Sunday, January 30, 2011

The impact of a run on an Egyptian Islamic bank

Bloomberg reports:
"Egypt’s banks may risk a surge in customer withdrawals when they open for business, placing them among companies worst hit by the nationwide uprising against President Hosni Mubarak."
"Central Bank Governor Farouk El-Okdah said in a telephone interview Jan. 29 that his bank has $36 billion in reserves, enough to accommodate investors should they wish to withdraw funds. His deputy, Hisham Ramez, said interbank lending “will function properly” when banks are reopened. He said the security situation will determine when that is possible."

"Asked about the risk of a bank run, Mohamed Barakat, chairman of state-run Banque Misr and head of the country’s banking association, said in a telephone interview that Egyptian lenders are “very liquid,” with average loan-to-deposit ratios of 53 percent."
"The Egyptian interbank offered rate, the rate banks charge to lend to each other, is at a 16-month high of 8.5 percent."
Despite what I thought, there are several Islamic banks operating in Egypt: Faisal Islamic Bank, Al Baraka Egypt (Al Ahram Bank) and Abu Dhabi Islamic Bank NBD (formerly National Bank for Development). Al Watany Bank of Egypt also has an Islamic window. There may be others as well, but it is at least present in Egypt and the risks of a run on the bank should concern those interested in Islamic banking around the world because it could provide a test of how resilient Islamic banks really are to crisis.

What I mean is that the Egyptian situation, which could be a fantastic opportunity for the Egyptian people, could expose a weakness within the Islamic banking industry if it is problematic. The main risk to any bank is that there is a run and the bank cannot meet depositor withdrawals with the cash available on hand. This forces the bank to raise cash from other means. In most cases, it can either get an inter-bank loan from another bank overnight that allows it to handle withdrawals. If other banks are hesitant to lend to a given bank because of fears of asset quality, then the bank will usually have access to an overnight borrowing facility with the central bank, which operates as the lender of last resort.

If neither of these options are available, the bank will have to try to raise funds by selling its assets, most of which (loans) are illiquid in the short run. It will have to take a loss on the sale to realize the cash it needs to meet withdrawals. If this continues and the bank sells enough assets at a discount to the value they are held on the balance sheet, the bank's equity will be negative (the value of assets minus liabilities) and it will become insolvent (having earlier only been illiquid). This is the fundamental danger in banking from a financial stability perspective. If enough banks face runs and have to sell assets, the run could become self-sustaining and contagious. Even a healthy bank facing a run can become insolvent.

The key for Islamic banks is that they are not able to take advantage of the inter-bank lending market, nor are they able to borrow from (or lend to) the central bank because those loans are interest-bearing. The only alternative is to find other banks (mostly Islamic banks) willing to extend Shari'ah-compliant, bilateral loans often using commodity murabaha. In a country like Egypt where the Islamic banking industry is a small portion of the total banking system, it does not create a systemic risk if Islamic banks fail, but it does matter a lot to the depositors of other Islamic banks in the country and globally. If there is the potential that a run on an Islamic bank will not be stopped by someone; whether that is a foreign bank, a multi-lateral bank like the Islamic Development Bank or the central bank of Egypt (through emergency measures), then it could hurt confidence in Islamic banks.

The loss of confidence is more than just a reputational hit and a hit on the egos of Islamic bankers. It would make it more difficult for Islamic banks to attract and retain depositors and it could raise the cost at which it can attract depositors. This would make the bank, all other things equal, less profitable (it makes profit of the spread between the return on invested funds and the cost of funds borrowed from depositors). Lower profitability will lower the attractiveness of Islamic banks to equity investors limiting their ability to increase capital through equity offerings (or at least increasing the dilution to current shareholders). It will lower the amount available to supplement capital as well as pay dividends to its shareholders.

Therefore, it is important that the Islamic banks in Egypt make it through the 'run' that is predicted if it materializes, not just for those banks' shareholders, but also for the Islamic banking industry. I have laid out the negative case (the "worst case"). This scenario also has an opportunity for Islamic banks; if Egyptian Islamic banks make it through the crisis unscathed, it will lower the perception of risk associated with Islamic banks in terms of their ability to meet high volumes of depositor withdrawals in a crisis. However, it remains to be seen which outcome materializes in Egypt. I'm watching; you should too.

Monday, January 24, 2011

Can Western corporates take advantage of sukuk?

The news that the UK government will not issue sukuk because they don't offer "value for money" is not surprising. A similar conclusion was reached earlier and it has been nearly four years since the government issued its report on the possibility of issuing sukuk. However, I agree with John Sandwick, who is quoted by Bloomberg: "This will discourage other governments from selling sukuk[...]If the U.K. says that sukuk aren’t value for money, it’s likely other governments may reassess their positions, and the number of sovereign issuers new to Islamic finance may drop."

It is a continuation of slower growth back in the sukuk market outside of Asia, where much of the recent issuance has come from. The idea of taking advantage of the latest hot trend in finance (which Islamic finance was in 2006 and 2007 and even into the first half of 2008) is no longer the biggest appeal post-recession where finance is more difficult to come by for all issuers, including some sovereigns. This focus on value for money is not necessarily a negative for Islamic finance because it should force the industry to develop more standardization in the lower-cost 'basics' like ijara.

The movement towards more simplified sukuk will put the focus on attracting new, quality issuers and will make it appear less imposing to issue sukuk compared with conventional bonds. With continuing liquidity flowing into the GCC, this will generate some additional demand for sukuk, so long as investors do not become wary of the sukuk structures used. This further supports the move towards less complex sukuk. The opportunity may not be missed as well as the International Islamic Financial Market is reportedly working on a standardized asset-backed sukuk master agreement to simplify issuance (and reduce costs for issuers).

