BNM Deputy Governor's speech

There are many things I would comment on if I had several hours to sit and go through the speech line-by-line, but unfortunately I don't have the time.  However, I think that Deputy Governor Muhammad bin Ibrahim's speech to the ISRA-IIBI 2nd Annual International Thematic Workshop 2010 titled "The Polemics of Governing Law in Islamic Finance" is worth reading by all interested in Islamic finance. 

Islamic finance as ethical finance?

 An issue that comes up periodically with Islamic finance is that the Arabic terms used to describe the products and the underlying prohibitions driving the industry (e.g. riba, gharar or Shari'ah-compliant).  There are many areas where Islamic finance overlaps with ethical finance and, therefore, Moinuddin Malim, the CEO of Mashreq al Islami Bank said that the industry should 'Westernize' the labels: "Why is it Islamic banking? It is ethical banking.  A lot of people think that it is only for Muslims, and it is not - it is for everyone. [...] But the problem is that it doesn't appeal to non-Muslim investors in Europe, primarily because they do not understand the various Arabic phrases".

There are many reasons why the industry should use more 'familiar' terms for the products being used and some of the resistance might due to fears that it will move the industry outside of its niche.  Not all Muslims are native Arabic speakers so the use of Arabic terms may create a need for more explaining of products than is necessary if they were called by a different name.  However, there are differences between the products used and the products they might be called (e.g. ijara versus a lease).  If a product is substantively different (for example, in the rights and responsibilities of the two parties as in an ijara compared with a lease), the use of 'lease' instead of ijara could be misleading.

There is a more fundamental reason, I think, that Islamic finance should retain the use of the Arabic terms for products: the industry is created to cater to the specific prohibitions within Islam.  It is not in and of itself ethical finance.  The industry does not universally adopt an ethical stance that would be expected by many investors, even some Muslims.  For example, even within Islam, man is placed as caretaker of the earth, yet many Islamic financial products finance activities that are destructive to the environment.  There is not even a delineation between whether the financed companies use industry best practices or are egregiously destructive to the natural environment.

The industry was created and is designed to serve investors who want to avoid that which is prohibited in Islam according to the scholars who advise the financial institutions offering the Islamic financial products.  It is not necessarily even created for the needs of all Muslims; there are some Muslims holding a different view of what is permissible in financial services and if those views are outside of the consensus within the Islamic finance Shari'ah scholar community, then the Islamic financial industry may not be suitable for them.

This is not meant to be a critique of Islamic finance.  It serves a valuable place in the financial services industry globally by providing an alternative to a significant proportion of Muslims who believe that the way the rules on finance are applied by contemporary Shari'ah scholars is correct.  It does a good job at catering to those individuals' needs, even if there remain significant gaps in product offering to actually meet all consumers' needs.  However, it would dilute the purpose of Islamic finance and confuse it's methodologies if it were marketed as 'ethical finance'.

There are two things that should happen if my description is accurate.  First, the Islamic finance industry would reach out to non-Muslims who can see the ethical features of Islamic finance.  For example, using non-Muslims' frustrations with large international banks who are using their deposits to finance either unethical or overly risky products and who present a systemic risk to the financial system (and therefore to the economy as well).  An approach to this group of potential consumers would b to explain the terms used in Islamic finance, but emphasize the fact that Islamic commercial banks by and large are much more pure intermediaries.  They take in deposits and make loans.  Depositors are paid based on the profitability of the financing.  This is an approach that has been successfully applied by credit unions (at least, I switched from Wells Fargo to a credit union for a similar reason, but I think others did too).

Another example would be to appeal to other consumers with an Abrahamic background who are looking for the 'basics' in terms of screening.  They want to avoid pork, gambling, alcohol and tobacco companies and those producing weapons or distributing pornography.  These are areas where Islamic finance has a well developed methodology for more than just investment: from banking to private equity.  With a proper understanding that the economic outcome of most Islamic banking products is the same, just with different labels, they could be convinced that an Islamic financial institution would be able to meet their needs.  The one area where a change of terminology might be helpful to appeal to new consumers would be by finding an alternative to the 'Islamic' label.  Even with Arabic terms, the gap can be bridged by explaining how an ijara works, but some consumers may not even ask the question if they think that the financial institution is working only for Muslims based on its 'Islamic' label.  This has been done before: Turkish Islamic banks are called participation banks, for example.

Moving to the second way that Islamic finance could attract more non-Muslims without changing its use of Arabic terms: if the industry wants to take on the broad 'ethical' name, it should widen its restrictions beyond the prohibitions it uses now.  Of course the expansion of mandate should be vetted by scholars to ensure that they are Shari'ah-compliant, but with few exceptions, that should be an easy test to pass (for example, the mitigation of excessive environmental damage financed by Islamic financial institutions).  This would provide a better base for Islamic financial institutions to credibly claim that they are concerned with the wider 'ethical' ideas, beyond those that are prohibited explicitly within Islam.

