Saturday, March 20, 2010

ShariaUMEX, more TID and Nakheel, wadiah-based retakaful, Islamic Repo 105?

A new Islamic exchange will be launched in London in May, the Shariah Ummah Information Exchange (UMEX). The exchange will be open to companies with at least GBP 20 million ($31 million) seeking to raise up to 20% of their market value. It will operate as a Multilateral Trading Facility (MTF) according to the chairman of Halal Industries, which will manage the exchange. MTFs are low-cost electronic trading platforms under the Markets in Financial Instruments Directive (MiFID). The ShariaUMEX expects to have 10 enterprises and 100 securities listed when it launches and hopes there will be 100 IPOs within a year. The exchange will launch Islamic equivalents to American and Global Depository Receipts (ADRs and GDRs). The primary question I have about the exchange is whether it can provide exchange listing at a similar cost to larger exchanges like the London Stock Exchange and related AIM. Presumably, the companies listed on the exchange will be subject to the same standards of reporting and transparency as other exchanges. One of the largest challenges will be whether the exchange can attract sufficient liquidity to allow relative efficiency in pricing which is necessary to attract future listings. There is certainly some minimum level of trading and listing that the exchange has to reach in order to get to a 'critical mass' where it will attract further listings.

The analysis of the TID v. Blom Bank case continues. An article in the National which continues their solid coverage of Islamic finance describes several areas where the decision could impact the Islamic finance industry as a whole. One area is the increasing Shari'ah risk in UK courts allow TID to argue that a product was not Shari'iah-compliant and therefore outside of its corporate power to enter into despite a ruling by its own Shari'ah board approving the product at the time. Generally, the ability of secular courts too enforce decisions based on religious rulings is a negative because they do not have the expertise to make a ruling in this area. The decision of a Shari'ah board that a given product is Shari'ah-compliant should be what determines whether the company can enter into it. If this is changes so that ex post, the bank can argue in a secular court that a contract is not Shari'ah-compliant for nearly any contract it has entered into if it is in financial difficulties. This erodes the role of the Shari'ah board as the arbiters of what is or is not Shari'ah-compliant. Shari'ah boards should be given the exclusive authority to judge Shari'ah-compliance of a given contract and be allowed to force an institution to change its implementation of a Shari'ah-compliant contract if it is doing os outside of the bounds of the original fatwa. The secular courts, on the other hand, should be limited to judging whether the specific aspects of the contract have been followed, not whether it is Shari'ah-compliant or not. The claim by the TID that the contract was not Shari'ah-compliant because it stipulated a fixed rate of return is another separate issue that Shari'ah scholars can discuss and highlights the problematic nature of some contracts which mimic conventional products, but that is a whole other area of discussion.

Reuters weighs in with an article on the Nakheel debt problems saying that the crisis and eventually a resolution could strenghten Islamic finance by forcing the industry to deal with issues raised by the near-deafult. It has also forced investors in the Nakheel sukuk as well as others looking on to consider the limitations that a sukuk may provide in terms of creditor protections compared with a conventional bond.

Another very interesting article in The National discusses whether accounting tricks like Lehman's Repo 105 transactions could come out and bite Gulf-based financial institutions that use similarly misleading transactions. The National reports: "The [anonymous] accountant noted the example of companies issuing sukuk, which may not transfer all of the downside risk attached to an underlying asset to the bondholder. Neither does that risk appear on the balance sheet of the issuer." This is most likely referring to an ijara, mudaraba or musharaka sukuk where the asset underlying the sukuk is transferred to the SPV issuing the sukuk certificates. I am not knowledgeable enough about accounting under IFRS to make a judgement on the accounting treatment of these sukuk, but it would not surprise me if the assets underlying these sukuk were not included on the balance sheet of the issuer (with the beneficial interest transferred to the off-balance-sheet SPV). This would make it appear that there is no asset on the balance sheet that could lose value and cause the issuer a loss. There are only the debts payable to the SPV (which would then pass them on to the certificateholders). However, if the asset loses significant value, then under most sukuk structures, the bank would be forced upon maturity to repay the principal through the purchase undertaking and take a possibly depreciated and depreciating asset back onto its balance sheet. When this event occurred, the outcome would be the bank paying the par value to redeem the sukuk and receiving an asset on its balance sheet that it would probably have to immediately write down to a fair value from the purchase price, which would cause a loss. I would be grateful if any reader more skilled in IFRS accounting could enlighten me on the subject so I could provide a more accurate assessment on the potential pitfalls of sukuk structures that are described by the accountant in the National article.

The International Shari'ah Research Academy (ISRA) has developed, although not yet released, a model for wadiah-based retakaful, which would clarify who owns what in the fund better than the mudaraba or wakala model, according to ISRA. The way it would work is that takaful providers would contribute to a fund that is managed by the retakaful provider. The funds would be invested and the retakaful provider would receive an agency fee and also be liable to pay claims from the participants. In the case that there is a profit on the investments after claims were paid, the profits would be retained by the retakaful provider and any surplus amount in the account (of contributed amounts) would be owned by the participating firms. The retakaful company is able to keep the profits from the investments, so long as the claims are paid to the takaful firms contributing capital, but the difference between contributions paid and claims paid remains owned by the participants, which should reduce the incentive for the retakaful provider to invest too aggressively, because it is forced to return to participants the difference between the contributions made and the claims paid. If it recognizes substantial losses on its portfolio and there is a surplus of contributions, it would be forced to return those funds to the participants, even if its investments lost money.

With all deference to Dr. Hussein Hamed's expertise, I have to disagree strongly with his statement at the Dubai Peace Convention that "Currency value has become interest-based and, therefore, when the crash happened, the only monetary system that was not affected was the interest-free Islamic system." The idea that the Islamic financial system, either in its theoretical form or in how it is actually practiced today is somehow insulated from economic cycles is just not true. The system is operated by people, often with noble intentions, but it is just as susceptible to crisis and recession as any other economic or financial system. The degree to which it can be decimated by poor decisions through over-leveraged financial products like credit default swaps and collateralized debt obligations may be avoided. However, the problem of, for example, overbuilding in Dubai, some of which was financed through Islamic financial products (Nakheel's sukuk, for example) cannot be avoided simply by replacing the conventional financial system with an Islamic one. Human nature being what it is will always create excesses one way or another, although the Islamic restrictions may limit some of the more harmful excesses. If anything, the Islamic financial system should be more, not less, dependent upon the economy cycle because it is supposed to be based on real tangible assets and profit and loss sharing. How many sukuk need to default and financial institutions fail or nearly fail to demonstrate that a severe economic recession can take its toll on the Islamic financial system?

Other News

  • Malaysia is considering offering long-term sukuk to provide investment opportunities for takaful firms to reduce their reliance on equity and real estate investments.
  • Hong Kong will change its laws to allow sukuk issuance. Hong Kong's financial secretary John Tsang also said "We're also enhancing market infrastructure and product development and educating market participants and investors in raising the profile of Hong Kong as an Islamic finance platform".
  • An announcement on the fate of Amlak Finance and Tamweel is expected soon. The likely outcome will be a merger into an Islamic bank that will receive government support. The reports do not describe whether the new bank will be able to restart lending, or whether it will simply wind down the two companies in the least costly way, although there is no indication that this is the likely outcome.
  • The United Arab Bank launched its Islamic banking unit on March 17th.

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