This is a very positive development for Islamic finance. Before the crisis, the focus was on creating the next new sukuk structure; pre-IPO, convertible, etc. These were great in terms of generating publicity for the structuring firms and the issuer (as well as significant fees), but it did not facilitate easy understanding of how Islamic finance worked among new issuers. They could be assured that innovation was continuing, but not that this innovation was creating value for them if they chose to issue a sukuk.

The ultimate issue for Islamic finance investors is that there remains a stark lack of diversity among issuers in quality, geographical location and the term of the sukuk (most are under 10 years with a majority maturing in 5 years). The investors are not given the opportunity to diversify their holdings, which makes the fixed income component of their portfolio hard to fill and may lead them to substitute this portion through conventional bonds, cash, short-term placements using wakala or murabaha, or real estate. They are looking for diversification and this requires more than just new issuers from the GCC and Malaysia.

This presents an opportunity for Western issuers with solid balance sheets to tap a new source of liquidity and diversify their funding sources. However, unless the structure used is simple, affordable and legally secure (for both investors and issuer), it will be difficult to convince them to tap a market that is unfamiliar when these companies can issue conventional debt locally at low spreads over Treasuries. It is not, however, an impossible task. Gatehouse Bank and Bank of London and the Middle East each say they will facilitate the issuance of GBP200 million for European issuers. GE Capital, which issued a sukuk in 2009, is planning another in 2011.

The GE Capital sukuk (for which I provided a brief summary) was notable in that it converted conventional airplane leases to be Shari'ah-compliant by stripping out non-conventional aspects (payments from which were donated to charity). These sukuk were eventually unsecured debt (asset-based), but a similar method could be used to broaden the assets which could be used for asset-backed sukuk.

There is much to be done to make sukuk less of a foreign concept and to reduce the costs to issues, but global (particularly Western) corporate issuers could provide a boost to sukuk issuance and also provide needed diversification for investors.

Wednesday, January 19, 2011

The role of structured products in Islamic finance

Bloomberg reports that the International Islamic Financial Market (IIFM) is working on a master agreement for derivatives, according to the IIFM CEO Ijlal Ahmed Alvi. The article then goes on to describe Islamic structured products that are having some difficulty meeting international (as opposed to simply local) standards. Structured products combine a debt security with a derivative to provide, for example, returns based on an index performance combined with capital protection. These products are fairly common across the Islamic finance industry and financial institutions like their high fees, while investors may be attracted to the capital protection embodied in them.

However, I think they should be of limited use in the industry because they provide limited benefit to investors (although good returns to the financial institutions offering them in terms of high fees) and are, in my opinion, representative of the worst of financial replication of conventional products in Islamic finance. These products offer the promise of equity-like returns with debt-like risks. The risks of their debt characteristics is understated through claims of "capital protection"; generally these products will only be as safe as the debt offered by the institutions offering these products (or their counterparties in the commodity murabaha products that sit alongside the derivatives that provide the equity returns). It may be that the popularity of these products is due to the lack of debt-like alternatives (e.g. sukuk) for asset managers to diversify across asset classes. Instead of investing in (cheaper) sukuk funds, managers are forced to find quasi-debt investments that also give equity returns.

The reason that I find structured products objectionable is that they hide the risks of debt products with the "capital protection" (I believe they are generally unsecured debt), while generating high fees for the issuer, which can hedge the risks of paying out the upside gains through derivatives. They replicate the most cynical aspects of conventional finance (creating fancy products that generate high fees) with little benefit to investors except providing debt-like protection of capital. In my opinion, the investors would be better off using an equity investment like a mutual fund or managed portfolio of equities balanced with a fixed-income investment through a diversified portfolio of sukuk. However, it is difficult to compose a diversified portfolio of high-grade sukuk. Therefore the appeal of structured products.

Perhaps I am cynical about the rationale for structured products generally in finance. However, they don't seem to serve much purpose except where fixed income markets are lacking. For conservative investors, they would be better suited in lower-fee sukuk funds or deposit accounts at Islamic banks. Non-high net worth investors would be better served by a balance of either Islamic mutual funds or individual equities and sukuk funds. High-net-worth individuals have the resources to invest in diversified portfolios of both equities and sukuk (in addition to some alternative assets). Hiring managers within each asset class is surely a lower cost method of investing than structured products. This even omits the role that Islamic ETFs (if they were prevalent) could serve for investors just wanting to track the benchmarks with some diversification.

The IIFM has done some good work standardizing commodity murabaha contracts (the Master Agreement for Treasury Placements) and with the planned master agreement for asset-backed sukuk. Even the derivatives master agreement (Tahawwut) which has attracted criticism is valuable because Islamic banks, like other conventional financial institutions, need to hedge against currency and interest rate fluctuations (and other companies need to hedge commodity price fluctuations). However, tailoring standardized documents designed for structured products is not going to provide much benefit to the industry as a whole. It may lower costs, but that is unlikely to lower costs to issuers, but these probably will not pass through to investors who are charged high fees in conventional structured products as well.

As much as the sukuk structures are criticized for replicating conventional bonds, they at least serve a primary purpose in most, if not all, portfolios as fixed income replacement. The same cannot be said for structured products, which I suspect are favored by financial institutions for their high fees with little regard for whether they add much to the end client's portfolio.