There are ways that Islamic finance can be opened to non-Muslims more than it has so far, but just changing the terms used or adopting new marketing approaches that use a broad 'ethical' label are unlikely to be successful.  Islamic finance can be ethical finance (in fact, for many people it already is), but it depends on the consumer's view of what is ethical and many people's understandings would find gaps in the screens used by Islamic financial institutions today.  Reaching out to non-Muslims is important--in many countries it is essential for Islamic financial institutions to grow.  However, just changing the names and hoping people understand the industry better and thus choose to use it is not going to be sufficient. 

Shari’ah Supervision: Can The Industry Incorporate More Scholars?

Shari’ah scholars are probably the most important—and often viewed as the most scarce—resource in the Islamic finance industry.  There are fewer than 20 scholars with the widest recognition who are used by the majority of Islamic financial institutions and conventional institutions with Islamic ‘windows’.  The conflicts of interest (actual or perceived) that Shari’ah scholars face with their duties to maintain confidentiality and their receiving of payment directly by the institutions they regulate have come under greater scrutiny over the past several months.

One of the most stringent regulations of Shari’ah boards was recently implemented in the United Arab Emirates for takaful companies, which prevented Shari’ah scholars from being on multiple boards simultaneously and prohibited them from having a financial interest in the company except for their pay for serving as members of the Shari’ah board. 

In addition to the UAE regulation, the Islamic Financial Services Board (IFSB) released a new standard (IFSB-10) covering the “Guiding Principles On Shariah Governance Systems For Institutions Offering Islamic Financial Services”.  The IFSB standard is not as rigid as the UAE regulation and it does not set a maximum number of boards that a scholar can sit on, so long as he is able to devote enough attention to each board of which he is a member. 

The central bank of Malaysia, Bank Negara, has adopted standards in line with the IFSB standard for Islamic financial institutions in that country.  Clearly, the question of Shari’ah scholar independence and potential conflicts of interest are being addressed.  However, with more stringent regulations, it will be a challenge if the top 20 scholars are included on nearly every board.  The latest report from Funds@Work and Zawya (pdf) found that the Top 20 scholars held 624 positions while the remaining 300 held only 520 positions (the report only looked at scholars who are on a Shari’ah board).

With a cluster of the top 20 scholars holding such a disproportionately large share of Shari’ah board memberships, it raises the question about how the industry will be able to sustain its growth as the number of institutions multiplies across the world.  However, the ability of such a small number of scholars to represent such a large number of institutions suggests that, if their time is managed well and the less represented scholars are incorporated into Shari’ah boards, the industry is not facing as much of a shortage of scholars as is commonly stated. 

However, the fact remains that despite significant attention being paid to the ‘scarcity’ of top scholars, there has not been much movement towards incorporating less experienced scholars into the boards at Islamic financial institutions.  What can be done to change this?  Are there ways that the traditional role of older Shari’ah scholars as teachers and mentors for younger scholars can be used as a way to spread the responsibilities for Shari’ah review and supervision more effectively across the industry?

I think there is a solution that can maintain the requirement of having experienced Shari’ah scholars on each board, while also broadening the pool of scholars who sit on multiple boards.  However, this will require a change in attitude by many Islamic financial institutions which may face resistance from some (particular international financial institutions), who rely on prominent scholars as a way to demonstrate their Shari'ah-compliance to potential clients. 

One of the areas where the Zawya Shariah Scholars database[1] can contribute is by showing the linkages between different scholars (who has worked with whom in the past) as well as the relative areas where each scholar has the most experience.  However, the availability of that information may be necessary, but is not sufficient.  There needs to be a change in the way that Shari’ah boards are put together, which may require more stringent regulation by standards setting bodies and national regulators.  It is not evident that Islamic financial institutions will voluntarily move away from hiring the most recognized scholars.

However, that being said, a regulation that specifies the maximum number of boards on which any one scholar can serve, is not the best way to regulate Shari’ah boards.  There is no hard and fast number of positions where a Shari’ah scholar becomes too busy to effectively serve each institution and each scholar will have his own limit.  The peripheral issues raised by the UAE, BNM and IFSB regulations relating to perceived conflicts of interest can be more widely applied without too much difficulty. 

There are two different tracks that I could see being an effective way of leveraging the relationships that already exist between Shari’ah-scholars are 1) Shari’ah advisory firms; and, 2) retaining the institution-by-institution system with some form of limitation that limits the most well recognized scholars from serving together on boards.  I think the limitations of regulation make the latter idea not practicable. It would more likely represent a status quo approach reliant on the voluntary decision by institutions to find a way to reduce their own reliance on the most in-demand scholars.  The former, by contrast, would create a way to manage conflicts of interest as well as use the existing relationships between scholars.

As I have mentioned before, the Shari’ah advisory firm model reshapes the Shari’ah advisory function into something that more closely resembles law firms and accounting firms.  Instead of hiring individual Shari’ah scholars, the institution would hire an advisory firm, who would be responsible for assigning the individual scholars to different firms based on their experience in that firm’s type of business, as well as the time constraints facing their scholars. 

