Wednesday, December 31, 2008

Last post of 2008

The past year has been a difficult one for conventional financial markets and the problems that began in the subprime mortgage industry spilled over to the economy as a whole. The problems which began in California, Nevada, Arizona and Florida have, by year end, expanded far outside these U.S. sunbelt states to impact global economic growth across Europe, Asia and the Middle East. These developments affected the Islamic finance market directly: most sukuk lease and profit payments are based on LIBOR (or another interbank interest rate) and the profitability of Islamic banks is directly related to the return on its investments which are heavily dependent on the economy.

The challenge for the Islamic financial industry in the coming year is to recognize and accept the linkages that connect it (through LIBOR and the global economy) to the conventional financial industry. Although Islamic finance presents a different approach to banking that in many ways represents a return to an intermediation role connecting depositors and borrowers. The lack of diversification in asset sector allocation, which is currently tilted towards struggling energy and property markets, could lead to the collapse of some Islamic finance institutions with exposure to underperforming investments in these markets.

One of the clearest description of these risks is from Badlisyah Abdul Ghani, the CEO of CIMB Islamic, the Malaysian Islamic bank, in an article from Reuters. The primary distinctions he draws are between banks with the most exposure to property markets versus those (mostly outside the GCC) with less exposure and (more importantly) the banks with sovereign backing versus private backing. The Islamic banks with the backing of a sovereign government are unlikely to fail no matter how impaired their assets become because they are, but private Islamic banks are going to be allowed to fail. The importance of sovereign backing was highlighted by the Tamweel and Amlak merger in progress with government assistance.

ING also highlights the reaction in the bond (conventional and Islamic) markets that are pricing in a depression, particularly those companies with exposure to the property market. One indicative sukuk they mention is the Nakheel Properties sukuk which was yielding 32 percent, although the secondary market is not very active.

There are bright spots to the industry in the coming year as economic growth should return eventually. There will be a few new sovereign sukuk issues from Indonesia and perhaps one or more non-Muslim majority country. The outlook long-term for Islamic finance is strong. A resumption in sukuk issuance would create more discussion among Islamic finance practitioners and Shari'ah scholars about creating products with greater differentiation from conventional products. Whatever challenges arise in the coming year, they will provoke a response that should make the industry more resilient in the long term and hopefully help nudge the industry towards more standardization.

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