Tuesday, January 18, 2011

US court dismisses lawsuit about AIG's takaful business

A Michigan court dismissed a case filed against the US government challenging the permissibility of the Federal assistance provide to American International Group (AIG) on the basis that AIG provided Islamic financial products and therefore the assistance violated the First Amendment of the US Constitution, which prohibits the government from engaging in the establishment of religion. The case ultimately revolved around the size of AIG's takaful business, which the Court noted accounted for only 0.022% of total revenues in 2009; the subsidiary which offers takaful in the United States generated 0.0006% of its revenue from that product in 2009. The case was filed on behalf of Kevin Murray, a military veteran, by the Thomas More Law Center, a right-wing Christian legal organization. When I inquired in 2009 after the plantiff's standing to proceed with the case was upheld, Dr. Robert Tuttle, a Professor of Law a George Washington Law School and expert on Establishment Clause cases, expressed doubts that it would succeed.

The Court reviewed the financing provided by the US government to AIG, but excluded $40 billion in preferred shares that were used to repay debt owed by AIG to the Federal Reserve Bank of New York, leaving only the $30 billion extended under the Emergency Economic Stabilization Act (the TARP), of which $7.5 billion had been drawn on by AIG by February 2010. AIG was required to certify the uses of the funds provided by the US government. The plantiffs in the case argued that the AIG bailout was undertaken with the purpose of advancing religion because AIG was provided funds "to support all of its activities" including Islamic finance (takaful).

However, the court decided that the TARP legislation and the AIG bailout was created for a secular purpose (preventing the collapse of the financial system) and relied upon the small share of total revenue generated by Islamic finance by AIG to support its case in this case. The Court also rejected the claim by the plaintiffs that the TARP bill led to the government taking control of AIG, which included its subsidiaries that offer Islamic financial products noting that "the Trust [which holds ownership for the benefit of the Treasury department] was established by actions taken pursuant to Section 13(3) of the FRA [the Federal Reserve Act]--not the EESA [the TARP]". Section 13(3) of the Federal Reserve Act allows the Federal Reserve, which gives the Federal Reserve Banks the power to intervene in unconventional ways under "unusual and exigent circumstances".

In this claim which was based on the government being entangled with AIG's Islamic finance business by virtue of the financing it provided, the plaintiffs argued that the case is similar to the government providing grants to religious organizations and used their expert witnesses to attest to what they consider the insidious aspects of Islamic finance, which the Court found was irrelevant because it did not address AIG's takaful business specifically. The Court also noted that "Plaintiff cannot defeat Defendants' motion for summary judgement, or prevail on its own, but arguing that the evidence in support of his claim is so overwhelming that he need not present any [evidence] to the Court".

In addition, the Court found no evidence to meet the other ways in which the government could be entangled based on AIG's offering of takaful products; in order to do so, the organization would need to be primarily 'sectarian' (i.e. provide a primarily religious mission) or the government funding would have to fund religious teachings directly. In the other claim for excessive entanglement between the TARP funds and AIG's takaful business, the court ruled against the plaintiffs on the basis that the plaintiff's ceded the point by declining to provide evidence and failure to respond to the US government's arguments against their claim.

Finally, the plaintiffs claimed that the Treasury Department had given its stamp of approval to Islamic finance by publishing a paper on by Dr. Mahmoud El-Gamal on Islamic finance, by creating the position of scholar in residence, which was held by Dr. El-Gamal, by having a member of the Treasury Department speak at the Harvard University Forum on Islamic Finance and by holding an "Islamic Finance 101" conference. The Court found that, in addition to those events being held prior to the TARP legislation, they did not "show that the government favorably endorses Sharia-based Islam or religion in general" and that it was permissible for the government to endorse an educational message relating to religion citing previous court rulings permitting using the Bible for the "study of history, civizilation, ethics, comparative religion, or the like".

The case is significant for Islamic finance in the US because it demonstrates that not only did the Islamic finance activities of AIG when it was under majority ownership by the government not pose a threat on grounds of money laundering or the financing of terrorism, it did not violate the establishment clause. The former was not mentioned in the order, even as the Thomas More Law Center, which brought the lawsuit, cited as justification for the lawsuit that "in abetting the spread of Sharia-compliant financing, AIG and the federal government are abetting the same legal system that motivated the murder of nearly 3,000 Americans on 9/11". This case should have been the spotlight for Islamic finance if it were engaged in illegal practices because the plaintiffs were arguing that not only was AIG supporting Islamic finance, but the government was by virtue of its ownership of nearly 80% of the company. However, there was no finding that Islamic finance had led to support of any illegal acts and beyond that, the government's actions did not violate the Establishment Clause.

This won't stop the echo chambers that are the anti-Islamic finance movement from continuing to spread their baseless claim that Islamic finance supports illegal activities including terrorism, but it does discredit their claims substantially. If there were any untoward activities in Islamic finance, this would have been the ideal forum for this group and its supporters to make it. The judge's order did strike at the heart of one of their main "arguments": that non-permissible income that is donated to charity is used to support charities promoting violence or proselytizing. The judge noted in a footnote that Lexington Insurance Company, which offers a "takaful homeoners policy", "a certain percentage of the net surplus, if any, derived from the collection of premiums is paid out to either the National Children's Fund or the International Federation of Red Cross & Red Crescent Societies [...] selected precisely because they lack religious affiliation".

In the best case scenario, this ruling could provide support to US financial institutions involved with Islamic finance, whether or not they received or have outstanding loans from the TARP fund. It demonstrates that the US courts view Islamic finance as "just another business", as they should. It also supports the precedent from the East Cameron sukuk case that Islamic financial products will be judged by US courts on their merits as financial products, and not on the basis of the religious and ethical grounds for their orgination. In my opinion, the Establishment clause is important both because it limits the ability of the government to favor one religion over another, but also because it limits the ability of groups hostile to one religion or another from using the cudgel of litigation to limit the freedom to shape individual's choices based on their religious beliefs, even where these are expressed by demanding products from large financial institutions that may be bailed out by the US government from collapse based on their other business activities. This should be supportive for Islamic finance in the US because it moves the focus--both in the legal and regulatory sense--from the religious arguments to the practical arguments. How does Islamic finance work as a financial product? Is it fair to consumers? How does its structure fit in with the regulations and laws of the US? This is where Islamic finance belongs in its relationship with secular governments and it should also move the discussion among lawmakers and regulators from the "Islamic" aspect to the "finance" aspects.

