S&P Islamic Finance Outlook (part 3)

The Standard & Poor's report (which I earlier discussed with a focus on Islamic banks and profit-sharing investment accounts) also goes into considerable depth on sukuk. I have organized this part of the summary into a few important categories: current state, near-term outlook, benefits from the sukuk structure, the use by Islamic banks, future developments, uncertainties and the secondary markets.

The Standard & Poor's report does a good job of describing the challenges that have led to a sharp drop in the number of new sukuk issuance and highlights some key uncertainties that both restrict issuance and raise the costs associated with issuance. The solutions, unfortunately, are quite difficult and are not likely to be realized quickly. However, the report is generally positive on the future of sukuk as a key part of the growth in the Islamic finance industry. Because S&P provided so much description and thoughts on many aspects of sukuk, I decided to structure it more like my summary of the State Street report, with many direct quotes from the report.

Current state

The S&P report describes how the sukuk market has mirrored the conventional bond market. In the secondary market, at least, the performance has been in the same direction (widening spreads), but the magnitude has been much greater. I have explored a few bond issues in particular (JAFZ and Nakheel) and while there are some factors that would be expected to raise yields, there are also some issues that are reflections of the illiquidity of the secondary markets for sukuk (discussed below). In terms of new issuance, the shift to smaller sukuk and towards local currency seems fairly natural given the lag between the economic conditions in the U.S. and other Western countries and those in the GCC. The market for risk dried up much earlier in the former than the latter and therefore there was less demand from investors looking for global currency sukuk. Sukuk issuers turned inward towards the (smaller) local currency markets.

"Credit spreads on sukuk have followed the same trend as for conventional bonds, with a sharp widening in the past 12 months. The average size of the sukuk issued last year declined significantly, partly due to the lower appetite of investors. At the same time, the U.S. dollar lost is place as the currency of choice for sukuk, with only about 10% of issues raised in this currency. Standard & Poor’s expects the sukuk market to continue being skewed toward issuances in local currencies, at least in the foreseeable future. Once global markets return to normal, dollar-denominated sukuk issuance will pick up again."

Near term outlook

"The market’s estimates of the current pipeline of potential sukuk issues are in excess of $45 billion. In our view, several factors support the sukuk market’s sustainable growth, including the increasing popularity of Sharia-compliant financial instruments, governments’ increasing openness to Islamic finance around the world, substantial investment and financing needs in the Gulf, and issuers’ desire to tap investors from the Middle East and Muslim Asia."

The healthy pipeline of sukuk indicates that when markets return to normal, there should be a pickup of new issuance hitting the market. However, since the GCC has lagged behind the rest of the world in entering the economic crisis, this recovery could be later than S&P expects (second half of 2009 and into 2010). However, because of the illiquidity in the secondary markets (mostly holders of sukuk being unwilling to sell), there is a bit of a chicken-or-egg problem. Holders of sukuk are unwilling to sell because they do not expect to be able to replace the sold sukuk with another sukuk. Newly issued sukuk are in short supply and secondary markets also suffer from a lack of supply. New issuance are scarce in part because global credit markets are stressed which has increased the cost of all debt and sukuk are by in large priced using conventional bond markets (LIBOR, for example). One factor which could 'unlock' new issuance is the recent rise in oil prices (WTI closed around $66 and Brent at about $65 on Friday). This means that additional liquidity has begun to flow again into the GCC and could lead to enough additional demand so that sukuk are priced with lower spreads over LIBOR/EIBOR than they have been when liquidity in the GCC was constrained by oil prices in the $30-40 range.

"In our experience, the costs of structuring and issuing sukuk remain high relative to conventional bank loans and bond issuance. Legal and accounting fees contribute to this higher cost structure, as does uncertainty regarding the perceived risk associated with these instruments. Moreover, the lack of standard structures, perceived differences in approach to sharia compliance, and a relatively illiquid secondary market may, in our view, discourage investor appetite for sukuk."

These risks (discussed in more detail below) are the growing pains for the industry. The are unlikely to abate quickly and are natural for something as new as sukuk which only became common within the last 5 or 6 years. Right now, sukuk largely mirror conventional bonds, but they do so in a way that is slightly different in terms of contractual form. This adds a risk that the differences will lead to different legal treatment. The Shari'ah-compliance issue poses a slightly different risk. If a sukuk were issued and then the structure were ruled to not be Shari'ah-compliant, it could significantly affect the price because much of the demand for sukuk comes from investors who would shun a financial product if its Shari'ah-compliance were in doubt. This is probably accentuated right now because the investors who saw sukuk as an alternative asset class and were not concerned about Shari'ah-compliance (or lack thereof) have taken a hit (think Western hedge funds for example). With fewer assets to invest and a pullback away from risk, the demand from this type of investors is well below where it was a year ago.

Benefits of the sukuk structure

”Furthermore, on a corporate basis it’s unlikely that there would be a significant difference in the risk component between a sukuk and secured corporate lending, assuming that the same underlying assets constitute security under the two different issues. It’s possible, however, that by having less off-balance sheet and derivative type counterparty risks, a sukuk transaction could be considered less exposed than a secured transaction with the same underlying assets.

"Ultimately, the flexibility of the sukuk instrument may hold key to it increasing its share in financial markets. Although most sukuk issues so far have been debt-like, their ability to be structured as an equity instrument through convertibility means they could access a much wider investor base than traditional loan financing.”

The difference between sukuk and conventional bonds are only beginning to take shape. Many of the sukuk in the market and many that will be issued over the next few years have bond-like structure for the simple reason that they are new and investors and issuers want to invest in familiar instruments. As investors and issuers become more comfortable with these sukuk, the industry will be able to take advantage of the flexibility of sukuk to take advantage of their quasi-equity qualities. Issuers will be able to receive financing at more attractive rates and investors will be able to invest in securities that, while resembling bonds, have the potential to offer greater returns without taking on equity-sized risks in many cases. Establishing liquid secondary markets will aid this development because it will not force investors to look at sukuk as hold-to-maturity investments and they will have more flexibility in changing market conditions.

Islamic banks' sukuk issuance

"Financial institutions are seeking to better balance their funding, especially in the Gulf where short-term funding sources typically dominate and maturities are increasing on the asset side.

The issuance of sukuk by Islamic banks is probably going to be one of the areas where supply is the most reliable in the future as Islamic banks move their liabilities towards longer-term sources. However, this supply is going to come gradually because one of the most common types of sukuk issued by Islamic banks were mudaraba and musharaka sukuk, which are still out of favor following the AAOIFI ruling which questioned their Shari'ah-compliance. Once an acceptable structure becomes more common for this type of sukuk, the supply should come as the Islamic banking industry grows.

Future developments

”In the longer term, we foresee increasing issuance of more complex sukuk with no credit enhancement mechanisms, which would fall into the second category. More generally, we expect securitization, particularly in the Middle East, to increase and to take the form of Sharia-compliant structured transactions, giving rise to asset-backed sukuk notes with limited or no guarantee from the asset originator. The tranching of liabilities, a conventional securitization tool, is still under discussion among Sharia scholars regarding compliance, although a few tranched mortgage-backed sukuk have already been issued in Malaysia and the Gulf region, as well as asset-based subordinated sukuk.”

"In our opinion, there are four important considerations that need to be addressed for sukuk financing to become a major component of project and infrastructure funding:

• Greater clarity in transaction structures. Improved documentation, increased standardization, and lower overall complexity;
  
• Consensus among Islamic scholars around the world, including better issuer and investor education about sukuk and sharia compliance generally;
  
• A liquid secondary market; and
  
• A more predictable legal framework. There is a lack of clarity of local law in a number of markets where sukuk issuance is prevalent. In particular, we consider that there are issues surrounding the enforceability of collateral."
  

