Sunday, May 24, 2009

Tawarruq ruling, Islamic finance: theory and practice, TID default

Islamic finance: theory and practice
An article from Islamic Finance News is reproduced describing the current financial and economic crisis and the Islamic finance industry. One quote, in passage, was interesting to me and led to a few additional thoughts. The article talked about how
"Islam seeks to realize greater justice in human society. The financial system may be able to promote justice if, in addition to being strong and stable, it satisfies at least two conditions based on moral values:
  • The financier should also share the risk of financing to avoid shifting the entire loss to the entrepreneur and making unjustifiable profit without taking any risk.
  • An equitable share of financial resources mobilized by financial institutions should be made available for social welfare projects, such as helping eliminate poverty, expanding employment and reducing income inequalities."
The article was in general interesting, but these two criteria should also be reviewed in relation to how the Islamic finance industry operates today. The industry strives to achieve both, but there are difference between theory and practice.

On the first point, the reliance on debt-based replications of conventional products leaves room for improvement. On the second point, the gap is greater: there are few resources put towards projects like developing an alternative method of microfinance in the Islamic finance model, particularly developing microfinance products that are not replications of conventional debt. This is one of the areas where profit-and-loss sharing mudaraba/musharaka products could create a greater impact than the large mostly positive contribution of conventional microfinance. As the industry develops it should keep each point in mind and constantly reevaluate whether these lofty goals are being met. It will strengthen the industry in the long run.

Tawarruq ruling
A press release about the tawarruq ruling welcomes the decision but requests greater clarity on what is permissible and what is not to minimize the disruption in the industry like that which came following the AAOIFI ruling on sukuk in February 2008 and in Malaysia following a few court cases about the permissibility of BBA in April 2009. This is important because the tawarruq and commodity murabaha products make up a lot of the activity in the Islamic finance industry and an adverse ruling on them, while not unexpected, would be very disruptive unless it is very clearly articulated and implementation of the rulings are carefully implemented.  

TID default
The Investment Dar sukuk default is likely to be only the first of defaults in the sukuk market and will provide a test of the the legal systems and ability to restructure sukuk. However, any defaults in the sukuk market could have a salutory effect on the market for new sukuk after the defaults are resolved. One of the risks in new sukuk issue is the uncertainty surrounding default and this is one part of the higher yields demanded by sukuk investors compared with conventional alternatives. With greater certainty about how investors will fare following a default, these yield spreads could narrow. Other 

  • An article by RAM Ratings describes Malaysia's Islamic capital markets and provides probably the a good assessment of the effect of the current financial and economic crisis on Islamic finance:
    "The Islamic financial market has undoubtedly also been afflicted by frozen credit markets and the current confidence crisis, along with the backlash from the global financial mayhem. Nonetheless, it has mostly escaped the direct fallout from the sub-prime crisis that had begun in the United States, thanks to the Shariah prohibition of investing in the kinds of instruments that had sparked off the current chaos. This is perhaps because of the “built-in antibody” that Islamic finance has in the form of its Shariah conformity, which has provided some degree of stability and resilience in facing the current global financial turmoil."
  • CIMB Investment predicts that local currency sukuk in Asia will be preferred to dollar denominated sukuk as "issuers are looking at dollar credit spreads versus local-currency credit spreads and seeing the local-currency space is much cheaper" according to Lee Kok Kwan, CIMB Investment Bank's head of treasury.
    The Mauritius central bank will encourage the development of a Shari'ah-compliant structure for commodity markets to aid the Islamic financial industry.
  • Bahrain-based Sakana is considering issuing a $50 million sukuk towards the end of this year or beginning of 2010.
  • The Investment Dar may raise additional capital as it restructures. It was the first GCC sukuk issuer to default.

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