There remain unsolved questions associated with this method.  For example, how would the potential for large firms with higher budgets to hire the top scholars while the smaller, local firms be forced to have less experienced scholars assigned to their boards be mitigated?  Would there be overlap allowed between Shari’ah advisory firms (for example, would one scholar be allowed to work at more than one Shari’ah advisory firm?).  How would the firms avoid becoming entrenched in one way of thinking.  For example would Shari’ah advisory firm A be known for being more lax on interpretations, while firm B would be known as having scholars who provide more conservative interpretations? 

Despite these unresolved questions, the Shari’ah advisory firm model is more realistic in my opinion, because it avoids the question of how to determine the maximum number of board positions each Shari’ah scholar is allowed.  It also makes a step forward in ‘professionalizing’ the Shari’ah review business that can over time limit the cost to Islamic financial institutions by spreading administrative and workflow management costs across a larger number of scholars.  This should ease the strain on the existing scholars who hold the most positions, reduce costs for the industry and also help to bring less prominent Shari’ah scholars onto more boards where they can learn from the top scholars and ensure the industry has the resources it needs to continue growing and pass Shari’ah supervisory duties from one generation of scholars to another.

[1] The Zawya Shariah Scholars database provides information on over 300 scholars with information about their affiliations, statistics on the other scholars with whom they have worked and the sukuk for which they have provided fatawa.  Thanks to Zawya for providing me with a tour of the features of the database.

Basic Terms & Concepts in Islamic Finance

The Islamic finance industry is full of terms and concepts that, while generally familiar to anyone with some experience in or knowledge of finance, are still difficult to understand. The use of Arabic names can be confusing to non-Arabic speakers. For a more detailed description of Islamic finance terms and concepts, I would recommend the Islamic Finance Wiki, hosted over at IslamicFinance.de.  Any suggestions on how to improve this "Basics of Islamic Fnance" piece should be dropped in the comments or emailed to me at blake@sharingrisk.org.

Basic Concepts

• Riba: Riba is commonly equated with interest, although it is not an exact equivalent. It literally means 'increase' and the prohibition was originally prohibiting the pre-Islamic practice of doubling a debt in exchange for extending the maturity (riba al-nasiyah). The other main form of riba is an exchange where one commodity is exchanged for an unequal amount of the same commodity (riba al-fadl). For example, if one party gives one pound of high quality dates in exchange for two pounds of lower quality dates. The hadith concerning this type of exchange says that to avoid riba, the high quality dates should be sold for cash and then the cash should be used to purchase the lower quality dates. For the roots of the prohibition of riba and interest, there is a brief article on IslamicBanker.com.
  
• Gharar: Gharar is generally described as impermissible contractual uncertainty. One example of gharar is a conventional insurance contract. In exchange for a series of insurance premiums, the insurer agrees to make a specified payment to the insured. This is considered to be impermissible because the payment of premiums is being made in exchange for payment based on the occurrence of an uncertain event.
  
• Maysir: A contract is prohibited where the contract is based on an uncertainty where one party wins and the other party loses. For example, in a conventional options transaction, one party pays the other for the right to buy a security at a specified price before the expiration date. There are only two outcomes: the price is 'in the money' and the contract is exercised or the price is 'out of the money and the contract expires worthless with the option writer keeping the premium paid.
  

Basic Contracts

• Murabaha: One party buys an asset and sells it to the other party for the cost plus a markup. The repayment is often deferred with either regular payments for a specified term or payment due at a specified date in the future. For example, if I want to buy a car, an Islamic bank will buy the car for $10,000 and sell it to me for $12,000. I will be responsible to pay the bank $1,000 per month for 12 months. If the car is destroyed or defective after the bank buys it but before I take possession, it is the responsibility of the bank.
  
• Ijara: One party with ownership of an asset leases it to the other party for a defined amount per month, quarter or year. The lessor (owner) is responsible for maintenance and upkeep of the asset subject to the lease. The lease can cover a specified period where the owner retains ownership after the lease or it can be a lease to own or end with ownership being transferred to the lessee (ijara wa iqtina). For example, if I want to buy a home that costs $100,000, a bank will buy the house and lease it to me for $600 per month for 30 years and at the end of the lease, I will own the house (assuming financing cost of 6% per annum).
  
• Istisna'a: One party wishes to finance the construction of a custom-designed asset. The project is created according to pre-designed specifications and the other party receives payments on a pre-designed schedule. The payment schedule is flexible and can be regular, due on delivery or paid over time after delivery. The schedule is often designed to match a conventional project financing schedule. A parallel istisna'a is designed where a third party steps between the two parties and the party manufacturing the asset is paid during manufacture with progress payment and the party buying the asset making regular payments to the third party in equal monthly payments. For example, if I want a piece of machinery built according to my specifications, I will contract with a bank to contract with a manufacturer to build the machinery according to my specs. The bank will make payments during the construction process to finance the parts for the machinery. When the machinery is completed, the bank will deliver it to me and I will pay the bank in monthly payments the amount the bank sells it to me for a greater amount than the bank paid the manufacturer.
  