The future development of the sukuk market will be a long-term process. As issuers and investors become more familiar with the types of sukuk, the prospects for investors in case of default and get a better idea of how sukuk perform in varied market conditions sukuk will become priced more competitively compared to conventional debt. Additionally, greater clarity about which sukuk are preferred by Shari'ah scholars will lead the industry towards certain structures and will encourage the greater use and (hopefully) greater standardization of these types of sukuk.

Uncertainties

"In our view, the February 2008 announcement by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOFI), which addressed the issue of whether bonds structured with no transfer of collateral were sharia-compliant, contributed to market uncertainty. We understand anecdotally that the AAOFI's position may have prompted investors to seek a 'risk premium' for particular sukuk transactions and, consequently, to a lull in issuance. "

"Sometimes uncertainties pertaining to the legal environment surrounding sukuk issuances are simply due to the fact that the relevant legal framework has so far been untested, because the laws have been so new and defaults lacking."

All of these uncertainties will be cleared up over time, but it will take time. The AAOIFI ruling and the difficult economic conditions should force the industry to consider many different possibilities and defaults will increase the legal certainty about how investors can expect to be treated. However, until there is a longer history of sukuk with varied economic conditions, there will be a 'risk premium' associated with sukuk. The greater the degree to which industry addresses the shortage of Shari'ah scholars, either through training new scholars or reducing their workload by standardizing the 'plain vanilla' contracts, the quicker the risk premium will come down.

Secondary markets

”Standard & Poor’s Ratings Services estimates sukuk outstanding worldwide to be in excess of $76 billion at yearend 2008. Over two-thirds are unlisted, over-the- counter instruments, with the remainder listed. The number and size of listed sukuk are increasing fast, the largest being that issued by Dubai-based Nakheel Group in early 2007 for $3.52 billion, listed in London and Dubai.”

"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."

As I mentioned above, the shortage of sukuk compared to the demand has caused much of the illiquidity in secondary markets. As the pipeline turns into new issues and economic and credit market conditions improve, this shortage will diminish. The standardization of contracts should also help encourage secondary markets because the pricing of different sukuk will become more meaningful in evaluating one sukuk compared with other sukuk of similar structure.

The Economist on GCC sukuk, first Canadian Shari'ah-compliant ETF planned

Canadian Islamic finance compaany UM Financial is partnering with Jovian Capital Corporation to explore the launch of a Shari'ah-compliant ETF. North America currently has a lack of investment products for Muslim investors. Although there are a few mutual funds, the landscape is currently dominated by Amana Funds which offers only two Islamic mutual funds. The greater development of Shari'ah-compliant ETFs would serve to expand the investment options available to Shari'ah-sensitive investors.

The Economist discusses the prospects for the Gulf bond and sukuk markets following the credit crisis and the first GCC-based sukuk default (The Investment Dar).

In a report for LSE's Kuwait Proramme on Development, Governance and Globalization in the Gulf States, Rodney Wilson points out the "the search for alternative means that Islamic banks are likely to receive more attention" in the wake of the credit crisis that originated in conventional financial institutions in the US.

Other News

• The Islamic Development Bank may raise its planned sukuk issuance from $5 billion over 5 years to $6 billion over the same period.
  
• NCB Capital commented on the prospects for GCC sukuk issuance, while Malaysian-based Aminvestment provided a rosy outlook for the Malaysian sukuk market.
  
• Islamic banks are levying 'maintenance fees on small accounts and are treating them as current accounts and not providing them with the profit-sharing features common for accounts at many Islamic banks.
  
• 
  
• Standard & Poor's has launched an Shari'ah-compliant version of the S&P/TSX 60 Index.
  
• The Investment Dar continues the process of restructuring, forming a steering committee to communicate with investors.
  
• Salama, a takaful and re-takaful company has partnered with Credit Agricole Asset Management to launch a series of Islamic funds.
  
• An article describes the methods by which trusts can be created to be Shari'ah-compliant.
  
• Malaysia's Securities Commission revised its list of Shari'ah-compliant securities to add 13 and remove 1. Unlike most other countries, Malaysia centralizes many Shari'ah-compliance functions.
  
• Terry Lacey describes the ASEAN annual meeting of Shari'ah scholars held in Indonesia and warns the industry of 'flying to close to the sun'.
  
• Hawkamah issued a declaration calling for the development of isolvency and creditor rights systems for the Middle East and North Africa "Noting the importance of Islamic finance institutions in the region and beyond".
  

S&P report summary (part 2)

In an earlier post, I began a summary of the Standard & Poor's Islamic Finance Outlook 2009 and I want to continue the analysis with a more in depth look at one of the main liquidity risks that is particular to Islamic banks: the use of profit-sharing investment accounts. The idea of profit-sharing deposit accounts instead of traditional interest-bearing deposit accounts goes back to the early conceptions of Islamic banks where they operated raising funds from depositors under a mudaraba arrangement (acting as the mudarib, the manager of the funds). In this arrangement, deposits would be invested on behalf of depositors and profits would be shared between the Islamic bank and the depositors but losses would be borne exclusively by depositors (as the rabb ul-mal, the provider of capital).

This ran into two primary problems. First, there was an informational (and incentive) asymmetry causing a principal-agent problem between the depositors. The depositors prefer greater stability over higher returns because they bear any losses whereas the bank benefits from the sharing of any profits but are not on the hook for losses. Second, absent a solution to the principal-agent problem, Islamic banks have a competitive disadvantage vis-a-vis conventional banks who are more than willing to accept deposits from clients who refuse to accept any interest.

In order to be competitive with conventional banks while still adhering to the mudaraba style deposit, Islamic banks developed several safeguards to protect depositors against losses of principal. Standard & Poor's describes these:

• "Profit equalization reserves (PERs): These reserves constituted by IFIs can be used to smooth returns offered to PSIA holders in cases of reduced distributable cash flows. For instance, if an Islamic bank realizes an effective profit that is not sufficient to offer its PSIA holders a satisfactory return, it could use part or all of its PER to boost the return and maintain its deposit base. PERs are deducted from a bank’s gross profit before allocating the mudarib fee.
  
• "Mudarib fee: This is the remuneration of the bank for acting as a manager (mudarib) of PSIAs. The mudarib fee is not fixed and differs from one bank to another, but is typically between 20% and 40% of the distributable cash flows. This can provide a bank with some room for maneuver in case of unexpected profitability deterioration; it could simply decide to waive its fee, allowing a higher remuneration to PSIA holders.
  
• "Investment risk reserves: These are reserves constituted by IFIs in order to curb the risk of future unexpected losses and enable them to be in a position to support PSIA holders should such losses occur. IRRs are set aside by IFIs after allocating the mudarib fee.
  
• "Liquidity: IFIs offering PSIAs are in general more liquid than conventional banks as they are aware that their reliance on PSIAs could trigger liquidity stress. The average liquid-to-total assets ratio for GCC-based IFIs rated by Standard & Poor’s was 30% at midyear 2007, compared with 18.1% for GCC-based conventional peers. This extra liquidity has a negative impact on profitability, however. Some leading Islamic banks have a portfolio of assets that can be repoed with their central bank.
  

Profit equalization reserves. Profit equalization reserves offer the first cushion between an Islamic bank's asset performance (funded by deposits) and depositor returns. When returns are above the level needed to meet the competitive rate, additional profits are put aside into the PERs. If the bank's investments returns falls below the level needed to offer a competitive rate for depositors, the PER can be tapped to make up the shortfall.

Investment risk reserves: These are essentially an additional buffer for depositors that are set aside from depositor returns (e.g. after the mudarib fee is taken) out of profits that would otherwise flow to depositors. Their presence adds protection to depositors, but at the same time, because they are taken from the depositor share of profits, lower returns for depositors. This smoothing of paid-out returns to depositors is used to make the deposit base more stable. Without the smoothing, depositors could move their deposits between banks in search of the current highest return. If this happened, it would undermine all Islamic banks' returns because they would either face liquidity shortages (forcing them into sales of assets at fire sale prices) or more likely, they would hold additional assets in low- or no-yielding assets which would reduce their overall profitability and therefore limit their ability to generate returns for depositors.