The court's ruling is here
The plaintiff's lawyer's long paper on why Islamic finance is a legal risk can be downloaded here

Wednesday, January 12, 2011

IIFM working on sukuk master agreement

According to Khalid Hamad, chairman of the IIFM in an interview with Arabian Business, the International Islamic Financial Market (IIFM) is considering issuing a master agreement for asset-backed sukuk in the next 12 to 18 months. This would be a significant step for the industry, which has until now relied heavily on asset-based sukuk.

The main difference between the two is similar to the difference between unsecured and secured debt. Asset-based sukuk use an asset (e.g. in a leasing transaction for an ijara sukuk) to create the stream of coupon payments to investors. However, they give the investors only beneficial (in contrast to legal) ownership of the asset through an SPV and are generally guaranteed by the issuer (which is responsible for lease payments and retains legal ownership of the asset).

I have occasionally thought that the asset-based structure is misleading to investors, especially when coupled with the cheerleading about how Islamic finance generally is "asset-backed", in contrast to conventional finance. The offering circulars for asset-based sukuk are clear with regards to the investor's rights to recourse against the underlying asset: they don't have any. However, the industry has not dissuaded the media from repeating the idea that Islamic finance is based on tangible assets rather than just debt. In asset-based structures, the sukuk are nothing more than a re-structured debt; the issuer's full faith and credit is all that stands behind these instruments. There is no asset except to characterize the relationship between borrower and creditor; it is an unsecured transaction.

It is always better that investors are clear about their rights in a financing transaction like a sukuk, so the IIFM master agreement should make it easier to issue asset-backed sukuk that do give investors recourse against the underlying asset. However, this is not sufficient to cure the deficiency in the asset-based sukuk space. The industry needs to make it more transparent that there can be secured and unsecured transactions in the sukuk market.

There is nothing inherently wrong with an unsecured obligation through a sukuk. In fact, the disguised asset backing of asset-based ijara sukuk may discourage other forms of sukuk that are favored by some (e.g. mudaraba and musharaka) because they are not backed by (or based on) an asset. Why would an investor choose to invest in a mudaraba sukuk with a similar coupon, risk profile and rating as an ijara sukuk if the returns on the former are just based on the success of a risky enterprise whereas the latter was based on rent paid on a building? After all, the building is a tangible asset that should make payment more likely than a business venture lacking an asset.

However, a careful reader of the ijara sukuk offering circular would notice that the ijara sukuk does not transfer any ownership of the asset; only the right to receive rental payments from the issuer for the use of the building. The final redemption payment is entirely based on the issuer's ability at that time to repurchase the beneficial ownership of the building (which is based on the underlying issuer's ability to generate free cash flow). Is that as different a risk profile from a mudaraba sukuk which (under the new AAOIFI rules) can force investors to take a loss on the underlying business? If the business cannot generate free cash flow, the investors in both sukuk will have their principal at risk; the underlying asset does not factor much into the risk analysis for the investor. Yet ijara sukuk have nearly captured the sukuk market.

If the IIFM issues a master agreement that makes asset-backed sukuk easier to issue, I would hope that more ijara sukuk would be issued in an asset-backed framework and the unsecured sukuk would be issued using a mudaraba (or musharaka) structure. That would make them more coherent from an operational perspective[1]. In an ijara you lease an asset you own to someone else; in a mudaraba or musharaka, you invest funds in a business without recourse to the business unless it is wound up in bankruptcy and your return can be smoothed out using reserve accounts over a specified period until you are bought out (redemption). It would also give a clearer difference to investors about their rights rather than the somewhat opaque asset-based versus asset-backed distinction used today.

[1] Note: This is a generalization as it ignores the differences between leasing assets for use versus using a lease as a financing mechanism within conventional and Islamic finance.

Tuesday, January 11, 2011

Responding to the anti-Islamic finance critics

From my newsletter (subscribe to the left):
I am always hesitant to raise issues of politics as it connects with Islamic finance, but there are times when politics and finance connect in an indirect way that necessitates some observation. Islamic finance has become one front in a war of words with critics alleging that it is part of a nefarious plot; one critic described "Sharia[-compliant] finance is jihad with money". The rhetoric has been heated for years with many of the same (debunked) arguments used for why Islamic finance is somehow dangerous to the West and the United States in particular (perhaps I see a disproportionate share in the US because that is where I am based).

Efforts to place Islamic finance on level ground with conventional finance in France and South Korea have faced hurdles placed by critics of the industry (or the politicians who share their views). In the US, one group even sued the US government for its bailout of AIG because of AIG's takaful unit. However, the rhetoric against Islamic finance has stayed as just rhetoric.

With the recent tragic assassination in Arizona, however, I think the Islamic finance industry--particularly in the West--needs to consider how to improve its outreach and better explain what it is and why it exists, lest the overheated rhetoric combined with general ignorance lead to an attack on Islamic finance. I hope that this message can soon be written off as just my response to a shocking event, but the general political rhetoric that is receiving a second look in response to Arizona is not too far removed from some of the "anti-Islamic finance" crowd. They insinuate that Islamic finance involves financing of violence and even claim that it is part of a religious war, creating an "us-versus-them" mentality that we see can lead to tragic results.

