Sunday, February 15, 2009

Truth and fiction in reporting the Islamic finance industry

As I began reading this article about the prospects for Islamic finance in the year to come, I almost cringed as it began with yet another denial of the reality that Islamic finance was significantly affected by the credit crisis that resulted from the subprime mortgage crisis in the United States. However, as I read further, there was a discussion of the impact from the credit crisis on Islamic finance and an acknowledgement of its severity:
"But to suggest that Islamic banking is set to grow strongly despite the global financial crisis may be stretching things a little too far. Last year’s credit crunch hit Islamic bonds much harder than other forms of debt as sharply lower international oil prices deprived oil-rich Middle Eastern investors of cash.

According to rating agency S&P, corporate and government sales of sukuk (syariah compliant bonds) reached US$30.8 billion in 2007, but plunged 56 per cent last year to just US$13.6 billion. By comparison, conventional international bonds and emerging-market debt dropped 5 per cent and 15 per cent, respectively"
The article ends with a very reasonable conclusion that the way Islamic finance is conducted without many of the financial instruments that cause excess speculation can serve as an alternate model to conventional finance. This, I believe, is the contribution of Islamic finance. It can provide an alternative model of financial services based on finance's underlying objective which is to facilitate the real economy. In the wake of the credit crisis, there is finally some understanding that all financial innovation is not necessarily beneficial and that there is too much of a draw created by financial services' pay packages for people qualified and talented in other areas besides finance whose efforts may better benefit the economy in these other fields. One lesson, however, that should not be underestimated is that even conservative areas of finance like Islamic finance can still become involved in speculative bubbles. Witness Dubai. A recent video I have seen on several blogs puts the popping of Dubai's real estate bubble in clear, on-the-ground terms, by interviewing a real estate agent in the Emirate.

Another article discusses the recovery in Islamic financial institutions and describes their advantages in both not being leveraged like conventional banks and also not having 'exposure' to the interbank lending market, which led to the illiquidity that doomed Lehman Brothers and Bear Stearns. On the first point, I agree (with a few exceptions) that Islamic financial institutions are more prudent about leverage than most conventional financial institutions. However, I find the liquidity risk of Islamic financial institutions to be more significant than for conventional financial institutions in most situations. The lack of access to interbank money markets (except in Malaysia) create a significant risk that illiquid Islamic financial institutions could be unnecessarily transformed into insolvent institutions. One area where illiquidity is particularly noticeable is in the secondary market for sukuk where government-backed companies like the Jebel Ali Free Zone (JAFZ) can see their sukuk trading at less than 60 cents on the dollar.

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