Wednesday, September 02, 2009

Is innovation in Islamic finance always good?

Emirates Business spoke with a number of Islamic finance analysts and one point of consensus was that the Islamic finance industry is not yet viewed as a credible alternative, in part because it is not well understood globally but also in part because there are questions about products which use different means to essentially replicate conventional products. One of the suggestions was that particularly outside of the GCC, Islamic finance should drop the use of Arabic terms to emphasize that the industry does not exclusively target Muslims. This is a point I have heard from other people with in the industry, but replacing the Arabic product names, particularly while retaining the 'Islamic' label could diminish the ability to focus on the differences in how products are structured compared to conventional products, in large part because the outcome is in many cases nearly identical.

This article also leads to consideration of another important question about whether the focus on 'innovation' as it relates to mimicking additional conventional products (for example, Islamic hedge funds and multi-tranched sukuk) makes sense for the industry as a whole. There is clearly room for innovation in Shari'ah-compliant products, but just as the debate rages in the conventional financial world about whether financial innovation is beneficial for society, I think it is important to consider the question about which innovations are beneficial for the investors in the products or whether they are simply a new product that can contribute to the profits of the firms structuring them.

In contrast to the innovations that merely mimic more complex conventional financial products, the focus of innovation would be more beneficial were it to focus on developing alternatives for controversial but incredibly necessary products like commodity murabaha/tawarruq. These products have come under fire recently for their similarity with interest-based products where there is only nominal trade in an underlying asset in order to structure short-term liquidity management tools.

Another area where the industry's efforts would provide a real benefit to the industry would be in creating more standardized types of sukuk which could be priced competitively with conventional debt. Were there ready-made sukuk structures that were accepted by the majority of scholars--an easy one to start with would be ijara--then it could reduce structuring costs and encourage issuers to bring sukuk into the market. The use of similar structures by a broad number of issuers would also have the effect of increasing the comparability between different sukuk issues and holders of one sukuk could use standard credit analysis to compare it to other sukuk in the secondary market without worrying that structuring differences would lead one sukuk to behave differently, for example if there were a default.

Innovation can benefit both the developers of the innovation as well as the broader Islamic financial industry, but this need not always be the case. For example, the Total Return Swap engineered by Deutsche Bank was certainly an innovation--it used a wa'd swap to create a Shari'ah-compliant wrapper for non-Shari'ah-com-pliant hedge funds--but it also led to Sheikh Yusuf DeLorenzo to dub the fatwa permitting it as the "Doomsday Fatwa for Islamic Finance". He dubbed it thus because if it is possible to use a wa'd swap instead of an alternative structure, it makes it possible for any non-compliant product to be fairly inexpensively wrapped using the wa'd swap and could compromise the legitimacy of the entire industry if adopted throughout. Innovation in finance is different from innovation elsewhere because it is possible for the innovation to do little more than generate profits without contributing any broader benefit. In the wake of the global credit crisis, in part caused by this type of innovation, the importance of considering whether a given innovation is beneficial or detrimental.

Another excerpt from the Yasaar Media's Islamic Investment Banking 2009 report is published in AMEinfo, this one focuses on venture capital.

Islamic private equity could be the beneficiary of asset fire sales and mergers & acquisition activity following the economic downturn according to the managing director of Rasameel Structured Finance, Issam Al Tawari.

Other News

3 comments:

asheikh said...

In my opinion, arabic names make the product more islamic...;-), Following news article from Gulf-times, Qatar, has islamic label with interest rates

"Islamic offers loan
International Islamic has launched a new car finance scheme where interest rate starts at 3.79%."

asheikh said...

here is the link:

http://www.gulf-times.com/site/topics/article.asp?cu_no=2&item_no=312202&version=1&template_id=36&parent_id=16

Blake Goud said...

There are other institutions which specify the language to be used when referring to their products. Each tries to manage the expectation of the customers. Mentioning interest to refer to the cost of financing may be a way to make the products understandable to customers accustomed to using conventional banking products, even though the Islamic financial product would be structured based on an underlying trade rather than interest.