The only reasonable response to this rhetoric is rational explanation of Islamic finance to educate people about what it actually is because that is the only antidote to the spread of incendiary falsehoods in any situation. It is our responsibility as people working in, researching and writing about Islamic finance to educate those we come into contact with about Islamic finance. As Mushtak Parker described, there are three types of people involved with Islamic finance: the diehard optimist, the fairweather fans and the hard-working pragmatists "who believe in Islamic finance not merely because of their faith traditions (not only Islam) but because they believe and have proven that Islamic finance is eminently workable, here to stay and a force for good in economic development, shareholder value and wealth creation and effecting socio-economic justice."

Most of the people with whom I speak with about Islamic finance fall into that third group. They work behind the scenes largely within the Islamic finance industry. But now, I think, there has to be a broader focus. Continue to work within the industry to improve it, but also educate the people who respond with a puzzled look when you mention Islamic finance.

Tuesday, January 04, 2011

Where do mudaraba depositors fall?

In a bid to catch up with Malaysia, Indonesia may consider tax incentives for mudaraba depositors with Islamic banks in the country. I think this is an excellent way to promote Islamic finance because it amounts to an explicit subsidy for depositors to choose Islamic banks over conventional banks. Depending on how it is structured, it may not be as great in practice as it is in theory (it effectively lowers the cost of funds for Islamic banks compared to conventional banks, which should reduce the rates they charge on financing). For instance, if the exemption is only usable for higher income individuals, it will benefit larger banks over microfinance institutions or institutions with a greater reliance on small depositors.

It also started me thinking on the differences between the participation investors have whether they are mudaraba depositors, investors in specific funds or equity/debt investors in Islamic banks. I think it raises a potential problem for the Islamic banking structure as is currently is created. The main difference between depositors in banks and mudaraba investors in Islamic banks is that the latter are on the hook (i.e. they could lose their deposits) if the bank's investments lose money. In a conventional bank, the depositors are generally insured by the government (at least in the US and many other countries). That means that in a bank insolvency, the depositors will be made whole up to a certain point (at which they will be treated as unsecured creditors). The debtors will have a claim on the bank's assets, either secured or unsecured. Investors in any funds sponsored by the bank will have recourse against the assets in the fund (which should be segregated from the bank's other assets). Equity investors are last in line, but at least go into that position with that full knowledge.

Mudaraba depositors are not in such a position. In some countries, they are covered by deposit insurance (which may not be Shari'ah-compliant). However, they are placing their funds in a bank with the possibility of loss, but they are not placing them in the bank with an expectation that they could lose it all (as equity investors do). This creates somewhat of a grey area. It may be covered in banking laws that they are entitled to a senior position to equity holders (or even creditors), but I don't know if it is the case in all countries that depositors are given a specific legal priority in the winding up of the bank if it fails.

How are the depositor's covered in the legal structure of a bank? Are they treated as depositors and given whatever priority each country provides for depositors (senior or junior to creditors?) Are they subject to full loss and subject to the same risk of loss as equity holders (based on the mudaraba contract, but shielded by any reserve accounts set up by the bank?)?

If there is no solid standard (or if depositors are subject to total loss alongside equity investors or unsecured creditors unless national laws count them as depositors), then I would be worried. If there were an Islamic bank failure in a country that allowed Islamic banks to actually subject depositors to the standards of the mudaraba contract (which puts the risk of loss of capital on the provider of funds, the rabb ul-maal), it could create a run on all Islamic banks in that country. Not only that, it would put the onus to explain how their countries had greater protections to keep the run on Islamic banks from spreading to other countries.

Islamic finance in Afghanistan

Bloomberg has an interesting article on the proposal to allow Islamic banks in Afghanistan. It would certainly have a market with the large Muslim population in Afghanistan. However, I foresee problems that could impact both Afghanis and the Islamic finance industry for a growing (albeit small) Islamic banking market in Afghanistan.

The first problem is whether creating commercial Islamic banks as a concept in a country that is still largely at war and where regulation is likely to be difficult (at best) will pose problems. It is not that Islamic banks require more supervision than conventional banks, but even in relatively stable societies, early experiments with Islamic banks have seen unscrupulous people come in promising to provide Shari'ah-compliant banking only to create "affinity fraud" (e.g. the various Ponzi schemes in the 1980s in Egypt that were promoted as Islamic banks). This is always a problem (for example, the alleged Sunrise Equities fraud in Chicago, Illinois), but in a country where the central government (let alone banking regulators) have limited control over some areas, it could become a serious problem. If this type of fraud became commonplace, it could create a general suspicion of "Islamic" banking generally and could hinder the growth of the industry if the country stabilizes.

The second is whether Islamic banking, by virtue of light regulation from a distant central bank and national center of regulation, could become captured by people who use it as a way to launder money or otherwise fund terrorism, either by the Taliban or other groups. This would create "evidence" (note the quotes around the word) that Islamic finance is nothing but a form of covert jihad that the anti-Islamic finance groups could use to try and discredit Islamic finance globally and use to limit the growth of Islamic finance particularly in the US and Europe (and also East Asia).

I would hope that my concerns would prove baseless, but being in the United States, I am well attuned to the "anti-Islamic finance" tactics (absent facts, they have gotten a lot of traction using just baseless insuinuations about connections between Islamic finance and terrorism, at least politically). If it is possible (and desired), I would wish for a thriving Islamic finance industry in Afghanistan, integrating both commercial and investment banks as well as microfinance institutions. This could be a fantastic way for the world to channel finance towards the rebuilding of the country and poverty reduction efforts in a country that has seen too much destruction and poverty since the Soviets invaded in the 1980s. However, it has to be done in a way that will benefit Afghanistan and not create "bad apple" examples of either lax regulation or fraud that could limit Afghani's or other countries' regulators enthusiasm for Islamic finance.

