their savings from the banking system that may leave a bank in a liquidity crunch, the central bank can buy bonds to increase liquidity. As a first step, the central bank can purchase commercial banks’ liquid assets excess of SLR and CRR. Moreover, SLR and CRR can be reduced so that banks’ investment capacity is enhanced. Besides, the government should act to convince people that any sort of financial panic is uncalled for. Depositors need to be assured that there is no shortage of liquidity in the banking system and appropriate measures are already put in place to keep the health of financial system sound. This confidence is highly essential in a situation like the current one to ensure that citizens behave rationally. An irrational panic, once it engulfs the society, can turn deadlier than the pandemic itself.
Given the limited capacity of the national government in terms of fiscal spending, development organizations such as the Islamic Development Bank, IMF, and World Bank can extend their direct assistance to increase the financial strength of developing countries. These organizations can offer loans at zero or near-zero rates to national governments.
The full e-book, "Impacts of the COVID-19 outbreak on Islamic finance in the OIC countries" is available as a pdf download from HERE. The e-book is published by Indonesia's Islamic Finance and Economy Committee (KNEKS) in partnership with DinarStandard and Salaam Gateway. It was launched on May 27, 2020. The 12 countries covered are: Bahrain, Bangladesh, Brunei, Indonesia, Iran, Malaysia, Nigeria, Oman, Pakistan, Saudi Arabia, Turkey, and UAE.