Ratings Agencies' reports on Islamic finance

Moody's Investor's Service has a FAQ (pdf)relating to the relationship between Islamic finance and oil prices that also describes the susceptibility of Islamic financial institutions to the economic crisis. A few quotes from the article:

"The drop in oil prices is a concern for the Islamic finance industry, but not a major one for two main reasons. First, there is still a vital link between oil prices and Islamic banks. The industry remains much intermediated, i.e. dominated by banks. [...] Second, oil liquidity also used to be a big driver of the disintermediation process in the Islamic finance industry, i.e. the slow emergence of Islamic finance without Islamic banks, mainly through sukuk and Shari’ah-compliant funds."

"In addition, prices on such instruments are now completely distorted, simply because oil liquidity is less abundant. This is not a major concern, though. Indeed, in previous benign periods, Islamic banks were wise enough to accumulate asset liquidity and capital on their balance sheets. This is good news in the sense that currently they are using their core asset liquidity to continue to grow their credit portfolios, despite scarcer funding sources. Large capital bases help to buffer asset price declines and possibly also higher delinquency rates in credit portfolios."

"Several Islamic banks therefore are in a position paradoxically to gain market shares at the expense of conventional peers, which have been weakened by toxic sub-prime assets. However, in the absence of long-term funding in the form of sukuk, Islamic banks find it difficult to apply proper asset-liability management and are forced to shorten the maturity profile of their assets, which is not exactly what local economies need. These require long-term finance, especially in infrastructure, and are certain to have to rely on government funding, with the attendant risk of larger budget deficits."

"Both wholesale-funded Islamic financial institutions (IFIs) and disintermediated businesses are significantly affected by the slump in oil prices. Wholesale-funded IFIs are unable to access the retail deposit segment for funding. Retail deposits are more granular, more stable, cheaper, but, typically, Shari’ah-compliant investment and merchant banks and specialised Islamic finance companies cannot use them. In a situation of stress, like at present, wholesale funding is problematic because it is concentrated and becomes more expensive as liquidity gets scarcer. Wholesale depositors are savvy and constantly arbitrage institutions in need of funding. It is no coincidence that Islamic intermediaries like Global Investment House (GIH) in the field of merchant banking and Amlak and Tamweel in specialised mortgage finance are finding it extremely difficult to fund their businesses."

"In summary, Islamic finance is not an island; it has suffered from the liquidity drought, to the point where a few of the sector’s investment banks have defaulted, but as an industry it now has a track record of resilience (which had not been tested before). As such, it can now prepare for the next challenge: globalisation."

IFIs have been more resilient to the ongoing crisis than their conventional counterparts because direct investment for such institutions in sub-prime assets and their derivatives, such as collateralised debt obligations (CDOs) and special investment vehicles (SIVs), is prohibited, as per the principle of ‘no riba and no gharar’. However, IFIs are not risk-immune and, like any financial institution these days, face three types of constraint:

• Liquidity is scarce and liquidity management, one of the structural weaknesses of IFIs, is becoming even tougher;
• Asset price decline: IFIs can and do invest in tangible assets, but these, in a situation of crisis, tend to lose value, and liquidating them means accepting a huge discount; and
• Asset quality is deteriorating across the board because of the impact on the real economy of the ongoing financial turmoil, and IFIs will suffer as much as their conventional peers.

Those IFIs involved mainly in credit – capturing deposits to provide financing to households and companies – are less adversely affected than investment houses. GIH and TID are not banks per se; they have banking licences, but economically they behave as investment funds. Therefore, asset price decline, asset quality deterioration and the liquidity crunch are more painful for them than for deposit-taking commercial banks. Investment houses especially face funding problems; wholesale funded, they face the risk of sharp and sudden fund withdrawals, with no renewal of liquidity lines, which would trigger emergency liquidation of assets at a deep discount."

Standard & Poor's released a report concluding that "Gulf Islamic financial institutions and takaful companies are feeling the repercussions of the current global financial market disruption less than most of their conventional counterparts because Sharia law prohibits interest-based financial products". However, the report does mention that the economic downturn following the credit crisis has not entirely spared the Islamic financial industry.

Humayon Dar, the CEO of BMB Islamic UK, a Shari'ah advisory and structuring services, provides responses to Finance Asia questions about the future of the Islamic finance industry.