• Salam: One party purchases a commodity from another party with payment made at the time the contract is signed and with delivery of the commodity at a specified date in the future. For example, a farmer needing financing for his crops will sell his 10,000 bushels of wheat to a financier for $6 per bushel. The financier will provide the farmer with $60,000 and on a specified date after harvest, the farmer will deliver the 10,000 bushels of wheat.
  
• Mudaraba: One party (rabb ul-maal) provides financing to another party (mudarib) who is responsible for managing the business. The parties split the profits from the business in a pre-specified ratio. The rabb ul-maal is responsible for all losses, while the mudarib loses only his work put into the business, except for cases of fraud. For example, if I want to open a business selling mangoes but I need capital I would approach a financier. He would provide me with $1,000 in capital to buy mangoes and we agree to share profits 60% to the financier and 40% to me. If in the first year, I use the capital to sell mangoes and make $250 in profit. I would keep $100 and pay $150 to the financier. If the business was not profitable and went out of business, I would lose the work I put in and the financier would lose his $250 investment.
  
• Musharaka: Like a mudaraba, the contract is one of a joint-venture. However, in addition to the contribution from the financier, the entrepreneur also invests his own money. All profits and losses are shared . The profits can be shared according to any pre-agreed ratio while losses must be split in accordance with the ratio of capital contributed. Unlike a mudaraba where one party contributes capital and the other manages the business, both parties contribute capital and both are able to participate in the management of the business. For example, if I want to start a business selling mangoes, a financier will provide me with $750 in capital and I will contribute $250. We agree to share profits 60% to the financier and 40% to me. If the business generates a profit of $250, I keep $100 and pay $150 to the financier. If the business was not profitable and went out of business, I would lose my $250 and the financier would lose $750.
  
• Wakala: One party (the wakil) with excess funds hires an investment firm as agent (muwakkil). The muwakkil invests the funds on behalf of the wakil and is paid a fee for the service, while the wakil receives profits and is responsible for bearing any losses. For example, if I had $1 million to invest, I would hire an investment manager for $10,000 per year. He would invest the $1 million and be paid his wakala fee of $10,000 per year regardless of the investment results.
  
• Sukuk: This is an instrument similar to a bond. There are many forms of sukuk (e.g. mudaraba, musharaka, ijara, hybrid). Each form of sukuk is managed differently, but in general, the structure takes its underlying form where the role of financier is taken by a special purpose vehicle (SPV)--an entity set up specifically for the transaction--which issues certificates representing proportional interests in the SPV. The underlying structure functions as normal but the profits or losses accruing to the financier are passed through by the SPV to the investors in accordance with their share of the SPV.
  

General Prohibitions

• Alcohol
  
• Tobacco
  
• Pornography
  
• Pork products and related producer
  
• Riba-based industries (e.g. banks, brokerages, conventional insurance)
  
• Gambling
  
• Weapons
  
• Gold and silver trading on a deferred basis
  
• Futures
  
• Options
  
• Derivatives
  
• Companies with a high reliance on debt, those that hold cash in interest-bearing interest instruments, those that use their accounts receivable as collateral for loans, those with high interest expense or income and those with material income from prohibited activities.
  

Islamic finance and social media

In his latest column at Gulf News, Rushdi Siddiqui named several sources (including Sharing Risk, for which I am greatly appreciative) that have provided the coverage and analysis of the Islamic fnance industry. He also presented an open challenge to bloggers:

How can Islamic finance, especially at consumer retail, take advantage of the social networking phenomenon for awareness, education, and greater market penetration?

My first response is that many players in the Islamic finance industry can benefit if social media is used more widely, although there are limitations to the role that social media can play in developing the industry. For example, the needed product innovations can only be encouraged and sketched out in rough form on a blog such as this one.

However, there are many areas where Islamic financial institutions can use social media to reach out to potential consumers, critics and other industry participants that can begin to widen the debate on the industy, as well as provide responses to the challenges in and critiques of Islamic finance. This is not an academic argument either. There are many people--Muslims included--who believe that Islamic finance has been co-opted by multinational banks that have little care for the principles of Islamic finance except to the degree they can be managed to create another profit center for the banks.

There are other Muslims who believe that the Islamic finance industry is entirely superfluous because it adheres to rigidly to the prohibition of riba (whose equivalence with interest has been questioned by a few non-industry scholars like the late Sheikh Tantawi of Al Azhar University in Egypt). In the view of some, Islamic finance is an unnecessary layer within finance that does little to advance the social goals of Islam, while adding additional costs that enrich the bankers that develop and promote it.