Mudararib fee: In exchange for managing mudaraba deposit accounts, Islamic banks receive a share of any profits. In cases where the investment risk reserves and PERs are depleted or are in danger of being depleted, Islamic banks reduce the share of profits they take in order to preserve the other buffers. This functions the same way for depositors as the PERs and the investment risk reserves but the funds come from a different source. This helps Islamic banks maintain their deposit base but come at the expense of shareholders instead of out of depositors' retained profits in the investment risk reserves and PERs.

Liquidity: This is the most similar to conventional banking (especially in situations where deposit insurance is absent). In order to meet depositor withdrawals and stem any potential runs on the bank, all banks are required to hold liquid assets. However, because the mudaraba deposits are not insured and because there are limited sources of external liquidity for Islamic banks because they cannot turn to conventional inter-bank money markets, this liquidity buffer is significantly larger for Islamic banks than for conventional banks (30% versus 18% in the GCC).

Overall, the goal of all four buffers is to attract and retain depositors at competitive rates. Another way to think about it is in terms of the flows of money within a bank as it collects deposits, invests them and pays out profits to depositors and shareholders.

Depositor funds are invested by the bank and expect a return that is equal to the rate of return they could receive from a conventional bank. The bank takes the deposit and invests it in assets that have a higher average return than the market rate paid on depositor accounts, but this return can fluctuate. In the good times, the deposited money generates profits that exceed the return expected by depositors by more than the mudarib fee. Some of these profits are placed into the profit equalization reserve account. The remainder is divided between the depositors and the bank (through its mudarib fee). The expected return is paid to depositors and the remainder is placed into the investment risk reserve account. This happens every month (or year) while profits are healthy enough to afford it. If in one month or year, profits leftover for depositors fall short of the expected depositor return, the difference is made up from the investment risk reserve account (depositors' retained profits). If this is not sufficient, it is supplemented out of the PERs (retained profits, some of which is depositors', some is the bank's retained mudarib fee). If the PER is not sufficient, then mudarib fees are cut in order to make up the difference (shareholders' retained profits). If all sources of retained depositor investment profits are exhausted, the bank has run into trouble and depositors will receive less than their expected rate of return. If depositors remove their funds en masse, the bank will have to draw from its liquid assets to meet withdrawals to avoid selling assets at distressed prices. Without a sufficient liquidity buffer, the bank could be forced into distressed asset sales which would constitute a crisis and could, depending on the price at which they can sell assets, precipitate insolvency.

Sukuk funds, Ernst & Young report on Islamic funds

Two sukuk funds were launched in the last few days. The funds, the Qatar Investment Bank-European Finance House Global Sukuk Plus Fund and the Tharawat Investment House Sukuk Fund. Sukuk funds have been fairly rare until now but provide an interesting development for the industry. Both firms noted that the sukuk market was experiencing some disruption and creating sukuk funds to invest in outstanding and new sukuk issues provide a good opportunity. The one challenge for the sukuk funds will be to find enough sukuk to invest in, especially if they attract significant investments. The sukuk secondary market is very illiquid and sukuk issuance has tumbled since its peak in 2007. The sukuk markets will see growing issuance as the conditions in credit markets and the economy improve, but whether the funds will be able to subscribe to enough of these sukuk will be interesting to follow.

Ernst & Young released their Islamic Funds & Investment Report 2009 which contained several different pieces of information from the S&P report:

• "Shari'a sensitive investable assets in 2008 in the GCC and Asia touched US$736 billion as compared to US$267 billion in 2007 (in computing the total asset size this year, the report included Awqaf and Endowments, Takaful operators in Malaysia, SWFs in the MENA region and Asia, and it also includes the markets of Pakistan and South East Asia - all of which where not included in last year's figures)"
  
• "The largest concentration of Islamic funds remains in the Middle East and equity funds lead the field for choice of asset type. 19% and 23% of Islamic funds are domiciled in Saudi Arabia and Malaysia respectively."
  
• "Islamic indices have performed poorly worldwide - we see the average return from Islamic equity funds fall to minus 39% in 2008 as compared to a 23% return in 2007. In the first quarter of 2009, the average return stood at minus 3.7%. Average Islamic fixed income fund return dropped from 3% in 2007 to 1% in 2008 and Q1 2009."
  
• "Sukuk issuance has slowed as spreads widen - sukuks worth US$15.5 billion were issued in 2008 as compared to US$47.1 billion in 2007."
  
• "Omar Bitar, Managing Partner, Middle East Advisory Services at Ernst & Young Middle East, said, 'Two-thirds of all players manage less than US$100 million each in Islamic assets - the global competitive landscape is fragmented and a shakeout appears likely.'"
  
• "[Head of the Islamic Finance Services Group] Sameer [Abdi] said, 'The business risks landscape for Islamic asset management has changed substantially since 2008. Revisions of expected returns have caused some investors to withdraw capital and previously robust business models have struggled to cope with extreme market events. The economic downturn, a reduction in investor risk appetite and unclear valuations will be the most pressing business risks in 2009.'"
  

Other News

• A Malaysian perspective on the Standard & Poor's Islamic Finance Outlook.
  
• Kuwait Finance House-Bahrain is no longer in talks to acquire a 40% stake in Bahrain Islamic Bank from The Investment Dar.
  
• The Investment Dar will meet with creditors to update them on its restructuring plans sometime in June.
  
• Humayon Dar, head of BMB Islamic described the impact of the crisis on Islamic financial institutions very accurately: ""Clearly Islamic finance, along with the rest of the financial industry, has suffered from the downturn, but the effect came later and resulted in less of a slowdown because Islamic institutions were not exposed to any of the toxic assets which caused the slump. Islamic equity funds have clearly suffered because of the credit crunch which has seen all equities fall, but they have lost less than conventional financial funds." The chief economist at NCB Capital describes the evolution of the sukuk market well: "Initially sukuk wanted to mimic the conventional bond markets, but that is how new markets get started. Now they can move to where they have their own identity."
  
• US-based Thomas Weisel announced a partnership with Ideal Ratings to begin offering Islamic funds and separate accounts for helping investors invest in the small- and mid-cap sector in the US.
  

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.

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 

News

• 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.

Sukuk, SPVs and the 'true sale'

I want to begin this post with a caveat that this post is about a topic--legal and regulatory treatment of securitization--in which I do not claim an exceptional degree of expertise. However, I saw an article that deals with off-balance sheet, bankruptcy remote entities used for securitization of credit card receivables that I believe has relevance to the Islamic finance industry.

While I was writing an article for Islamic Business & Finance magazine about the bankruptcy of East Cameron Partners, which had issued the first U.S. corporate sukuk, I did some research into the SPV structure used in most sukuk transactions. In most sukuk transactions, assets are sold to an off-balance sheet SPV which pays for them using funds raised by issuing sukuk to investors. The use of these bankruptcy-remote SPVs provide investors with ownership of an asset that, at least in theory, will not be subject to claims made by other creditors of the company that sells them to the SPV to raise money if the company goes into bankruptcy.

They are also used in many sukuk to create asset-backed financing where investors do not have recourse to the company's other assets in case of default; a default usually triggers a dissolution of the SPV and, in effect, a redemption of the remaining principal through a repurchase by the company of the asset. Between November 2007 and February 2008, there was a good deal of attention paid to how the repurchase/redemption is structured from a Shari'ah-compliance perspective.

In the article, "Securitization: Advanta and the Fiction of True-Sale", the focus is on whether securitization--specifically the sale of assets to off-balance sheet entities--constitutes a 'true sale'. The 'true sale' concept provides the degree of separation that protects assets owned by the SPV from creditors of the company and the company from investors claims on its assets apart from the assets sold to the SPV. If the 'true sale' is not recognized, it would jeopardize the entire structure, which, in a bankruptcy proceeding, would be combined together, much to the chagrin of investors and the company. One law professor I spoke to writing the East Cameron article whose expertise is in securitization and bankruptcy law said that absent unusual circumstances, the 'true sale' would most likely be respected by bankruptcy courts.

