Monday, May 25, 2009

S&P report summary (part 1)

Standard & Poor’s released their Islamic Finance Outlook 2009 a few weeks ago and in addition to descriptions of how S&P rates Islamic financial institutions, sukuk and takaful, there are a number of points they raise that I think are extremely important for the industryas it deals with the current crisis and looks out beyond. The report begins with a detailed description of how S&P believe Islamic banks will be able to handle the economic crisis that has followed the financial crisis. They identify a number of potential problem areas and discuss a few mitigating factors that should help Islamic banks weather the crisis. The first area of concern expressed by S&P is with Islamic bank's liquidity situation:
"We understand that IFIs’ instruments for managing liquidity are scarce compared with those of conventional counterparts. IFIs generally place any excess available liquidity with other international or local banks through Sharia-compliant instruments (mainly international murabaha). The market for sukuk notes remains fairly illiquid because no developed secondary market exists. We understand that investments in sukuk are mainly classified as held to maturity. We are of the view that IFIs could take advantage of the current challenging times to innovate and broaden the offering of acceptable instruments for liquidity management."
This is likely to become an even greater concern for Islamic banks as sukuk issuance remains weak and other methods of liquidity management are being examined for whether they are Shari'ah compliant. The particular method that one primary product is used in the Gulf and elsewhere for liquidity management, organized (as opposed to classical) tawarruq, was recently ruled by the OIC Fiqh Academy to contain riba:
"It is not permissible to execute both tawarruq (organised and reversed) because simultaneous transactions occurs between the financier and the mustawriq, whether it is done explicitly or implicitly or based on common practice, in exchange for a financial obligation. This is considered a deception, i.e. in order to get the additional quick cash from the contract. Hence, the transaction is considered as containing the element of riba."
This ruling, while not binding on Islamic financial institutions, will likely result in a revision of Islamic banking practices with regards to liquidity management that will shift towards commodity murabaha at first and other products later. Even this is fraught with some difficulty because it remains unclear whether the ruling applies only to organized tawarruq or is extended beyond it to commodity murabaha.

In discussing the liquidity needs specific to Islamic financial institutions, S&P also raises the issue of how governments can lend support to Islamic banks. Unlike, conventional financial institutions, the traditional 'lender of last resort' and unconventional programs like the Capital Purchase Program (TARP) in the US are not available to Islamic financial institutions. Instead, S&P points to the UAE as an example: "The UAE has based its support to IFIs on wakala, which has required some time to implement". I have not seen specifics on these wakala agreements, but I would imagine they are temporary investments through Islamic banks where the banks are paid a fee to manage the investment, but are then required to later return the investment plus profit minus wakala fees to the government. Although this type of support has already been given to some Islamic banks, S&P points out that not all Islamic banks will need it; more conservative balance sheets leave them with a greater degree of protection than conventional banks:
"The still-adequate liquidity that we understand is available at rated Islamic commercial banks partially mitigates liquidity risk. On Sept. 30, 2008, these banks recorded, according to our estimates, a ratio of liquid assets to total assets of 19.9%. We understand that this ratio continued to decline in the final quarter of 2008, however, albeit remaining adequate."
Although they have sufficient liquidity now, the economic crisis spread to the GCC later than many other countries and therefore the problems in their banking markets could be at an earlier stage. Still it is a positive thing to have a large amount of liquid assets which should cushion many Islamic financial institutions.

The next area S&P covers is the effect of a large exposure to real estate and the sukuk market. S&P notes:
"According to Islamic finance principles, all transactions must be backed by a tangible asset. Therefore, one of the preferred asset classes of Islamic banks is real estate. We calculate total direct exposure to the real estate sector for IFIs that we rate at the equivalent of about 20% of total loans, which, in our opinion, is high and makes IFIs vulnerable to the correction in this previously fast-growing sector. In addition, we believe that certain loans to individuals granted by Islamic banks were used to finance real estate transactions."
The exposure to real estate is likely to be one of the areas where future difficulties are likely to emerge within the Islamic banking industry. However, in addition to direct lending for real estate projects, Islamic banks also hold sukuk on their books, many of which are issued by other Islamic banks or for real estate-related projects. This could create difficulties in the long run but in the short run there is some protection afforded Islamic banks because the sukuk are "mainly classified as held to maturity". This means that most of the sukuk on bank balance sheets are not marked to market. This will help to avoid one of the major systemic risks associated with the shortage of investment instruments for Islamic banks. Because sukuk are in great demand and short supply, more so with the fall off in supply and no growth in a liquid secondary market, Islamic banks have many sukuk holdings that are relatively undiversified with a good deal of sukuk held being issued by other Islamic banks. If these sukuk were required to be marked to market (which should eventually be the case when the supply begins to increase and a liquid secondary market develops) then distress in one Islamic bank would lead to many other Islamic banks taking hits to their balance sheet which could, if the distressed sukuk were a large enough component of their balance sheet, spread the problems across the Islamic banking industry.

There are more areas of the S&P report that I have not covered that I hope to write about in future posts including more on sukuk, the impact of profit-sharing investment accounts (PSIA) on Islamic banks' stability, takaful and additional regional growth in Islamic finance, particularly in France.

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