"Although there are some important differences between Islamic and conventional banks that must be properly understood and considered, these can be incorporated within the existing rating framework," Fitch states in its March report, "Islamic Banking - factors in risk assessment."

Fitch refutes the belief held within parts of the Islamic banking sector that conventional rating agencies do not fully understand and appreciate certain aspects of Islamic financial institutions, principally the fiduciary aspect, and that a different approach to capital adequacy calculation and accounting standards is required. It emphasises this point by saying that some regulators assess Islamic banks on the same basis as their conventional peers.

Nonetheless, Fitch agrees that there are a number of areas where an Islamic financial institution differs from a conventional one and that these differences need to be taken into account. They can still be incorporated in a conventional rating framework, however.

The differences lie primarily in the assessment of risk management, funding and liquidity. But the adoption of uniform accounting standards, a robust regulatory and operating environment and a good corporate governance structure are also areas where major differences often lie.  

Analysis of a bank's financial performance and its operating environment follow Fitch's normal rating assessment criteria, the report explains. Assessing the breadth and depth of a bank's franchise is important. This is typically determined by a bank's size — in other words, the larger the bank the broader the franchise — and its product range. In this respect, because Islamic banks are generally smaller and more localised than conventional banks they do not have the leverage that size can give a larger bank and growth prospects can be reduced accordingly.  There are significant exceptions of course such as banks in Iran, Sudan and Pakistan where the entire banking system is Islamic.

Islamic banks can also suffer from the inability, or unwillingness, to innovate and diversify. According to the report: "The constraints imposed by Shariah law on Islamic banking mean that management arguably needs to be more creative than that of conventional banks in order to develop product variations that enable them to compete with their conventional peers."

Despite these concerns, Islamic banks have performed well, Fitch notes and praises the high levels of profitability achieved by many — even prompting conventional banks to enter into Islamic banking. 

Fitch cites three reasons for Islamic banks' profitability. The first is a benign operating environment. Most Islamic banks are based in oil producing countries, which are enjoying high oil prices, robust GDP growth, low interest rates and positive consumer and business sentiment, the report states.

The second reason is that margins on some Islamic finance products tend to be high, "partly reflecting the lack of pricing transparency but also limited competition (at least until now)", states Fitch. The third reason is that a significant amount of an Islamic bank's funding comes from interest-free customer deposits, which typically lowers the cost of funding and boosts the bank's net profit margin, "although it leaves income vulnerable to falling asset yields".

Looking ahead, Fitch considers that the high margins enjoyed by Islamic banks could fall, but believes that "continued growth in demand for Islamic finance is likely to mitigate this".

Assessing the risk management function in an Islamic bank is more complicated, although the credit risk management function is essentially no different to that of a conventional bank, argues Fitch. There are three types of risk: credit risk, market risk and operational risk.

"There needs to be a clear distinction between risk management and the Shariah board," maintains Fitch. And "a Shariah board should not involve itself with the actual granting of credit," it states.

As for market risk, an Islamic bank will often argue that it is not exposed to interest rate risk, but "the reality is that an Islamic bank has to price its products competitively. Its 'commission' received and paid will therefore be based on interest yields even if this is not explicitly stated," states Fitch.  "Maturity and repricing gaps will occur in Islamic institutions for the very same reasons as they exist in conventional banks and these need to be recognised and assessed," the report continues.

The report also looks at funding.  The cost of funding is important for all banks and Islamic banks, in particular, can benefit from lower cost of funding than their conventional counterparts. But because the "contractual tenor of those deposits is short-term, the banks remain exposed to maturity/liquidity risk. In other words, in times of crisis the bank may witness substantial withdrawals," Fitch points out.

Islamic banks can also find it difficult to raise long-term funding to match their long-term assets, magnified by the fact that long-term capital markets in most Islamic banking systems are undeveloped, explains Fitch. And although securitisation can be another form of long-term funding, "significant legal hurdles need to be overcome before securitisation can be a feasible source of funding for Islamic banks," according to Fitch. The lack of liquidity, or a fully integrated Islamic financial system, is another problem confronting Islamic banks, it adds.

When it comes to transparency and disclosure there is no fundamental difference between Islamic banks and conventional banks, argues Fitch. But because many Islamic institutions are based in emerging markets where data tends to be less reliable than in developed countries any efforts to improve disclosure must deal with this underlying issue.

Fitch expects however that "Basel II and IFRS changes will act as catalysts to drive improvements in the quality and consistency of disclosure by Islamic institutions over the next few years".

Assessing the strength, or otherwise, of Islamic financial institutions would also be made easier if there were uniform accounting standards "in a relatively immature and fragmented Islamic banking industry", Fitch maintains.

The quality of supervision and regulation is also very important when assessing a bank's financial strength, including not only the strictness of the regulation but also the willingness and ability of the authorities to assess them. One concern is that Islamic banks are often "domiciled in countries that display weak economic fundamentals and/or potentially volatile operating environments". Another, according to Fitch, is that, "emerging markets also pose a number of other risks which are difficult to analyse, such as bureaucracy, corruption, cronyism, fraud and organised crime."