State Street report on Islamic finance

The State Street report on Islamic finance that was recently announced (see previous blog post) provides a good overview of where the industry is now and what the primary risks and issues challenges that face it. I would recommend that those interested in the full report request it from State Street at vision@statestreet.com. A few quotes and comments from me are below.

"While Shariah’s faith-based principles continue to hold strong appeal for Muslims, the pragmatic benefits arising from its application are becoming increasingly attractive to non-Muslims as well, particularly during the current economic crisis and the intense focus on risk management we are witnessing."

This is a particular interest to me as a non-Muslim that sees the potential benefit from Islamic finance to the ethical finance industry. The latter has been very good at screening investments (and using positive in addition to negative screens which Islamic finance is just beginning to consider). However, the move from investing to finance more generally has been slow in other areas of ethical finance and the tools developed within Islamic finance could provide a good path for ethical finance to move into new areas.

"These [Shari'ah] boards are viewed as both an auditor for the company offering the financial service or product, and a consumer advocate for the company’s clients."

I think the idea of Shari'ah boards as 'auditors' and 'consumer advocates' is understated. However, the way the Shari'ah review process is currently structured where Islamic financial institutions pay scholars directly compromises this role in perception if not in reality. The idea of standardization has been widely promoted (including by me) but the easier and just as important area that is coming into its own is external companies that provide Shari'ah review services. The development of this service is a positive development for the industry, but just as with the problems at credit ratings agencies has spurred criticism about their independence (and a similar critique of accountants and auditors in the early 2000s) the Islamic finance industry needs to continue to develop standards to ensure that Shari'ah boards are truly independent and unbiased. This is beginning to develop with IFSB standards on Shari'ah review (ED10, pdf).

"Financial institutions in the Gulf are experiencing widening mismatches between longer-term maturities on the loans they extend and the shorter-term financing that backs them, creating demand for access to longer-term funding."

The asset-liability maturity mismatch is one of the greatest problems facing the Islamic finance industry. Secondary markets will help, but as conventional financial institutions are realizing, the mere existence of secondary markets does not ensure that they function efficiently.

"The perception of whether a product or service is Shariah compliant, or whether an institution is engaged in activities that are deemed unlawful under Shariah, leads to reputation risk. Again, the Shariah supervisory board plays a crucial role in conducting due diligence and helping to ensure compliance to mitigate this risk."

Reputation risk is one of the areas where Islamic finance is more risky, but also one of the factors that constrains excesses. If institutions are subject to rigorous Shari'ah audits and require this for their continued recognition by consumers as an Islamic financial institution, it should constrain their activities that could lead to a negative audit result.

"Collateral coverage at Islamic financial institutions is often higher for conventional banks since they have an obligation to back any transaction with a tangible, underlying asset. Still, certain transactions carried out by Islamic banks can bear above-average credit risk, namely musharaka (venture capital financing) and mudaraba (trust financing), which can increase the risks carried by the banks. In addition, in murabaha (mark-up financing) and ijara, the existence of full collateral could lead Islamic banks to be less vigilant when assessing the creditworthiness of their borrowers.

Funding and liquidity risk is one of the most critical issues for Islamic financial institutions since only a small secondary market exists to enable them to manage liquidity. Their assets are generally not sellable on a secondary market, and they aren’t able to invest in fixed-income instruments for treasury management purposes.

Liquidity risk is of particular concern with regard to PSIAs, should PSIA holders decide to withdraw their deposits at maturity. Islamic institutions have developed some layers of protection to deal with this, namely profit equalization reserves, mudarib fees and investment risk reserves."

This outline of the risks (credit, funding and liquidity risks) is very well outlined and really hammers home the issues facing the industry.

"Opening the door to additional alternative forms of investing, particularly ones that emphasize the sharing of risk and reward, will certainly help to facilitate our goal. Despite an impending market recovery, we are likely to see a continued trend toward risk-averse investments and intense scrutiny of investment practices across the board, which will give Islamic finance a boost for years to come."

I wonder whether a recovery will lead to enough introspection for long enough to lead to more sustained attention to Islamic finance, but for the near term, it should provide an opportunity for the industry.