Where I see the potential for problems for the Islamic finance industry is with the complex, multi-jurisdictional structure of many sukuk transactions that create asset backed sukuk. These also include some provisions for the company to repurchase the asset or be responsible for provide investors with some form of guarantee of the expected payments if there is a default. One of the main legal risks to the sukuk market is that there have been few cases where the structures used were tested in courts in many of the areas where sukuk are issued. If a 'true sale' was not recognized by a court it could shock the industry to an even greater degree than the AAOIFI ruling on repurchase agreements in sukuk or the OIC Fiqh Academy ruling on tawarruq. Apart from additional experience which may be coming if more sukuk issuers default, there's not much that can be predicted in advance, but this could be one of the most difficult 'growing pains' for the young industry.

Role of Shari'ah scholars in the Islamic finance industry's development

I was involved over at the Zawya Network and I thought that I should share one of the messages I wrote with a broader audience. I would appreciate any thoughts about it; it's a rough outline of the arguments over Shari'ah scholars' role in developing the industry and my thoughts on the two primary ideas.

The comments on the OIC Fiqh Academy ruling on tawarruq has raised some interesting points about the role of Shari'ah scholars in the development of the industry. These are somewhat opposing viewpoints that I think are best described as 1) Shari'ah scholars should maintain a hands off approach in the industry's development and should focus primarily on certification/review role (the "auditor role") and 2) Shari'ah scholars have taken too much of a hands-off role in the industry's development and in the interest of the industry's growth have approved products that are too closely replicating interest-based financial products (the "facilitator role").

Both to some degree have elements off truth in them. Shari'ah scholars are the most knowledgeable about the Shari'ah and therefore can serve an important role in guiding product development away from replication. However, Shari'ah scholars, while having a degree of expertise in financial matters that qualifies them to understand complex financial product contracts and apply their expertise in Shari'ah to certify only compliant products, are not experts in new product developments.

In a way, one solution would be to limit Shari'ah scholars to the auditor role in much of the industry's development and leave innovation to financial institutions unless they move the industry away from Shari'ah-compliant products and focus more on circumventing restrictions. However, this leads to less development of microfinance and venture capital than many people feel would be optimal.

This moves the discussion away from Shari'ah scholars per se, but could involve Shari'ah scholars in creating a solution. However, it would require Shari'ah scholars to either provide volunteering time to areas of finance that do not have the resources of the larger Islamic banks (like microfinance) and also to communicating with Islamic financial professionals in broader discussions about the industry's development. To some degree, the lack of standardization of contracts in the Islamic financial industry hamper both because Shari'ah scholars spend so much of their time reviewing relatively plain vanilla contracts.

One new development I saw recently provides indication that a broader discussion could develop: Islamic Finance News is starting an "Ask A Scholar" column in June with several prominent Shari'ah scholars. As one step, this is a positive development, but it is not enough. Sheikh Yusuf DeLorenzo, for example, published an analysis of "Shari'ah convergence technology" dealing with swaps that provided greater insight to a wider audinece than I have seen many places elsewhere. I hope that a broader discussion about the industry's future involving Shari'ah scholars and industry practitioners can develop. Neither group has exclusive claim on leading the future of the industry. Only cooperation and broadly disseminated discussion from both will provide the industry with a more coherent vision for its future and that benefits everyone.

Sukuk markets 'recover'? DIB buyback, FTSE Yasaar index in Thailand, TID denies bailout.

Trowers and Hamlin, a law firm involved in the Islamic finance industry compiled a number of interesting statistics about the sukuk market, which has rallied 29% since February:

"Since the market's darkest day on February 11 the average yield on corporate GCC sukuk has fallen from 17.2% to 10.1% and the average credit spread over LIBOR has narrowed from 1,414 to 763 basis points."

Although the improvement in prices and drop in yields is a positive for sukuk issuance later this year, the explanation that the rally was due to optimism in caoital markets and governments in the GCC providing support to the issuers is only part of the picture. As I have tried to demonstrate by looking at two individual sukuk, Jebel Ali Free Zone (JAFZ) and Nakheel (which should be followed soon by a third on The Investment Dar sukuk on which the company defaulted). The two pieces highlight differences between sukuk, but focus on the lack of liquidity in sukuk secondary markets which makes them very volatile. One of the primary causes of this illiquidity is the shortage of sukuk which leads buyers to adopt a 'hold-to-maturity' position at greater levels than in conventional bond markets because there is unlikely to be another new sukuk to reinvest the proceeds from any sale. This is particularly true when new issuance has plunged, as it did during 2008 and the first quarter of 2009.

The Dubai Islamic Bank finished the first sukuk 'buy back' of $50.62 million at 88% of par value.

In response to earlier media reports that the Kuwaiti government was planning a bail out of The Investment Dar, the company released a short simple statement: "The Investment Dar Co. K.S.C.C. confirms that no negotiations are being held regarding a bail out by or other funding from the Central Bank of KuwaitCentral Bank of Kuwait, contrary to recent media speculation."

FTSE Yasaar launched its newest Islamic index, this one providing an index benchmark for the SET in Thailand.

Wednesday update

• A business management student at Singapore Management University shares some thoughts about a 15 week course on Islamic finance in the Straits Times.
  
• The AAOIFI Shari'ah conference held in Bahrain this past Monday and Tuesday discussed a number of topics including tawarruq and reverse tawarruq, two products that were recently condemned as a 'deception' by the OIC Fiqh Academy.
  
• Calyx Financial spins out an Islamic investment firm called Codexa Capital that, although based in the US, focuses primarily outside of the US.
  
• Islamic Finance News will begin an 'ask a scholar' column featuring the Shari'ah scholars on the ISRA Council of Scholars including Dr Mohd Daud Bakar, Dr Mohamed Ali Elgari,
  Dr Abdul Shukor, Dr Abdul Sattar Abdul Kareem Abu Ghuddah and Dr Yusuf Talal Delorenzo.
  
• The most recent Central Bank of Bahrain short-term ijara sukuk (which have a maturity of 182 days) was oversubscribed by 200% with a return of 1.30%, compared with the interest rate on identical maturity conventional debt issued today of 1.09%.
  
• Dubai Islamic Bank is buying back $50.6 million of its own sukuk maturing in 2012 at 88 cents on the dollar.
  
• The sovereign wealth fund of Malaysian region Kuala Terengganu, Terengganu Investment Authority, will sell 30 year oil revenue backed sukuk to raise up to $3.1 billion.
  
• Humayon Dar, cEO of BMB Islamic, does not believe the UK will issue a sukuk within the next 12 months. While in Malaysia he said "I wouldn’t think that in the near future, and the near future means in the next 12 months or so, there will be any Islamic sovereign bond issued by the government of Britain."
  
• Malaysia is putting aside $1.72 billion to promote Islamic venture capital. Deputy Minister of Finance Dr. Awang Adek Hussin said "By providing funds to budding entrepreneurs with sound ideas, Islamic venture capital can help to promote innovation, job creation and the development of high growth industries".
  
• There is an interview with Malik S. Sarwar, CEO of New York-based Sarwar Wealth Advisors which is interesting except for the title which focuses on Islamic finance as a 'panacea'.
  
• Kenyan Islamic bank First Community Bank is planning expansion beginning with entry into neighboring Uganda and Tanzania within the next year and a half.
  

