Banks in distress present a threat to orderliness and stability in financial markets. Left unresolved, users and providers: Islamic Financial System Assignment, LU, Malaysia

University LimKokWing University (LU)
Subject Islamic Financial System

Banks in distress present a threat to orderliness and stability in financial markets. Left unresolved, users and providers of funds in distressed banks quickly respond to uncertainty, rumors, and loss of confidence–all combined in precipitating a run on depositors’ funds. Evidence suggests that during bank runs, depositors fail to distinguish between good and bad banks (Hasan & Dwyer, 2007; Chen & Hasan, 2008).

This behavior was exemplified in the collapse of Islamic Bank Ltd (IBL) in South Africa in 1997. Associated with this failure was the seriousness of the bank run on muÌÉrabah-contracted deposits first occasioned by noise, then opaque operational information, lack of confidence, and finally contraventions of law, dodgy accounting, poor operational practices, and SharÊÑah non-compliance.

The result of IBL’s collapse showed up in reputational damage to the nascent development of Islamic finance in that country (Loonat, 2004). Its failure was not occasioned by a lack of faith in Islamic finance, but by a lack of good governance and management practices revealed in the South African Reserve Bank’s (SARB) Inspectors’ Report (IR).

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Reacting to rumors, IBL management unconscionably assured that depositors’ savings were safe while the opposite prevailed. The bank’s largest SharÊÑah attenuation was accumulating ribÉ-based property debt which, weighed against its heavy promotion of SharÊÑah compliance, was at odds with its own ethical charter and public image.

This paper presents evidence of the causes and consequences of the bank’s collapse. The next section deals with a review of the literature on bank failure with a focus on experiences in South Africa. Thereafter follows a discussion on methodology and data. Finally, empirical evidence is presented together with a discussion of the implications of bank failure for Islamic finance.

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