Even within the industry, there are critics like John Sandwick who argue that the Islamic finance industry can add value, but efforts by many institutions has been counterproductive. In The National's article on Gulf Finance House, Mr. Sandwick is quoted: "For years GFH relied simply on overcharging investors for investments and pocketing the difference as its revenue, but neglected to create businesses that had steady income". The basis of his argument is that the focus exclusively on the real estate-backed private equity projects left the industry's customers over-charged for risky financial products but lacking in the bread and butter of asset management: fixed income and money market products.

With critics writing and speaking about Islamic finance being too permissive, or too concerned with creating solutions for problems which don't exist, or being too focused on developing products that serve the bank's interests over the investors, it can almost seem that there are no supporters of the industry except for the bankers, layers and asset managers who are profiting from its creation. However, this would be a mistake. There are many Muslims who do view interest as riba and who do find Islamic financial products valuable because otherwise they would not be able to buy a house or a car or finance their businesses or invest for retirement. For this subset of Muslims, the conventional alternative is not an alternative at all. That being said, most have questions about whether the industry as it exists today is truly serving up a Shari'ah-compliant alternative to conventional finance, but use still use it because there exists no other alternative.

Weaving through these contradictory views towards Islamic finance is challenging enough and with a severe recession underway in many parts of the world, it is even more challenging for Islamic financial institutions to market themselves to potential consumers[1] and attract the skeptics into even a discussion about what is necessary to make the products offered into a realistic alternative to cost-conscious consumers. In this area, the canned press releases and articles that 'cut and paste' from these press releases do the industry a disservice and push away more people than they attract. The opposite approach from the canned news--"persuading" consumers to switch to Islamic finance by questioning the religiosity of Muslims who use conventional finance--is equally ineffective and (fortunately) is rarely employed by mainstream Islamic financial institutions.

Now that the problem has been defined, is there a solution that includes the use of social media? Let's redefine the groups that Islamic financial institutions and think tanks need to appeal to if they are to continue the rapid growth of the last decade:

• Muslims who think Islamic finance is too close to conventional finance;
  
• Muslims who think Islamic finance is unnecessary and enriches no one but the bankers who offer it;
  
• Muslims who find conventional banks totally off limits and who use Islamic banks, but would like them to shift their focus away from replications of conventional products;
  
• Muslims who use Islamic banks and are happy with them;
  
• Muslims and non-Muslims who have heard, but don't understand the terms "Islamic" and "finance" used together; and,
  
• Non-Muslims who wonder whether Islamic finance is just applicable to Muslims or could be an alternative to the conventional banks in the wake of the financial crisis.

These groups can overlap somehow, but in general they all require different approaches for Islamic finance institutions to reach. A one-page ad in a newspaper or magazine may reach the Muslims who already use Islamic finance and are looking for reassurance about the banks' commitment to Shari'ah-compliance or it may reach Muslims who are outside the financial system looking for a Shari'ah-compliant alternative. However, they are unlikely to reach those Muslims and non-Muslims who are unaware of Islamic finance or are skeptical of industry for one reason or another. Social media can provide a way to reach out in a more detailed, engaging way. It can start a two way discussion, whether through a blog where people can comment and the blogger can respond; it can be shorter, as in a Twitter page where the Islamic financial institution can announce new initatives, link to articles that address a particular area of interest to the bank's audience, or it can make people aware of press releases from the bank.

The area I know most about in social media is blogging. I'm no expert in marketing in general, but I have been writing this blog for more than four years now and I've found ways to reach an ever growing audience of people with some interest in Islamic finance (or who just stumbled on this blog and became interested). The blogging format can be used as a way to attract attention as well as to share opinions and news with a broad, largely anonymous audience who are free to turn it into a dialogue.

One aspect of blogging makes it useful for Islamic financial institutions who wish to provide information within an effort to develop its business is its informality, the lack of space limits and the absence of restrictions designed to create an unbiased perspective. Traditional academic journal articles and mainstream media provide a valuable service, but they adhere to a relatively rigid, formal format and are expected to be neutral and unbiased. They fail when they step outside of these guidelines. In general, blogging fails to be interesting when it remains hemmed in and tries to compete with the better funded media and academic publications. It succeeds where it steps outside of these guidelines and uses the interactivity that blogging can have to create an ongoing dialogue with the audience.

To take a specific (hypothetical) example, think of a Western Islamic bank operating in a country where Muslims make up a very small share of the population and many have integrated into the society and, with hesitation, use conventional banks because they provide the services necessary at a reasonable cost. These consumers by and large may have a nagging feeling about conventional banking and would feel more comfortable if there were a Shari'ah-compliant alternative to conventional banks, but they don't have faith that the Islamic banks are Shari'ah-compliant. These banks all use murabaha and ijara which seem indistinguishable from conventional mortgages for their home financing products and they cost more than conventional banks. They may even sell the mortgages on to a national housing finance agency, which packages them into securities along with conventional mortgages to sell to investors. How would a blog be able to help the Islamic banks convince these consumers that the additional cost is justified and that the structures they use are not just interest in disguise, but are in fact designed to comply with the prohibition of riba?