Dubai may issue more bonds to support government related entities, Kuwait government may bail out TID

Dubai has handed out nearly half of its first tranche raised in its recent $10 billion to government related entities including DP World and Nakheel. The government of Dubai is also likely to issue another $10 billion tranche of bonds to continue to support GREs including assistance to Nakheel as its $3.52 billion sukuk reaches maturity in December (a sukuk I discussed earlier this month). Troubled Islamic mortgage providers Amlak and Tamweel will not be merged until after they are restructure, plans for which are expected in a "few weeks" according to Sheikh Khalid Bin Zayed Bin Saqer Al Nahyan.

The Kuwaiti government may bail out troubled Islamic investment bank The Investment Dar which recently defaulted on its sukuk, the first such default in the GCC. Critics point to a mismatch between cash flow and liabilities as well as the company's highly leveraged position which included its partial takeover in a leveraged buy-out of Aston Martin. Two interesting paragraphs in the article, which touches on systemic risk in Islamic finance, the topic of my forthcoming opinion piece in Business Islamica magazine:

"Bankers agree that the TID default may be a one-off and would not have a contagion effect even if there were one or two more defaults in the Sukuk or wider Islamic finance market. The financial market generally also prices in default probabilities to a certain extent.

"Another Islamic capital markets expert, however, warned that the main "issue has always been a lack of transparency in the structure and Shariah compliance process. The issuance is also not under a well-regulated jurisdiction familiar with Islamic financial products. Obviously there will be some contagion, as investors will now relook at the structure of the product they are holding. But it is fortunate that there is no secondary market otherwise the mark to market valuations across the board would be in a state of disarray."

Other News

• The Saudi Gazette has an article summarizing the speech given by Enad Al-Menaie, the chairman and managing director of the Liquidity Management House at the 6th IFSB Summit in Singapore recently.
  
• Brunei issued the 30th in its series of short-term ijara sukuk. So far the country has issued over B$1.6 billion ($1.1 billion) in ijara sukuk since April 2006. One of the topics discussed at the AAOIFI conference was the use of arbitration instead of commercial, secular courts in handling disputes about Islamic financial products.
  
• AAOIFI held its annual Shari'ah Conference in Bahrain on May 18-19, 2009. Indonesia will host a meeting of Shari'ah scholars from Southeast Asia later in May.
  
• Indonesia may issue another sukuk, this one for IDR 5 trillion ($485 million), later this year.
  
• UM Financial Group, a Canadian Islamic finance company, and Mint Technology are launching prepaid cards targeting the Muslim community in the country.
  
• An interview with Eric Meyer, CEO of Shari'ah Capital describes their strong balance sheet and the performance of their long-short equity funds which focus on commodities.
  
• The managing director of Korea Investment & Securities Co. Ltd. discusses the country's interest in Islamic finance in an interview.
  
• Bank Islam and MayBank Islamic have both denied reports that they may merge.
  

UK sukuk, TID sukuk default

The UK Treasury plans to issue a sukuk appear to be back on the table again "A sovereign sukuk may form a part of our financing for the future, I am keen in principle to look to issue sovereign sukuk but conditions have to be right to do that," according to Business Minister Ian Pearson. The government had been expected to announce a GBP 2 billion ($3.03 billion) sukuk last year but plans were shelved due to challenging market conditions.

An article in the UK newspaper the Telegraph (with a fairly cynical view of Islamic finance) describes the default of the Investment Dar sukuk. I hope to take a more in depth look this weekend and post a summary either here or more likely on my blog at Zawya.com

A Time magazine article looks at the halal industry, including Islamic finance:

"Citing the kosher and organic industries as successful examples of doing well by doing good, some entrepreneurs even see halal products moving into the mainstream and appealing to consumers looking for high-quality, ethical products. A few firms that comply with the Shari'a code — the religious laws that observant Muslims follow — point out that already many of their customers are non-Muslim."

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.

S&P, State Street reports, Nakheel bailed out by Dubai gov't, TID defaults on sukuk, first in the GCC

In its 2009 Islamic Finance Outlook, Standard & Poor's discusses some of the challenges facing the industry but "continues to foresee a bright future for Islamic finance". S&P Credit Analyst Mohamed Damak believes that "The long-term pipeline for sukuk issuance is healthy, and the market is attracting interest from an increasing number of issuers in both Muslim and non-Muslim countries." The report is available for download (pdf) from www.gcc.standardandpoors.com.

The Nakheel $3.5 billion sukuk that matures in December is one of the most at risk sukuk following the default of the Investment Dar sukuk. An article describes the sukuk and challenges facing Nakheel, most of which I covered in a post on my blog at Zawya (which was also posted here). They have also said they received financial assistance from the Dubai government.

The Islamic finance industry is going to see a significant test of its legal structures and the relative importance of common and Shari'ah law in the resolution of defaults in the next few years, according to an article from Reuters. As in the case of Beximo Pharmaceuticals v. Shamil Bank of Bahrain earlier this decade, I think it is highly unlikely for many cases to be determined by the Shari'ah-compliance or lack of compliance unless they have specific clauses that forces the dispute resolution first to an arbitration involving Shari'ah scholars. In most cases, like the Beximo case, the contracts are subject to English (secular) law and the Shari'ah-compliance is not an issue.

According to the Chairman of Dubai Financial Market's Shari'ah Board Dr. Hussain Hamad Hassan, the exchange is planning a release of comprehensive standards on sukuk issuance, listing secondary market and market making. The announcement of the standards is expected within about two weeks once they are approved.

Other News

• State Street issued a report on Islamic finance. It included the observation that "Western markets may also get close to thoughts and policies that underline Islamic finance."
  
• Despite a challenging year in Islamic finance, the assets in the industry within Bahrain grew by 50% from $16.4 billion to $24.6 billion according to the Central Bank of Bahrain.
  
• The BBC has a story on Islamic finance.
  
• Abu Dhabi Commercial Bank is planning to launch an Islamic subsidiary, Abu Dhabi Commercial Islamic Finance Company, soon. This is one of the first new banks launched in the GCC in a while following the economic difficulties facing the region.
  
• Dubai Gold Certificates, the ETC traded on NASDAQ Dubai has attracted significant interest from institutional investors.
  
• Islamic banks face difficulties in expanding internationally in the short-term although increasing geographical diversification can provide long-term benefits according to a report by Moody's.
  
• Two Qatari Islamic financial institutions have applied for approval to operate in France.
  
• Islamic finance is soon coming to Spain with the launch an Islamic current account at a building society in the Balearic Islands.
  
• Kyrgyzstan is moving forward on plans to adapt regulations to allow Islamic financial institutions.
  
• The Philippino dairy industry may opt to raise up to 5 billion pesos ($105.6 million) to finance a breeding program for increasing milk production using a sukuk if that will help attract funds from Saudi Arabia and other countries with Muslim majorities.
  The Labuan Offshore Financial Services Authority (LOFSA) reported growth in Islamic finance:

  "Islamic Financial Services
  
  The Islamic finance industry and the retakaful sector remained active in 2008. The retakaful gross contributions increased by 48.2% to USD162.3 million, driven by four full-fledged retakaful operators and nine retakaful windows.
  
  This is followed by the Islamic private fund management. Five new Islamic private funds were established in 2008, with an approved fund size of USD1.5 billion increasing the total Islamic private funds to USD2.8 billion. This represents one-third of the total size of private funds in Labuan IBFC. The growth in the portfolio of the Islamic funds reflects the emergent role of Labuan IBFC in facilitating Shariah compliant investment activities in the region.
  
  In the Islamic banking sector which comprises 6 Islamic banks and 3 banks with Islamic windows, the total deposits grew to USD337.3 million from USD250 million in 2007."

• ABC Bank plans to expand its offering of wholesale Islamic finance products in Europe and in particular in the UK and France.
  

RGE Monitor stress tests the Islamic finance industry

RGE Monitor has an article providing an informal stress test of the Islamic finance industry and it provides only a stitching together of a few themes that I have mentioned on this blog.

