Tuesday, April 20, 2010

Islamic finance was not unscathed by the global financial crisis

I am getting a bit irritated with some of the media coverage of the Islamic finance industry. It is not that the articles are repeating any of the easily disproved negative comments about Islamic finance; in contrast, I am disappointed by the reporting because it is too positive. An article by AFP provides a few of the specific claims that are either not true or exaggerations (although this article is not unique, there are many articles repeating the same claims). The subtitle of the article claims that "Islamic finance has emerged unscathed from the global crisis". This is not true. Profitability at Islamic banks are down because of the recession and there have been enough distressed Islamic financial institutions (The Investment Dar, International Investment Group, Gulf Finance House) to claim that the industry is 'unscathed'. The first sentence of the article qualifies 'unscathed' by adding the word 'relatively' to the statement in the subtitle and the remainder of the article is more nuanced (it focuses on the need for tighter regulations). The financial crisis disproved, hopefully for ever, the notion that Islamic finance can be 'immune' from crisis. The article notes that:
"However, the global economic turmoil, which felled some mainstream banking institutions, has highlighted the need for the industry to shore up areas where it may be on shaky ground.
These areas of shaky ground for the most part reflect areas where there is not sufficient products available to Islamic financial institutions to survive downturn in asset values and (for banks) liquidity crunches.

Remember, the final nail in the coffin for many of the conventional investment banks was not necessarily the asset price deterioration of the toxic mortgage-backed products they held. That contributed (just as any asset price deterioration would), but the institutions were felled by a shortfall of liquidity after their funding dried up. During September and October 2008, the investment banks fell one after another and the primary thing that allowed JP Morgan and Goldman Sachs to avoid similar fates was their conversion to commercial banks, which allowed them access to the Federal Reserve as the lender of last resort. Had the Fed not been willing to step in, those banks might well have met similar fates as Bear Stearns and Lehman Brothers. The situation for Islamic banks will be similarly precarious in any future financial crisis: there are not lender of last resort facilities available that are Shari'ah-compliant and without this, the maturity mismatch between demand deposits and short-term sukuk (liabilities) and longer-term assets could turn a liquidity crisis into a solvency crisis as the banks would be forced into a firesale of assets.

The continuous reporting that Islamic finance emerged unscathed by the recent crisis lends some authority to belief that it will be impervious to future crisis and breeds dangerous complacency within the industry. It also somewhat minimizes the significant challenges that Islamic finance faces in its maturation process. If it withstood the most severe financial crisis since the Great Depression, the thinking might go, it will not have much to worry about until the next big global crisis which could be decades in the future. It would be far easier to worry about potential problems now when financial stability is in the forefront of the news than to wait and try to either develop it when the Islamic financial markets are booming, much less when the crisis does in fact hit.

Other News

  • The central bank in Malaysia is drafting regulations covering ibrar, the rebate used in some contracts. In general, ibrar is used where a customer defaults on a murabaha or BBA transaction because under the cost-plus sale, the full amount is due in a default including the profit for the entire amount. In contrast, in a conventional mortgage, the balance due is the unpaid principal plus interest. Ibrar is used to make the economic outcome in an Islamic finance transaction equivalent, but is discretionary for the Islamic bank, which has created uncertainty and legal disputes. The central bank is expected to put the policy in front of its Shair'ah board by the end of May.
  • France is seen as moving 'too slow' on Islamic finance.
  • An article by Morrison & Foerster LLP describes (with transaction diagrams) the structure of principal-protected structured products.
  • The latest sukuk al-ijara from the Central Bank of Bahrain was oversubscribed by 310%.
  • The government of Indonesia is planning another global sukuk for October 2010. The government is also considering Islamic T-bills and retail sukuk to diversify funding sources.
  • The Jordanian government is interested in issuing sukuk.
  • South Korea's legal changes for companies to issue sukuk have been held up in the National Assembly. The chart for sukuk issuance looks inaccurate. It projects $30 billion in issuance in 2010 exceeding the 2007 total. IFIS reported that total issuance in 2007 was $47 billion.
  • Pakistani Islamic banks are considering into Afghanistan.

2 comments:

Zied said...

Totally agree with you, there seems to be too much positive news coming out of the media about Islamic Finance. It did get hit by the financial, although, on a relative basis, it fared better than conventional finance....

But anyway, the financial media is always complacent, and never critical.

Good point!

Blake Goud said...

Thanks Zied. I agree with you. Islamic finance did get hit less because of its lower use of leverage and lack of time to develop its own ticking time bombs. If the industry is to have a similar relative performance in the next crisis, it needs to become more introspective and less "Islamic finance is inherently immune to crisis". I think this is happening with the IFSB/IsDB new work on financial stability in Islamic finance.