The bank could launch a blog where it describe in plain English how and why the mortgages are designed the way they are. It could highlight the differences between the ijara mortgage from a conventional mortgage. For example, it could explain how the product it offers differs because if the consumer became unable to make its payments, the bank would have recourse only to the home being financed and not the consumers' other assets, as a conventional mortgage might. It could explain the rationale for this structure being that the ijara contract stipulates that the owner (the bank) is purchasing a home and leasing it to the customer and the customer is gradually buying the home and during the period where the bank owns the property, it is responsible for maintenance and upkeep. It could describe that because the bank is acting as the lessor, if the customer can't make its lease payments on the home, the bank will sell the house and that is why it cannot go after the customer's other assets like a conventional mortgage provider would. In exchange, there are additional costs to the bank like the opportunity cost of foregoing the right to attach the customer's other assets to the mortgage or the risk that the home is worth less than the value of the mortgage and therefore the bank charges higher rent to offset this risk.

This gives the bank an opportunity to directly talk to consumers and explain the differences between its product and a conventional mortgage and explain the reasons for the additional costs of an Islamic mortgage. This is only one way that Islamic finance institutions can use social media to reach out to consumers. It would not be able to have as detailed and lengthy discussion (or take the perspective of "here's why our product is better") if it were writing an article for publication in a newspaper. The bank would also get the benefit of a broader audience than a newspaper, which is only in front of the subscribers of the newspaper, who are often clustered in one area and share specific demographic traits that may not be that of the potential consumers of the bank's products.

There are many other ways that Islamic financial institutions can use blogs and other social media and it takes a creative impulse to 'do something new' that many banks (conventional and Islamic) may lack. However, the challenges that Islamic financial institutions (not to mention the rest of the Islamic finance infrastructure from think tanks to individuals interested or working in the field to academics to Shari'ah scholars) face in explaining why things work the way they do and how they can be improved call for new ways of reaching out. Social media is a powerful tool because it has a much larger audience and is better at fostering a broad dialogue if done well. Though I was mentioned in the article as being one of the people working in social media (and might face greater competition for attention if more blogs are out there), I think it would benefit the industry and its consumers and skeptics if there were greater depth in the social media area talking about Islamic finance.

Anyone who has comments, criticism or their own perspective should feel free to comment on this post and I will do my best to respond. Or I can be reached the more 'old fashioned' way by email at blake@sharingrisk.org.

[1] For those who are interested in marketing approaches for Islamic banks, in July this year, I reviewed a book that was written by Paul McNamara, Brilliant Marketing for Islamic Banks".

The tragedy of microfinance

An article in the New York Times describes the crisis facing microfinance institutions in the state of Andhra Pradesh, India where up to 80% of microfinance clients have stopped repaying their loans. The story compares the situation to the subprime crisis in the US: "Initially the work of nonprofit groups, the tiny loans to the poor known as microcredit once seemed a promising path out of poverty for millions [but now] some Indian officials fear that microfinance could become India’s version of the United States’ subprime mortgage debacle, in which the seemingly noble idea of extending home ownership to low-income households threatened to collapse the global banking system because of a reckless, grow-at-any-cost strategy."

Similarities with subprime

I think there are definite similarities between the subprime crisis and the microfinance crisis as it is described in the Times article. However, I think the article glosses over the underlying cause of both crises. With the exception of some banking laws in the US which prevented banks from 'red-lining' certain (poor) areas where they would not make loans, a lot of non-profit efforts to increase homeownership among low income Americans were community-based efforts that focused on providing education and other non-financial assistance to borrowers to help them qualify for mortgages. In a similar way, most of the early non-profit microfinance institutions were lending, but their lending was accompanied by a lot of other assistance to help the borrowers understand how to run a business and provide other non-financial assistance.

The subprime crisis was fueled both by aggressive sales efforts, which concealed more about the loans they were offering than provided education that is so vital to incorporating previously under-served portions of the population into the mainstream financial services industry. When the volume of loans (and the profits of the originators) became more important than the outcome (increased low-income home ownership) and the regulation of the activities of originators was lacking, it was a set-up for failure. In the subprime area, however, there was another factor: it was "conventional wisdom" that home prices did not fall either at all or to a degree that would be significant enough to put borrowers underwater on their homes.

The microfinance industry shared some characteristic and the role of education was even more important to finance a microbusiness in order to achieve the repayment rates that are now expected in microfinance. However, what appears to have happened in many cases was that the costs of providing that education became an impediment to increasing loan volumes. The NY Times article mostly describes situations of borrowers who were provided with financing for improving their homes or buying consumption items.

Consumer spending

There is certainly a role for microfinance institutions to finance consumer spending (some of the problems of a micro-debt spiral were due to microfinance institutions financing repayment of other debts, whether they were aware of it or now). However, the primary focus of microfinance should be to create a sustainable income for the borrowers. If that limits the industry's size to a level smaller than what has been achieved in areas of high penetration like Andhra Pradesh, that should be accepted as a reality of the market, not an opportunity to become more reckless with the lending process.