Capitalization of IFIs:

"Preliminary estimates for the sector (but not individual banks) suggest that most are relatively well capitalized but most still have relatively small market shares. Moreover the rate of growth of Islamic bank assets and of funds placed in Sharia-compliant securities and funds is likely to be significantly slower than many predicted in 2008 as slower growth and tighter liquidity restrict the funds to be invested."

Impact of asset prices on Islamic finance:

"The core of Islamic finance stipulates that financial transactions should be backed by real assets - In practice, real estate and sometimes commodities. As a result, Islamic banks are greatly exposed to the ongoing property sector downturn and a phase of price correction especially in the GCC. Thus any stress scenario should factor in at least another 40% drop in property prices in Dubai and considerable drops in other markets. Islamic banks operating in advanced economies like the UK or the US are also exposed to such property declines. However, at least in the U.S. the community banks focused on Islamic finance may suffer fewer delinquencies than their counterparts given a reluctance to lend to subprime borrowers and lack of securitization."

Exposure to global credit markets, liquidity and Shari'ah-compliance issues:

"The absence of liquid Sharia-compliant asset classes does create a challenge to managing liquidity among the Islamic financial institutions. Moreover many securities are based off of libor providing a vulnerability to global credit conditions. Following the liquidity crunch, global sukuk issuance worldwide reportedly declined to $20 billion in 2008, compared with more than $40 billion a year earlier. Nonetheless, although the liquidity crunch of 2008 and pressure on most asset markets contributed to a drop in the global level of sukuk issuance (as it did to conventional bond issuance and equity public offerings), it was not the only factor. Concerns about the Sharia compliance of several sukuk structures contributed to lower demand even before liquidity conditions worsened in the gulf. This uncertainty as well as the regulatory issues will be a check to growth until resolved."

Other News

• Saeed Jawed Ahmad, a Saudi Arabian-based Islamic banker has an interesting commentary about the differences between conventional and Islamic finance.
  
• Islamic mortgage providers Amlak and Tamweel are expected to have their merger approved by shareholders. Amlak sukuk are currently trading at about 62 percent of par value as common share trading has been suspended and the government took control and the companies' lending was stopped.
  
• Dubai World may sell a minority stake in its ports businesses, DP World, to private equity firm Abraaj Capital. A dilution of the Dubai World stake could hurt the credit rating of the company because it would reduce the likelihood of government support according to Martin Kohlhase, an analyst at Moody’s in Dubai. This could hurt the prospects of holders of the company's $3.5 billion sukuk.
  
• Malaysia hopes that the easing of restrictions recently will allow it to attract a few larger banks providing Islamic financial services.
  
• AFP has a short summary of the IFSB summit, but confuses one fact about the prohibition of riba in Islamic finance with the prohibition of gambling (maysir). Arab News has a more complete summary with additional commentary.
  
• Mawarid Finance and Al Arabiya launched an Arabic-language portal for information on Islamic finance.
  
• Shariah-Fortune, a relatively new, UAE based informational website on Islamic finance, released a study showing that the Middle East leads the industry overall and Malaysia is the leading country in Asia.
  

OIC Fiqh Academy issues fatwa ruling tawarruq is not Shari'ah-compliant

While the OIC Fiqh Academy does not have the force of law in its fatawa, the recent fatwa condemning tawaruq as a deception will have a significant impact on the Islamic finance industry, perhaps a greater one than the AAOIFI ruling on sukuk in February 2008. The tawaqrruq product is one where a bank buys metal on the spot market, sells it to the customer for the spot price plus a profit margiin and then acts as the customer's agent to sell the metal again on the spot market. The economic result of the transaction is that no physical commodity (metal in the most common cases) exchanges hands but the customer ends up with cash as well as a deferred liability (a debt) to the bank that equals the cash received plus a pre-agreed, fixed rate of profit. It has been frequently used in the Islamic finance industry but has always been rather controversial because the trades involved have been executed to synthesize a conventional loan with little other activity. Neither the bank nor the customer have a use for the metal involved in the transaction.

Beyond its direct effect on tawarruq, the OIC Fiqh Academy ruling could have a greater impact on the industry as a whole by questioning whether the means justify the ends: that is, whether ensuring that products are structured in a way that is Shari'ah-compliant provides sufficient justification for creating an outcome that looks very similar to conventional financial products. In many cases, products will continue to be viewed as necessary compromises that, although creating economic effects that look like interest, are used in a way that directly facilitates economic activity.

In contrast to the tawarruq transaction described above where neither the bank nor the customer plan on using the metals involved is an ijara transaction like the ones used in many sukuk. In this case, a company owns a property and sells it to an SPV that has raised money for the purchase from selling ownership interests to investors. Upon selling the property to the SPV, the company then leases back the property for use in its business. The company also retains an option to repurchase the property at the conclusion of the lease, although the price at which it will do so is not fixed at the outset to avoid falling afoul of the AAOIFI rules on sukuk issued last year. In the ijara transaction, the company receives money from investors, pays regular lease payments tied to LIBOR and at the conclusion of the lease redeems the certificates by repurchasing the property from the SPV.

In both cases, tawarruq and ijara sukuk, the economic outcome remains the same--financing is provided and repayment is made later at a higher value than the initial amount--but in the former case, the traded commodity is used only for effecting the transaction but in the latter case, the commodity is used in the underlying business for which the transaction is structured. This, I believe, will become a more frequently used test to determine whether Islamic financial products are structuring for sake of replicating interest-based transactions or transactions created to finance business activity. This does not seem like an overly tight restriction, although it has huge implications for the industry and could restrict the industry's growth. It will now be a test for the industry to come up with replacement products tawarruq (and commodity murabaha) to provide unsecured financing such as that used to start businesses, pay for education and offer Islamic banks short-term liquidity management.

The translation of the fatwa into English is below and was provided by the International Shari'ah Research Academy for Islamic Finance.

Resolution 179 (19/5)

in relation to

Tawarruq: its meaning and types (classical applications and organized tawarruq)

The International Council of Fiqh Academy, which is an initiative of the Organization of Islamic Conferences (OIC), in its 19th session which was held in Sharjah, United Arab Emirates, from 1 - 5 of Jamadil Ula 1430 AH, corresponding to 26 – 30 April 2009, decided on the following:

Having reviewed the research papers that were presented to the Council regarding the topic of tawarruq, its meaning and its type (classical applications and organized tawarruq), a resolution were passed. Furthermore, after listening to the discussions that revolved about the applications of tawarruq, the resolutions were presented at the International Council of Fiqh Academy, under auspices of the Muslim World League in Makkah.

The following were the resolutions:

First: Types of tawarruq and its juristic rulings:

Technically, according to the Fiqh jurists, tawarruq can be defined as: a person (mustawriq) who buys a merchandise at a deferred price, in order to sell it in cash at a lower price. Usually, he sells the merchandise to a third party, with the aim to obtain cash. This is the classical tawarruq, which is permissible, provided that it complies with the Shari’ah requirements on sale (bay’).
The contemporary definition on organized tawarruq is: when a person (mustawriq) buys a merchandise from a local or international market on deferred price basis. The financier arranges the sale agreement either himself or through his agent. Simultaneously, the mustawriq and the financier executes the transactions, usually at a lower spot price.

Reverse tawarruq: it is similar to organized tawarruq, but in this case, the (mustawriq) is the financial institution, and it acts as a client.

Second: 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.

The recommendation is as follows:

To ensure that islamic banking and financial institutions adopt investment and financing techniques that are Shari’ah-compliant in all its activities, they should avoid all dubious and prohibited financial techniques, in order to conform to Shari’ah rules and so that the techniques will ensure the actualization of the Shari’ah objectives (maqasid Shari’ah). Furthermore, it will also ensure that the progress and actualization of the socioeconomic objectives of the Muslim world. If the current situation is not rectified, the Muslim world would continue to face serious challenges and economic imbalances that will never end.

To encourage the financial institutions to provide Qard Hasan (benevolent loans) to needy customers in order to discourage them from relying on Tawarruq instead of Qard Hasan. Again these institutions are encouraged to set up special Qard Hasan Fund.