Sukuk in 2011

In the December review of sukuk issuance for Zawya, Adnan Halawi points out that most of the December issuance was from secondary issuance in established sukuk program. However, January may see Nakheel return to sukuk markets, despite its difficulty in repaying the Nakheel 1, 2 and 3 sukuk due in 2009 - 2011 (all were repaid on time with assistance from the Dubai Financial Stability Fund). This would be an inauspicious beginning to 2011 for GCC sukuk markets, by reminding investors of the difficulty the market faced with several defaults (International Investment Group, Saad and Algosaibi, The Investment Dar were prominent) in addition to the government support required for the Nakheel sukuk.

The other point from the review that I think is short-term significant is that the issuance in December 2010 was mostly from Malaysia with $5.7 bllion in issuance compared with $364 million from Pakistan and a combined $221 million from the UAE and Bahrain. The general trend in sukuk markets is that GCC issuers have chosen to issue sukuk in Malaysia over the GCC markets.

In my weekly newsletter, I offered three predictions for 2011 including one about the growing trend for issuance in Malaysia over the GCC. Here was my prediction:
The focus of Islamic finance will shift back from Malaysia to the GCC as rising oil prices create excess liquidity to finance infrastructure projects
In the immediate aftermath of the credit crisis, the impact was not felt as much in the GCC as much as it was in Malaysia, with a sharp drop in sukuk issuance, for example. However, the crisis spread to the GCC leading to the Dubai debt crisis-caused investor nervousness about the etire region while Malaysia rebounded quickly. This has led to GCC corporates issuing sukuk in Malaysia. However, despite having a more developed secondary market for sukuk, Malaysia is a much smaller market and cannot absorb all of the sukuk that GCC issuers will want to issue. This will force issuers to turn back to the domestic markets, which will be boosted as the troubled investment banks and government-related enterprises finish up their restructuring or cease to do business entirely. While secondary market liquidity will still be limited, the new sukuk from issuers who have weathered the crisis, supported by continued sovereign issuance, will lead to a more liquid secondary market. International issuers like GE Capital will return to the market, which will increase confidence among investors and regional issues.
My prediction is counter to the current trend (I tend to be a contrarian). However, my prediction is not just based on my own contrariness. I think that the long term future for sukuk lies in the GCC (and to some degree in Luxembourg and the UK where a number of sukuk have been listed).

This is not to underplay the role and significance of the Malaysian sukuk markets. They have been crucial for providing an example of a market where sukuk secondary market liquidity has developed, albeit over nearly a 20 year period. However, it is just too small a market compared to the size of the GCC for that latter region to depend upon for future development.

As I mentioned in my post "What's wrong with GCC sukuk markets?", "Malaysia's GDP in 2009 was $193 billion compared with Saudi Arabia's GDP of $369 billion in the same year and the GCC as a whole representing $912 billion in GDP in 2009. Yet, sukuk issuance in Malaysia makes up 72.3% of the entire sukuk market in the first nine months of 2010 (9M10)." The GCC economy is four and a half times the size of Malaysia and yet issuance in the first nine months of 2010 was three to one in favor of Malaysia. That cannot be sustainable.

If sukuk markets are going to grow to be a significant source of capital for GCC corporates, it will not happen in Malaysia alone; it has to be accompanied by further development in the GCC sukuk markets. Returning to my first point, reminders of the source of the problems in the markets from 2009 (Nakheel was a trigger for the Dubai debt crisis) are not the best start.

That being said, there are more optimistic signs; for example, GE Capital may issue sukuk in the GCC in 2011. There is also the issue of liquidity. Not the secondary market liquidity I have opined about so often, but petro-liquidity. Despite the moves to diversify GCC economies, they are dependent to a large extent of their economic growth on the price of hydrocarbons (mostly oil although Qatar has significant reserves of natural gas). Thus, a large source of the liquidity that will fuel a demand for sukuk (as well as a supply) will be dependent upon the price of oil and natural gas. Oil prices in particular are at some of the highest levels since 2008 and this will create a flow of liquidity into the GCC.

Once this liquidity reaches the GCC, it needs to find a home and the infrastructure needs of GCC countries have been well documented (with various estimates from hundreds of billions to trillions in infrastructure spending over the medium-term future). The GCC economies also have a large population of young people and relatively high youth unemployment. This can be a source for sukuk. The wealthy, Shari'ah-sensitive investors will have resources that they want to invest in fixed income-like products (including higher-yielding non-sovereign sukuk) and the governments will want to meet the needs of their population through infrastructure investment and job creation.

There are many companies who will be called upon to provide services and if a portion of the infrastructure is built using public-private partnerships or joint ventures, it could create a large supply of sukuk if a portion of these private partners raise capital using sukuk. This, in addition to greater economic confidence from other corporates in the GCC region and multinationals diversifying their funding base, probably provide the necessary key for the GCC sukuk markets to develop. Will it happen in 2011? I can't say. Although, I think it can at least start to move in this direction over the course of the year.

Sunday, January 02, 2011

The Year Ahead--Mushtak Parker

Mushtak Parker has a great article in Arab News on the prospects for Islamic finance in the year to come. Here are a few points he made with my comments.
The feedback from the market on the prospects is mixed. There are the usual devoted diehard optimists for whom Islamic banking is more a conviction of faith as opposed to an alternative ethical system of financial management with all its attendant rigors.

Then there are the fair weather fellow travelers, whose nauseating platitudes will reverberate as long as the going is good and their renumeration packages stand out.

