Moody's Investors Service says that the ratings of entities in the fast-growing Islamic banking sector are stable, largely thanks to their ample liquidity, high profit margins and conservative leveraging. Nevertheless, Moody's cautions in its latest report on the sector that future upgrades may be constrained by issues relating to Islamic banks' under-utilised excessive liquidity, inadequate corporate governance and weak risk management, particularly in terms of the handling of asset-liability maturity mismatches. Moody's new Special Comment, entitled “The Liquidity/Leverage Trade-Off for Islamic Banks”, evaluates the liquidity and leverage trade-offs for Islamic financial institutions (IFIs) in a changing environment and assesses the impact that this exchange will have on their ratings. “IFIs have traditionally demonstrated low leverage for religious reasons, but also because of their very profitable assets, cheap deposits and high levels of core capital. However, the resulting reliance on concentrated short-term liquid assets to finance liabilities means that Islamic banks' balance sheets are deficient in medium- to long-term funding instruments,” said Anouar Hassoune, Moody's vice president -senior credit officer analyst. The Moody's-rated Islamic banks that are based in Gulf Co-operation Council (GCC) typically have C to E+ bank financial strength ratings (BFSRs) and A1 to Baa1 global local currency deposit ratings. The relatively low BFSRs reflect the banks' strong dependence on qualitative, or non-financial, factors, the scores for which capture the IFIs' unsteady operating environment, constrained risk positioning and weak franchise value in comparison with those of peers. “IFIs benefit from abundant liquidity, which is a very positive factor in an economic downturn. However, if such excessive liquidity is left underutilised, the lack of an innovative range of assets could slow growth during an economic boom,” Hassoune said. In the context of Moody's ratings, liquidity is usually a credit strength because it provides a financial institution with surplus cash to use as a shock absorber against potential future shortages relating to obligations and investments. Most IFIs in the GCC region have been able to use their surplus liquidity to aggressively boost deposit volumes and thus swell their market shares by growing lending volumes, while also maintaining their focus on the retail and corporate sectors. Moody's notes that securing funding has been relatively easy for IFIs because of the market perception that they will be more resilient to the global credit turmoil than their conventional peers, largely because Shariah supervisors forbid investment in highly leveraged structured instruments or global investment banks' shares. However, the ample liquidity of Islamic banks is not without its drawbacks. IFIs are grappling with risks associated with liquidity, balance sheet management and overall risk monitoring, all of which represent constraints on their ratings. __