IFSB summit, Moody's weighs in on sukuk form versus substance, Sheikh DeLorenzo on Islamic home finance in the US

Moody's released a report looking at the future of the sukuk market with a suggestion that investors look not just at the form of the structure, but the substance as well. Although many sukuk use standard forms (as approved by AAOIFI), they can vary significantly across different individual sukuk using the same form. This is particularly important, Moody's notes, because "The assets in the structure are commonly there for Shari'ah compliance purposes only, and ultimately have no bearing on the risk or performance of the sukuk investments, particularly in a distress situation." This is an important point because it raises questions about whether the sukuk market has focused too much on structuring transactions to receive Shari'ah-compliance and too little on creating a different asset class.

There is an interesting opinion article written by Shari'ah scholar Sheikh Yusuf DeLorenzo describing the benefits from the Islamic home finance product in the US for both Muslims and non-Muslims. These benefits are due to the participatory structure of many forms of Islamic home finance in the US and the non-recourse nature of the loans. The combination of these two factors, according to Sheikh DeLorenzo, leads to a lower rate of foreclosure following delinquency because the Islamic finance companies can only take the house in a foreclosure and if this value is below the outstanding amount owed (the mortgage is 'under water'), the bank faces a loss. Although this is the case in many states for all mortgages, it is not always the case in conventional mortgages.

The IFSB says that Islamic finance regulators need to focus on the entire system instead of having a narrow focus on individual institutions to prevent a repeat of the current crisis facing the conventional financial industry in the Islamic finance industry. I think this is very important because there are fewer safeguards on the industry to prevent contagion from spreading from one troubled institution to healthy institutions, like inter-bank money market and a 'lender of last resort'. The president of the Islamic Development Bank Dr. Ahmad Mohamed Ali said at the IFSB summit that the industry still has a significant amount of innovation needed to continue its rapid growth. The head of the IFSB was also quoted speaking to the Straits Times: "It all comes down to risk management. You've to have proper risk management and proper governance and practices so that an institution doesn't fall down".

Bank Negara deputy governor is quoted speaking about two critical issues that the Islamic finance industry needs to deal with to become more resilient in the future:

"There are a lot of issues that need to be addressed, for example the link to economic activity also has got its shortcomings because they are too focused on real estate for example. The absence of a money market that is also a source of risk."

Other News

• France's new laws that put Islamic finance on equal footing with conventional financial institutions for taxes has attracted the first institution, the Islamic Finance Advisory and Assurance Services, a UK-based consultancy.
  
• There is an article in Foreign Policy magazine that I may have already linked to about Shari'ah scholars and the Islamic finance industry.
  
• The Islamic Development Bank is planning a $500 million sukuk in the first half of 2009. The proceeds will fund the IsDB's activities in member countries this year. This is the bank's first issue in a five-year bond program that aims to raise $1 billion per year. The Monetary Authority of Singapore expects $1.3 billion in sovereign sukuk issues from Singapore, Malaysia and Indonesia in the first half of 2009. The Monetary Authority of Singapore also unveiled measures to attract Islamic finance to the city-state including legal and regulatory changes that allow Singaporean dollar sukuk to be treated identically with conventional government bonds.
  
• Dubai Islamic Bank is going to buy back $200 million of its $750 million outstanding sukuk in a tender offer at between 86% and 90% of par. The Shari'ah-compliance of debt buybacks was not raised in the article. The sukuk last traded March 13 on the London Stock Exchange at 82. The buy back is therefore being offered between a 5% to 10% premium.
  
• RHB Islamic, the Malaysian bank, is expanding its business to Singapore and has applied for a full banking license in the country.
  
• Gatehouse Bank in the UK is setting up a Shari'ah-compiant investment strategy focused on the water industry with Sustainable Asset Management (SAM).
  
• Islamic mortage companies Amlak and Tamweel will receive "major government support" due to their losses caused by the collapsing property markets, increased funding costs and halt in financing.
  
• Fattah Finance, a Shari'ah-compliant brokerage subsidiary of Almaty Financial Centre, is the first Islamic finance company to open in Kazakhstan following the changes in law to allow Islamic finance. Mauritius' first Islamic bank, HSBC Mauritius Amanah, opened today.
  
• A Shari'ah manager at BMB Islamic provides an overview of the basic principles of Isalmic finance.
  

FT special report, Tamweel and Amlak, and other news

Financial Times Special Report on Islamic Finance

One article focuses on the Shari'ah scholars and includes details about the dissent among the Shari'ah scholar community about Sheikh Usmani's criticism of some sukuk forms. I have been generally supportive of his criticism as an example of how the Shari'ah scholars are using their influence to shape the future of the industry, but the focus on strict interpretation also limits innovation in the industry. The issues of standardization and workload on the Shari'ah scholars (as well as the shortage of 'brand name' scholars) has hampered the industry's growth by focusing scholars efforts on certifying plain vanilla Islamic financial products instead of allowing them to focus on more controversial products and help shape the dialogue about the future direction of the industry.

Another article takes up the breather given to scholars caused by the global credit crisis to debate and deliberate on the industry's future. This is a vital topic for an industry that has grown so rapidly in recent years and will ultimately help the industry's progress. One interesting tidbit from the article is that the industry appears near to seeing an alternative to commodity murabaha for short-term liquidity management. Another article focuses on this issue and on standardization.

The sukuk market could be set for a resurgence as global credit conditions are under less stress and one of the principal sources of liquidity--oil revenues--should rebound a bit with the rise of oil prices from lows around $30 to $50. The sukuk market, however, will not be the same and most of the issuance will probably be local currency ijara deals because the recent AAOIFI ruling (Feb. 2008) cast doubt on the Shari'ah-compliance of many mudaraba and musharaka sukuk.

Islamic banks are not necessarily immune from the spill-over effects of the credit crisis into an economic crisis, especially those with high exposure to real estate as the property markets in the Gulf have tumbled. This article also cites a Nomura study of Islamic banks in Turkey during the crisis in 2001 and find no significant advantage. Further, the 'profit equalization reserves' set aside by Islamic banks may not be sufficient to offset losses and could cause Islamic bank deposits to 'break the buck'. I highlighted this potential problem several months bank in Business Islamica and it is a serious problem that may require government intervention if property markets continue to deteriorate.

Two other articles discuss Islamic finance in Asia and the West. One talks of the goal of Malaysia to become an Asian hub for Islamic finance, the other focuses on France and the US as potential challengers to the UK's lead in accommodating Islamic finance following the delay in a UK sovereign sukuk.

The special report concludes with a column by HSBC Amanah's chief executive Mukhtar Hussain.

Tamweel, Amlak and liquidity issues in Islamic finance

Tamweel reported profits for 2008, although it had a loss in the fourth quarter due to "a sharp rise in funding costs, significantly lower business origination levels which affected fee income, substantially lower income from property sales [...[ and higher prudential provisioning on the home finance portfolio". It also excludes a significant amount which was off balance sheet following securitization. The results demonstrate the difficulties caused by the economic crisis and property market crash that affects Islamic and conventional financial institutions alike. Amlak Finance, the Islamic mortgage company in Dubai that will be likely merged with Tamweel is also seeing a rise in delinquencies. The first-hand crisis in subprime mortgages and derivatives has led to a liquidity crunch hitting parts of the Islamic finance industry as a whole.

Other News

• The New York Times has two articles about Islamic finance in the last few days. One includes an analysis of Christianity, Judaism and Islam in terms of their approach to finance and in particular their attitudes towards debt. The other focuses on a few Muslims in New York City who have received home financing from Guidance Residential, a Virginia-based Islamic finance company.
  
• Amid the difficulties facing the Islamic finance industry from the economic crisis caused by the global financial meltdown last year, Kuwait Finance House continues its expansion into China and Saudi Arabia to make it an even more global firm.
  