Finally there are the hard-working pragmatists who believe in Islamic finance not merely because of their faith traditions (not only Islam) but because they believe and have proven that Islamic finance is eminently workable, here to stay and a force for good in economic development, shareholder value and wealth creation and effecting socio-economic justice.
I couldn't agree with his prognosis of the perspectives within Islamic finance. I hope he would agree that I am part of the third group of people who believe that Islamic finance can be a positive force within finance, can incorporate more ethical screens and can be improved. I view this as the realist perspective, but it is more than that. His third group includes people who want Islamic finance to be more than just an 'alternative to conventional finance'. We want Islamic finance to provide something that is concerned with the outcome of finance; its impact on society as a whole. This is one area where I think that Islamic finance is lacking now. There is so much focus on avoiding prohibitions--riba, gharar, maysir and non-Shari'ah-compliant activities--and too little focus on making positive contributions. This doesn't mean that Islamic finance should be turned into a charitable venture; it wouldn't survive if it were. However, Islamic finance can contribute to avoiding environmental degradation by incorporating screens to ensure that mankind acts as a responsible steward of the earth. Or by providing financing for Islamic microfinance institutions. Or by considering the affect of project financing on the local communities affected by adopting the Equator Principles.
"Industry organizations such as the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) have done pioneering work in introducing prudential, supervisory and accounting standards for the global industry, but where they have been wanting is helping to suggest and develop policy, regulatory and legal frameworks for Islamic finance to create a level playing field in this respect."
This is an excellent point. AAOIFI and the IFSB should provide guidance on creating a level playing field for Islamic finance institutions. Because of the wide usage of legal systems based on the British (common law) legal system, there are many areas where the regulatory and tax restrictions that hamper Islamic finance are the same. These institutions could also be valuable resources for national regulators and legislators in deciding on the best ways to reform their own unique systems to put Islamic finance on a level playing field because they have experience working with member countries with diverse legal, regulatory and tax systems.

One area where I disagree with Mushtak Parker is:
"How on earth can the sector move to the next level when the government and regulators of one of the most important Islamic finance markets does not see fit to introduce a separate regulatory, supervisory and legal framework for Islamic banking to encompass its special characteristics?"
I think that there should be a separation between the Shari'ah regulation (which is done by Shari'ah scholars) and the national financial regulators and legal systems based on secular law. I think it would hurt the growth of the industry if there were special laws for Islamic financial institutions. They may be subject to Basel rules (and AAOIFI standards if they are members) for accounting and the fatawa from their Shari'ah board, but their consumers should be able to make claims against them with the domestic regulators or legal system, whether or not this can incorporate Shari'ah in determining the rulings. The role of good lawyers is designing contracts that are in compliance with Shari'ah at the outset (as determined by the Shari'ah board) but which can be litigated by a secular legal system in a way that will not contravene Shari'ah without incorporating Shari'ah into that legal system.
"The truth is that Islamic finance despite the impressive growth of the global industry over the last three decades, is still a highly parochial and insular one - still largely engrossed in talking to itself and to its principal immediate stakeholders - the shareholders, investors and its regulators. Outside this limited stakeholder paradigm, there is hardly much interaction with other equally important stakeholder groups - the government policy-makers, national Treasuries or finance ministries, parliamentary finance committees and consumer groups and watchdogs."
I agree. There is not enough discussion outside of the Islamic finance industry with people who affect the industry to explain how the industry works and proactively find potential areas of conflict with existing laws and regulations.
Under-developed consumer awareness and market education reflects the paucity of the marketing policies and strategies of Islamic financial institutions, who unfortunately too seem to have fallen for the hype of the "Mad Men" of advertising and some of whom are not averse to paying for recognition and commercial awards.
I have written about social media and Islamic finance in two blog posts and I think Mushtak Parker is reflecting a similar sentiment. Islamic financial institutions are not reaching out to consumers effectively and practitioners are not creating enough public dialogue about how the industry works to challenge incorrect statements about the industry or open up a public dialogue with consumers to figure out what consumers' and observers' views of the industry are. There is a lot of private discussion, but far too little public discourse.

I would recommend that readers click through and read Mushtak's piece in full. It is definitely a thought-provoking read.

BNM Shariah Parameter Reference 5: Istisna'a

I was reviewing the Bank Negara Malaysia Shariah Parameter Reference 5 on Istisna'a and I think the effort is incredibly valuable for the Islamic finance industry by laying out the specifics of each contract. This is something not widely available (although Al Baraka has published some compendium of fatawa on Islamic finance products). The aspect of the BNM SPRs that provides an added benefit to fatawa compendium is that it takes the material and compacts it into a more succinct format than just the underlying fatawa.

There were a few points that I read and didn't know whether they would be accepted outside of Malaysia from a Shari'ah perspective. I don't claim to have the expertise necessary to make any ruling on these points, and I would appreciate reader's perspectives on whether these areas are acceptable outside of Malaysia.

1) "The price of Istisna' assets shall be determined upon the execution of the contract. The agreed price concluded may take into consideration the warranty, after sales services and length of delivery period."

--Is this considered two sales in one; one sale of the istisna' asset and one sale (or lease) of the after sales services for a specified period of time?

2) "The purchaser shall not be entitled to claim from the seller any reduction of Istisna’ sale price due to reduction of construction/manufacturing cost. However, the manufacturer may decide to waive (Ibra’) part of the selling price based on its own discretion."

--Is the concept of Ibra' acceptable outside of Malaysia? When I have read about conflicting views of ibra', it is in the context of the Malaysian market (specifically bai' bithamin ajil)?

3) "In the cases of late delivery of the assets without a valid reason, the manufacturer shall be liable for damages and subject to any penalty specified in the contract."

