The Reuters summit has not occurred yet (it is scheduled for next week) but there is one article which prefaces the summit and discusses how the industry has not yet found a way to move beyond the real estate driven crisis that began over recent years. There were four things mentioned in the article that are relevant as the industry tries to move beyond the crisis. When the summit concludes, it will be interesting to hear the different viewpoints on these areas, but in advance, I'll lay out my opinions on these four topics.
Maturity mismatches
"'This situation is very common whereby companies have gone out to get short-term funding but then put it into illiquid assets (such as real estate),' [Mohieddine Kronfol, managing director at Algebra Capital] said."
The maturity mismatch problem--that of borrowing short term to purchase long-term assets--is one that is important throughout finance. The real estate bust in the U.S. was precipitated in large part by this exact thing. Bank's structured investment vehicles (SIVs) were financed using asset-based commercial paper and then bough mortgage-backed securities. Their difficulties, which led them to be taken back onto bank's balance sheets was an inability to roll this ABCP, which created a liquidity crisis in the SIVs and the rest is history.
The Islamic banking problem is not necessarily as extreme as the SIV problems (commercial paper is debt with a maturity of less than 270 days). However, it serves as a good example of the effects of a maturity mismatch in a crisis. In Islamic banking, the maturities are generally not quite as short, but the problems remain. The financing done by Islamic banks for real estate projects, many of which were not even expected to be completed in a couple years time, was rarely in excess of 5 years. Overall, there have been few (non-Malaysian) sukuk issued with maturities of greater than 5 years and this is not necessarily surprising given that they were issued in emerging markets and the riskiness of a sukuk issue is to some degree affected by its maturity. Changing interest rates (on which the coupons on new sukuk are based), alongside with market, political and credit risks means that investors are wary of investing in longer maturity debt.
That said, the larger problem in Islamic is the over-concentration of investments in one sector (real estate) and the general collapse of several real estate markets. There is always additional risk in not diversifying and the real estate boom in the Gulf coincided with a global boom that ended in 2007-2008. The maturity mismatch is not going to be overcome quickly and the lower-than-expected size of the Dar Al Arkan sukuk suggests that issuers of sukuk who are not sovereigns or high-grade corporate issuers are not going to be received as well as they were in the boom year. The Dar Al Arkan sukuk was a 5-year sukuk, continuing the trend of shorter-maturity issues.
As the market rebounds and investors become more comfortable with sukuk, the maturity of new sukuk could lengthen. However, that will require greater institutional changes in the markets from which sukuk are issued. There needs to be greater legal certainty about whether the rules under which sukuk are issued will remain constant five years from now, let alone ten years from now if the maturity profile of new sukuk is to increase.
Reliance on transitory sources of profits
"Asset management is seen as a key growth area for the industry, but experts say it needs to diversify its products by adding fixed-income components to its funds that are focused on real estate and private equity."
The Islamic finance market has been focused a lot on the high profile deals and also those which net the financial institutions the highest fees during the past few years. There have been many structured products and private equity deals that have captured the headlines of the industry. To be fair, there has also been more development on more plain vanilla products, but it has taken a back seat to these other areas like private equity and large real estate projects.
This is great for banks when everyone's dancing (to paraphrase Chuck Prince on the eve of the crisis). However, it means that the revenue sources for many Islamic banks, particularly investment banks, is very cyclical. When these deals are plentiful, the banks are making bumper profits, but when these opportunities disappear, we see banks run into problems handling their debt load, as recent problems at Gulf Finance House (which was downgraded to 'Selective Default' in the wake of its debt restructuring/rollover) evidence.
There are more stable forms of revenue and asset management is one of them because it has a longer-term focus rather than the transactional focus on the investment banking business. It may be less lucrative in boom times, but it is often more stable in times of stress in the financial markets. This balance between different activities is not one that only applies to Islamic financial institutions, but it is one piece in the puzzle about why some Islamic financial institutions have run into trouble recently.
Lack of standardized regulation
"Regulation also remains fragmented, with central banks, its own standard-setting bodies and scholars interpreting Islamic law all having a say in governing the industry."
The issue of standardization is one of the most complex issues in Islamic finance. I have refined my own views on standardization of individual products and that is a particularly difficult area for the industry to grapple with. However, the standardization of regulation is I think less difficult. Uncertainty of how Islamic finance is in most cases negative to the industry's growth. The uncertainty, for example, on Shari'ah issues plays one factor in the lack of longer maturity sukuk because of doubts that the accepted Shari'ah standards today will be so ten years down the line. When investors look at a sukuk, the risk that the structure will not be viewed as acceptable several years down the road may detract from interest in it. This risk may be heightened by the AAOIFI revision of standards on mudaraba and musharaka, which provide tangible examples how an accepted structure could be frowned upon by Shari'ah standards in a couple years time.
There is very little the industry can do to mitigate this risk because the rules are still in flux and individual Shari'ah scholars may view different products with different levels of acceptance even at one point in time. The only thing that can reduce this uncertainty is to build an institutional framework in which standards can be established and revised. To some degree, this is already taking place with development of standards by AAOIFI and the IFSB. However, there can not be too much work towards the goal of increasing certainty about what is and is not acceptable from a Shari'ah point of view.
Lack of size among local Islamic financial institutions
"The industry also needs to create bigger players, with local banks being too small to grab market share from the Islamic windows of Western conventional banks in syndicating loans and arranging Islamic bonds, or sukuk."
To some degree, the problem with standardization of Shari'ah supervision is intertwined with the lack of local financial institutions of sufficient size to compete with Islamic windows of the global financial firms. These firms are primarily (if not solely) involved in Islamic finance with an eye to the profits from creating products that receive Shari'ah approval. They may be staffed with people who believe that Islamic finance can provide a new model for financial services based on the Shari'ah, but on an institutional level, they are focused on profits.
THe smaller (mostly GCC-based) Islamic financial institutions that compete with them also share the desire to maximize profits, but there may be more of an institutional bias towards the development of the Islamic finance industry longer-term. A fully Shari'ah-compliant financial institution will depend for its survival upon the industry remaining relevant and will have much more difficulty changing businesses if Islamic finance is stymied. The global financial institutions, on the other hand, are able to shift between the businesses (conventional and Islamic) which produce the greatest profits and may act with a short-term focus on pushing the envelope by becoming the first bank to offer a Shari'ah-compliant version of XYZ conventional product.
That being said, there are benefits for the involvement of large financial institutions with their greater resources to develop the industry and their (often) longer history of operating within global financial markets. This benefit may outweigh the short-term costs of their involvement and so long as there is sufficient infrastructure built to support the growth in the Islamic financial industry that is apart from the shorter-term focus of the global financial institutions, the industry can benefit from their involvement.
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