Wednesday, April 11, 2012

Could off-balance sheet investment accounts become Islamic SIVs?

When I was going to look at the latest AAOIFI consultation paper on real estate, I noticed that I had missed a consultation paper (pdf) whose comment period expired recently that focused on the accounting treatment of investment accounts that use mudaraba and wakala. 

At the heart of the changes or refinements (not being able to look up the existing standard on the web, I cannot compare the new with the old) is that restricted mudaraba and wakala deposits will be treated as off balance sheet assets, while unrestricted mudaraba will be treated as on balance sheet assets.  In general the distinctions between how each type of account is treated (restricted mudaraba are investment accounts that are limited to a particular investment, unrestricted mudaraba are invested at the discretion of the bank, while wakala accounts are agency accounts where the financial institution acts as agent). 

One area of concern I have is that the standards as they relate to off-balance sheet accounts (restricted mudaraba and wakala accounts) are relatively untested in terms of whether those accounts would creep on balance sheet in a crisis.  An analogy to how they are treated is to remember back to the early days of the financial crisis when the structured investment vehicles set up off of bank's balance sheet (the shadow banking system at its worst) to invest in mortgage-backed securities). 

The way these SIVs worked is that a bank would set up an off-balance-sheet entity, which would issue asset-backed commercial paper (debt backed by collateral with a maturity of less than 270 days).  The proceeds would be used to buy MBS, as well as other higher-yielding, long-term investments.  The SIVs were engaged in maturity transformation (borrowing short-term and lending long-term), a typical role of banks,. except that the SIVs were acting outside the banking regulations because they were off-balance sheet.  The key for them to maintain their solvency was to keep a very high credit rating on their ABCP; any doubts about the assets backing the commercial paper could (and would) lead them to implode. 

During the financial crisis, the fall in value of MBSs, CDOs and the rest of the mortgage-related alphabet soup led to concerns about the solvency of the SIVs and made it more difficult for them to roll over their commercial paper.  Facing the prospects of the SIVs collapsing, the banks which sponsored them in most cases stepped in to provide financing when the market for commercial paper closed completely. 

After that travel back through time, an Islamic financial institution that offered a restricted mudaraba or wakala may not be legally required (and may be specifically prohibited by the Shari'ah board from offering such a guarantee) to repay the entire principal amount of the off-balance sheet accounts as if it were a deposit, but may still face market pressure to treat all off-balance sheet items equally to the unrestricted investment accounts that reside on their balance sheets. 

Just as the SIVs were their own separate entity, and the banks had no legal requirement to bail them out (they were supposed to be able to sell assets to meet any liquidity needs, but those markets had become distressed as well), an Islamic financial institution may also feel the need to bail out the restricted mudaraba and wakala deposit holders in order to maintain their reputation in the market (reputation specifically around their solvency).  In finance, the loss of confidence can be a death knell, even if the institution is fundamentally solvent. 

In the end, there is not necessarily a better way to handle the on-vs-off-balance sheet treatment than the AAOIFI rule does, so long as Islamic financial institutions offer sufficient disclosure (and investors read the disclosure) about off-balance sheet assets.  With Arcapita in bankruptcy now, it would be tempting to look to that case for some precedent, but that is not likely since they had few deposits, and what they did accept (which they said was more of a favor to investors in their deals, but which ended up becoming a significant source of funding for their portfolio companies) was unrestricted investment accounts, which would have been treated as an on-balance sheet investment account under the new AAOIFI standard. 

Unfortunately, the other cases of financial distress among Islamic financial institutions since the crisis probably have not been required to make as many disclosures about the resolution of their financial distress, mostly because a lot have stumbled on in shadows of their former selves with their investors agreeing to "extend-and-pretend".  Others have been folded into other banks and have not unfolded in public view. 

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