Calculating hyperinflation is ‘top priority’ for Islamic banks

Reuters

• Sharia-compliant accounting to calculate impact of hyperinflation
• Turkey’s inflation hit 85.5% and lira fell over 90% against dollar
• Islamic finance must decide who should take hyperinflation loss
• Previously a bank’s sharia board authorised shareholders to cover loss   

Islamic banking’s top rule maker is racing to create a new accounting standard to calculate the impact of hyperinflation.

Changes to sharia-compliant accounting practices could make some account holders liable for banks’ losses related to soaring prices. 

Under IFRS accounting standards, which are commonly used worldwide, there is a clause, IAS 29, that covers hyperinflation. This requires companies whose functional currency is suffering from hyperinflation to redo their financial statements to reflect the declining purchasing power of that currency. 

This has become an issue for Islamic finance as Turkey’s inflation spirals out of control. Annual inflation hit a 24-year high of 85.5 percent in October, while the Turkish lira has fallen more than 90 percent versus the dollar since the start of 2013.

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Gulf banks with Turkish subsidiaries such as Dubai’s Emirates NBD, Qatar National Bank and Kuwait Finance House (KFH) have started reporting their units’ financials under IAS 29 after Turkey’s cumulative inflation topped 100 percent over three years, a common definition of hyperinflation. 

Consequently, these banks recorded about $950 million of net monetary losses in the first half of 2022, according to a Fitch report that notes Emirates NBD and KFH were the most affected with these losses wiping out more than 15 percent of their respective operating profits for the period. 

“We expect further net monetary losses” in the second half of 2022 and full-year 2023, Fitch wrote. These losses will gradually decline as Turkish inflation slowly eases, the ratings agency forecasts. 

Yet the application of generally accepted accounting principles for hyperinflation is not compatible with the standards of Bahrain’s Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the industry’s leading rules setter. 

The non-profit is in the midst of developing a financial accounting standard that covers hyperinflation, said Mohammad Majd Bakir, director of professional standards development at AAIOFI.

“If all the stages of the due process are followed without any undue delays, the standard will be rolled out in 2023,” said Bakir. “As an item on our agenda, it is now top priority.”

The lack of a sharia-compliant version of IAS 29 poses difficulties for Islamic banks because they cannot show the impact of hyperinflation on their accounts, said Mohamed Damak, S&P Global Ratings senior director and global head of Islamic finance.

“The challenge in Islamic finance is when there’s a loss or gain because of hyperinflation, who should take that?” said Damak.

“Would it be the shareholders, similar to what happens in conventional banking? Would it be the profit-sharing investment account holders? Would it be the hybrid instrument holders?”

He added that it could be a combination of these parties, depending on their participation in the bank, the amount of deposits they hold, or which assets have been impacted by hyperinflation.

“What’s required is something similar to IAS 29 – investors need to know the impact on Islamic banks with operations in countries suffering hyperinflation.

“Islamic banks reporting under AAOIFI are clearly at a disadvantage versus banks that use IFRS. Ultimately, this is what the standard setting body is trying to resolve.”

In hyperinflationary environments, banks will usually suffer a decline in their monetary position – their profits are worth less in real terms – but enjoy a gain on their non-monetary assets such as real estate.

In the first half of 2022, Turkish Islamic banks covered by S&P Global, and which use IFRS accounting standards, showed a decline in their net profit to reflect the effects of hyperinflation. Yet the gains they made from the value of their non-monetary assets were larger.

“The impact was manageable,” said Damak.

Bahraini bank Al Baraka Group, which owns 45.1 percent of the sharia-compliant Al Baraka Turk Participation Bank and follows AAOIFI’s rules, highlighted its inability to account for Turkish hyperinflation. 

Al Baraka Turk is one of Turkey’s six Islamic – or participation – banks. These lenders owned 7.8 percent of Turkish banking sector assets as of December 31, 2021, according to a May report by Fitch Ratings. The sextet also held 10.5 of deposits and 6.9 percent of loans. 

As of 2020, Turkey’s six Islamic banks had Islamic assets totalling $58 billion, ranking them ninth worldwide. 

Holders of profit-sharing investment accounts at Islamic banks should take a portion of the losses if the underlying assets generate a loss.

Yet the Islamic finance industry has mechanisms to prevent such action, with one option to smooth profit volatility by deploying profits from boom years to bolster bank earnings during leaner times.

“Previously, when there has been a big loss, a bank’s sharia board has authorised shareholders to cover the loss on behalf of the profit-sharing investment accounts holders to avoid any potential negative impact on the liquidity position of the bank,” Damak said.