• American fund manager Franklin Templeton may be eyeing expansion in the Gulf and into the Islamic finance industry through its option to acquire up to 40% of Algebra Capital.
  
• Jordan has provided $10 million in financing to the Islamic Development bank to support microfinance programs.
  
• The International Islamic Financial Market (IIFM) held its 20th annual meeting and discussed, among other issues, its work on creating standardized contracts for several frequently used Islamic finance products.
  
• South Korea continues its efforts to make inroads into the Islamic finance industry at the IFSB meeting as a way to attract capital from the Islamic world.
  
• UBS's plan to increase its staff in the Gulf region and make inroads into Islamic finance appear to be on hold due to the company's problems arising from the credit crisis.
  
• Azerbaijan is considering legislation to allow Islamic financial institutions to begin offering products in the country.
  

Sukuk pricing: valuation or illiquidity (Part 2)

I am going to put this also on my blog at Zawya.com, but there are some technical difficulties preventing me from doing it right away, so I wanted to share it here.

In the last few days, Standard and Poor's placed several Dubai government related entities and sukuk on CreditWatch negative, largely caused by uncertainty about how the emirate will handle the maturity of a $3.52 billion Nakheel sukuk. Standard & Poor's wrote:

" The CreditWatch placements reflect our opinion of the likelihood of downgrades of the Rated GREs and The Notes if the potential for extraordinary government support to the Rated GREs and The Notes is not affirmed by the government of Dubai. The need for Dubai government support is potentially increasing in the face of deteriorating fundamentals for some of the Rated GREs."

While this announcement is not completely unexpected, it raises a few questions about the purpose of sukuk and their status as 'asset-based' or 'asset-backed'. This was one of the areas in the East Cameron Gas Sukuk, (currently in bankruptcy resulting from the issuer's Chapter 11 bankruptcy filing) that I examined in greatest detail to understand the structure with regards to possible default in a recent article in Islamic Business & Finance magazine. In the case of the East Cameron sukuk, there was an underlying asset, but the sukuk's musharaka structure provided no recourse for investors should the asset produce insufficient oil and gas to make payments to investors.

The reason I bring up the East Cameron sukuk in the discussion of the Dubai government related entity possible downgrade is because one of the sukuk in question, the Nakheel sukuk, is ijara, which should have different properties than the East Cameron sukuk in the case of default. As an ijara sukuk backed by an asset nearing its maturity date, the price in the secondary market, even if illiquid, should be heavily influenced by the final repayment of principal (asset buy-back). It provides a different example of whether pricing in secondary markets reflects valuation or illiquidity which I discussed earlier in regards to the JAFZ sukuk.

The Nakheel sukuk is an ijara sukuk on land the company is developing in Dubai. Two plots of land are sold to the SPV, which pays for it by issuing the sukuk. The SPV leases back the land to the developer to build on it and the payments are paid semi-annually. The lease payments are fixed throughout the term of the sukuk at 6.345% per annum (which was USD LIBOR+120 basis points when the sukuk was issued in December 2006). When the lease payments are made, 1/2 of the total amount is paid through to sukuk holders; the remainder is paid when the sukuk are redeemed. The holders of the sukuk receive, in addition to the periodic lease payments, the rights to participate in any public offerings by any of the Nakheel Group companies up until 1 year after the sukuk maturity date. These subscription rights allow sukuk investors to purchase shares at a 5% discount. The subscription rights are for up to 30% of the total public offering, with a limit based on the pricing of those offerings of 25% of the total value of the sukuk ($880 million). The sukuk investors through the SPV which issued the sukuk are hold mortgage rights on the properties, a share pledge of 18.89% of the shares of Nakheel (156.4 million shares), as well as an unsecured, guarantee from Dubai World.

The sukuk therefore is a secured debt backed by the land on which the developments are built that is 25% convertible into shares of Nakheel at a 5% discount. The valuation of the land (based on the developments that were planned when the sukuk was issued was AED 15.5 billion ($4.22 billion). The possible downgrade of the sukuk's rating reflects then one of a couple potential problems: Nakheel becoming insolvent, a decrease in the value of the guarantee from Dubai Ports (based on its ability to make whole the guarantee if Nakheel becomes unable to meet obligations to repurchase the sukuk assets), a decreased likelihood that Nakheel will proceed with an IPO which would trigger an additional payment of 2% per annum on the sukuk, or a fall in the value of the developments financed by the sukuk.

The sukuk comes due in December 2009, at which time, Nakheel will have to redeem the sukuk by repurchasing the assets it sold to the SPV plus 50% of the yield on the sukuk plus an additional 2% per annum if the company does not complete an IPO within 1 year following the maturity date. The redemption amount is $3.52 billion. The final distribution (of undistributed lease payments) is $335 million. The additional payment if there is no IPO is $211.2 million. The final periodic payment is $55.8 million and there is one more periodic payment due in May 2009 for the same amount. This means that Nakheel is facing payments totaling $4.18 billion. This is roughly equivalent to the valuation of the development when the sukuk was issued in 2006. SInce then, the property markets in Dubai as they have elsewhere worldwide, have fallen sharply. Nakheel saw its 2008 profit fall to AED 0.5 billion compared with AED 4.7 billion, largely due to a non-cash impairment on the valuation of its properties of AED 4.8 billion.

The exercise of looking deeper into the Nakheel sukuk was to provide more background on whether trading values reflect valuations or illiquidity in the secondary markets for sukuk. The Nakheel sukuk, which trades on the NASDAQ Dubai, last traded on April 21, 2009 at 73. The impairment taken on the property under construction represents about 4% of the company's total properties under construction. Although this impairment amounts to a small amount relative to the total value of the property, a similar impairment to the value of the assets on which the sukuk is based would fall to $4.05 billion, lower than remaining payments due to sukuk investors. A potential downgrade to the guarantor, Dubai World, provides a possible explanation for the valuation implied by the price at which the sukuk last traded. However, in an illiquid market, it is probably overstated. In an article last fall, a spokesman for Nakheel commented that "Globally the financial markets are in a period of unprecedented crisis, where pricing of financial instruments has been distorted across the board. Like the pricing of other sovereign credit, the pricing of the Nakheel Sukuk have similarly been affected, and current market pricing is not reflective of the credit quality of the Nakheel Sukuk". This example, like the JAFZ sukuk mentioned above, should provide further impetus for development of greater liquidity in the sukuk markets so that prices become better indicators of the value of the certificates and are not influenced greatly by the illiquidity of the market.

Podcast interview with Rushdi Siddiqui, head of Islamic finance for Thomson Reuters

Rushdi Siddiqui, the recently appointed global head of Islamic finance for Thomson Reuters, is interviewed by a radio station in Dubai (mp3). He provides his very interesting and relevant opinions on the growth in data about Islamic finance, the controversy about the size of the industry (it depends on which person is the keynote speaker at a given conference, but somewhere between $500 billion and $1 trillion), and increasing the appeal of the industry beyond Muslims to attract new sukuk issuers not motivated by the religious proscription, but viewing sukuk as an attractive alternative to raise money. The interview is highly recommended.

Reuters reports that one of South Korea's largest oil refiners was going to be the first to issue a sukuk with a Malaysian Ringgit-denominated sukuk has been denied by the company. GS Caltex says "We are not considering (an islamic bond). It's just one of many options available".

Standard & Poor's may downgrade several Dubai government linked enterprises if there is no plan created to deal with the maturing of Nakheel's $3.5 billion sukuk due in December. Without putting too much stock in the movement of prices of sukuk in illiquid secondary market, the Nakheel sukuk traded down over 16% in the past week closing at 73. The sukuk is an ijara sale, lease-back with repurchase upon maturity that is based on land and buildings on Dubai's coastline which were given an estimated value of $4.22 billion when the sukuk was issued in December 2006 according to the offering circular.

Terry Lacey argues that the recent Indonesian dollar-denominated sukuk was a success.