Islamic finance and the Indian microfinance crisis

Now, what does this all have to do with Islamic finance? The point of the twin stories of the subprime crisis and the current microfinance crisis in India demonstrate areas where conventional finance has failed, and has failed in a headline grabbing and significant way. In the case of the subprime crisis, the Islamic finance industry did not take the opportunity to highlight the ethical foundations of Islamic finance that should limit the type of abuses that contributed to the subprime crisis. Instead, a lot of the analysis and commentary (embodied in quotes in widely distributed articles) was that Islamic finance was 'immune' to the subprime crisis, despite the nearly universal absence of facts or theories to support that proposition. In fact, the industry had developed its own risks that would become apparent as the subprime crisis led to a deep global recession (for example, the problems of Gulf Finance House, as described by Mohammed Khnifer, Aatef Baig and Frank Winkler [PDF].

If the industry had been more up front about the vulnerabilities of Islamic finance to crisis (i.e. that it is not 'immune'), it could have spent more time discussing some of the features of Islamic finance that differentiate it from conventional finance, particularly in the sense of risk. There were many bad investments made by Islamic financial institutions in the run-up to the crisis, particularly in areas where the real estate boom rose the highest. However, the differentiating factor in most cases was that if one held an investment in a piece of property, it was unlikely to lose its entire value (although it is possible). In a collateralized debt obligation made up of lower tranches of subprime securitizations, it was easily possible that enough damage was done to the underlying securitizations in a recession that the entire value would be wiped out (for example, staff from the NPR show Marketplace bought a piece of a 'toxic asset' and reported extensively on in while they watched it die). However, at that time, the Islamic finance industry didn't take the opportunity to use the crisis to explain itself. Opportunity missed.

It may already be too late for Islamic finance to seize the opportunity to explain itself and explain how Islamic microfinance would be less likely to lead to the situation of microfinance in Andhra Pradesh. That the opportunity may be lost is due more than anything to the lack of attention that Islamic banks have paid to Islamic microfinance. However, should Islamic finance want to use this crisis as a way to demonstrate its differences from conventional finance (and in particular, microfinance), I think there are a few things that it should emphasize. First, it is useful to catalogue the problems in Indian microfinance are driven by several factors: i) large use of consumption loans; ii) rapid growth focused on boosting loan volumes; iii) lack of verification of customer financial situation and means for repayment; iv) lack of education of clients; and, v) focus on reducing interest rates by boosting loan volumes.

What should Islamic finance learn and how can it use this crisis?

The Islamic microfinance industry is still nascent and has not yet gotten to a point where it is common, let alone to the point of rapid growth, so there are a lot of things that can be used as cautionary tales for Islamic microfinance, as well as to highlight as differences between conventional microfinance and Islamic microfinance.

The over-riding lesson that the Islamic microfinance industry should take is that it needs to focus primarily on the development of business financing. That is where microfinance began and that is where it had the greatest impact and the fewest problems. The initial impetus for microfinance was to develop a way to help the poor create sustainable income sources in lieu of (or in addition to) charitable assistance. This should be the focus of Islamic microfinance as well and any move away from that purpose need to be considered very carefully to ensure that it cannot lead to the incentives for microfinance institutions (MFIs) to focus on their growth and profitability over the benefit of their customers.

Along this line of thought, there are plenty of products used in Islamic microfinance that can shift the incentives towards a more sustainable growth path. For example, while murabaha makes up the bulk of financing in Islamic finance (and may also become the case in Islamic microfinance), the use of mudaraba and musharaka rather than murabaha (or ijara/salam or other financing products) may make better systemic sense for the Islamic microfinance industry as a whole. The systemic benefit comes not from the greater stability of relying on these contracts (it will likely be more unstable than if murabaha is used), but it will focus Islamic microfinance on business financing and will also place the burden of failure more onto the microfinance institution, which should limit the incentives towards "growth at all costs". It will also to some degree limit the negative potential impact of reckless financing on the clients (which of course has important implications for the incentives of the client to act in both parties' mutual interest). However, for the Islamic microfinance industry, using mudaraba/musharaka should ensure that Islamic microfinance institutions continue to recognize the value (to them as well as customers) of providing education and technical assistance, along with financing.

There are still ways that non-business (e.g. for the purchase of an asset) microfinance can be effective in an Islamic context and there are even aspects to many of the contracts used that would prevent some of the abuses in Indian microfinance where loans were extended to repay other microfinance loans that led to customers becoming over-leveraged. Unless the Islamic microfinance industry develops and begins offering tawarruq/commodity murabaha-based financing (which it may still do), there will have to be some asset underpinning the financing. This can limit the excessive growth of debt without a corresponding growth in ability to pay.