--In the example, the late payment is specified as a certain percent per year based on the value of the istisna'. Is this acceptable outside of Malaysia or would that be prohibited because the delay is based on a fixed markup on the contract value based on the time elapsed? Would it be acceptable outside of Malaysia if the late payments were donated to charity?

4) "An IFI (purchaser) and the manufacturer (seller) under an Istisna’ agreement may enter into a separate forward lease agreement under which the manufacturer leases the manufactured asset from the IFI with an option or undertaking to purchase provided that the ownership remains with the IFI until the asset is sold."

--An article by Michael McMillen (Islamic Shari'ah-Compliant Project Financing: Collateral Security and Financing Structure Case Studies, pdf) described: "The Lease (Ijara) was executed at the same time as the other financing documents, but cannot become fully effective at such time due to a Shari’ah principle that prohibits the payment of rent for an asset until that asset has sufficient economic value and sufficiency for Shari’ah purposes--i.e., until the asset can be, and is, put to the intended use." This idea would conflict with payments being made through a forward lease. However, the debate on this issue may be a broader debate than just a Malaysia-elsewhere debate. In a paper presented at the Al Baraka 30th Symposium for Islamic Economics in August 2009, Dr. Abdul Sattar Abu Ghuddah presented a paper (pdf) on the uses of forward ijara (al-ijara al-mawsufah fi al-dhimmah), including for real estate financing where the asset is not yet constructed.

Again, I don't have answers for the question I posed and I appreciate any information, insights and comments from readers .

How are Islamic banks different from conventional banks?

A paper by Hadeel Abu Loghod[1] examines the performance difference of Islamic versus conventional banks using the logit statistical tool. This takes a number of factors to predict whether a given bank is conventional or Islamic (based on different characteristics of each). If a factor differs significantly between conventional and Islamic banks, the coefficient on that variable would be statistically different. If there is not a difference, then the coefficient would be insignificant.

The database used in the study is rather old, 2000-2005, but it is probably easier to find statistically significant relationships in data that does not include the financial crisis and after effects. The basic finding of the paper (the one asked in the title) is that Islamic banks do not have a statistically different (better or worse) performance than conventional banks.

This is not surprising because there is great heterogeneity in Islamic banks and between conventional banks. It is also not a surprise because although the products used by Islamic banks are structured differently, they create more or less the same economic outcome. Customers receive financing that they must repay over a set period. Conventional banks charge an interest rate, while the cost of funding in Islamic banking is based on 'profit' from a sale (murabaha) transaction or 'rent' in a leasing (ijara) transaction.

Even in the bank-depositor relationship based on mudaraba, the economic outcome is similar. Depositors put their money into their accounts with the bank. Theoretically they are liable to lose that money if the bank's financing activity is not profitable. However, the shareholders of the bank have the incentive to set up reserve accounts to prevent depositor's losses (because the loss by depositors could spark a run on the bank which would end up wiping the shareholders out. The average ratio of deposits to equity in Islamic banks in the sample was 5:1. The depositors are far more liquid than shareholders; they can demand their funds back and if they did so en masse, it would drive the bank into insolvency in most cases because deposits equal around 70% of total assets. Most of those assets are not liquid and could only be turned into cash at a severe haircut to book value.

In terms of the differences between Islamic and conventional banks, the study found that Islamic banks were more liquid, less leveraged and carried a larger percentage of fixed to total assets. This result makes sense when one considers the overall banking environment in which Islamic banks operate. For the period of the data, there were few if any ways besides inter-bank commodity murabaha or wakala for a bank to find liquidity to meet large depositor withdrawals, where conventional banks can go to either the inter-bank market or the central bank (as lender of last resort). There are also more short-term, liquid assets available to Islamic banks for them to place their excess liquidity with very little risk.

The finding that Islamic banks were less leveraged than conventional banks initially seems to make sense given the conventional wisdom that Islamic banks are more stable than conventional banks and can't leverage themselves using derivatives or other exotic products. However, there really is not a limit inherent in the Islamic banking model that would keep them from leveraging their balance sheet significantly. The explanation could be that Islamic banks take more conservative approaches to leverage either because debt is harder to access (sukuk markets are less developed) or investors are concerned that returns would be lower from a bank's sukuk by virtue of its higher proportion of liquid assets or because of a higher risk of the bank defaulting because of liquidity challenges.

The final finding was that Islamic banks held a higher level of fixed assets as a percentage of total assets than conventional banks. The author ascribed this to the use of murabaha and ijara by Islamic banks. However, most Islamic banks do not carry inventory of goods (for murabaha). The murabaha is designed so that the bank minimizes the risk of holding a physical asset by making the period between when it buys the asset and when it resells it very small, often a few minutes. I am not entirely sure of this point (it is more of an accounting issue), but I suspect that for an ijara, the bank would not account for the asset on its balance sheet even if it were being treated as the lessor (responsible for the maintenance and insurance of the asset) from a Shari'ah perspective. Or the asset would be held off balance sheet.

I thought this was an interesting paper; it limited its focus to one specific area of how conventional and Islamic banks differ. However, it does lead to questions for future research. For example, if Islamic banks hold excess liquidity and are less leveraged than conventional banks, why is their profitability not dented. Put another way, if Islamic banks had access to equivalent liquidity management tools and more access to debt financing, would they increase their returns on equity? Another point for future study would be whether these relationships still hold among Islamic and conventional investment banks, or Islamic and conventional banks during and after the financial crisis with rapid deleveraging occurring particularly in the conventional financial system.

[1] Abu Loghod, Hadeel. "Do Islamic Banks Perform Better than Conventional Banks? Evidence from Gulf Cooperation Council Countries," Arab Planning Institute Working Paper 1011.