There remain significant challenges for Islamic microfinance to develop when there are questions raised about the value of microfinance for customers, but also for the institutions funding the MFIs. However, there are specific areas where Islamic microfinance can focus that build in some safeguards (or incentivize Islamic MFIs to develop their own safeguards) to avoid the pitfalls being realized in Andhra Pradesh. It all adds to the issues that Islamic microfinance industry must grapple with as it develops strategies to attain the growth that the rest of the Islamic finance industry has seen in the past decade (even with the effects of the financial crisis).

An Islamic microfinance waqf

It has been a while since I wrote about Islamic microfinance, but the latest Opalesque Islamic Finance Intelligence included links to several resources on Islamic microfinance (in addition to other excellent articles). One article was released in August 2008 by the Asia-Pacific Economic Cooperation's Advisory Group on APEC Financial System Capacity-Building (pdf).

One of the ideas that I found interesting was that "Islamic banks can also use income derived from late-payment penalties as well other proceeds, which cannot be included in its income, such as earnings from treasury operations. These proceeds can be categorized as waqf and used for microfinance operations" (p.5). For an example of the types of fees that are not permissible, Bank Negara Malaysia's Shari'ah advisory board released a resolution in June that Islamic banks in Malaysia follow, and are likely to be similar to other Islamic banks internationally.

The key point is that Islamic banks are supposed to be concerned with upholding Shari'ah-compliance in their activities and there is a portion of their income that cannot be recognized as income because it is derived from fees to incentive repayment. Often this income is donated to charitable organizations. However, Islamic banks should also recognize that they are not excluded from conventional ideas of corporate social responsibility (CSR). In my opinion, the ethical basis of Islamic banking should encourage CSR at least as much as in conventional banks (although they are still, and should remain, for-profit companies). Currently, few Islamic finance institutions have embraced CSR in a meaningful way beyond charitable giving. By doing so, they are losing the opportunity to use their expertise in banking (as well as the expertise of their employees), as well as their resources which cannot be recognized as income.

The idea that they could use this money, and also volunteered time from their employees, to create a financing mechanism for Islamic microfinance appears to be a good fit. Their employees have more experience and training in banking than they do in charitable activities (and this should not stop them from charitable activities, which are valuable as well). This does not necessarily have to be a 'one bank, one waqf' activity. It would be much more beneficial and likely to be viewed with less suspicion (that it is promoting the interests of the bank above the microfinance clients) if it were a collaborative effort between several banks in a given country or region of a country. The banks would provide the capital and some volunteered experience of their employees to the waqf, which should be professionally managed by people with either direct Islamic microfinance or related experience in microfinance. It seems to me that this would be a way that Islamic banks could become more involved in developing Islamic microfinance locally, while also expanding their incorporation of CSR into their businesses in a way that does not hurt their profitability or compete for resources within the bank.

UAE Islamic CDs

The UAE Central Bank released more details about its Islamic CDs that it will offer "soon" according to Zawya Dow Jones. The sukuk will be murabaha, issued in UAE dirhams, US dollars and Euros, with maturities of between one week and five years. It will be likely limited to banks in the UAE as they are being issued as "a monetary policy tool for the Central Bank of the UAE" and "as a liquidity management tool for the Islamic banks".

The circular (PDF) from the UAE Central Bank describes in more detail the product. It will be a commodity murabaha where the banks (through the central bank as agent) purchase commodities in the spot market and then resell them to the central bank with deferred repayment but immediate delivery. The central bank will then resell the commodity in the spot market.

The one year and less maturity will be auctioned to banks daily with T+1 settlement and early redemption at the option of the banks. The method of the early redemption is that the bank requests early redemption and the central bank replies with an offer for "full proceed for the redemption through Reuters Dealing System". The reason this is done likely is for Shari'ah-compliance because a murabaha represents a receivable and therefore there is no early redemption discount permissible (accounting for just principal and accrued interest). This has been an issue in Malaysia where many Islamic mortgages are done via murabaha and in cases of prepayment, banks typically offer a rebate (ibra) representing the portion of the markup that has not accrued (based on an equivalent conventional mortgage) to equalize the outcome. Bank Negara Malaysia earlier this year issued a Shari'ah resolution that mandated ibra in murabaha financing.

As expected based on prior Shari'ah rulings, the sukuk will be non-tradable except at par ("due to Shariah limitations"). There will be no use of these securities at the central bank's repo facility "at the moment", which indicates a potential in the future for creating a repo facility based on the Islamic CDs.

The daily auctions of under 1 year maturity bills will be done for AED denominated bills and USD and EUR only "based on demand". Issuance of longer-term notes will be done "on bilateral arrangement".

In general, I think the new issuance is positive and it adds another country in the GCC (to Bahrain) whose central bank offers liquidity management tools for Islamic banks. Bahrain has offered limited issuance of salam and ijara sukuk with 3 and 6 month maturities, respectively. The CBB issues its sukuk monthly (compared to the UAE issuing daily) and the CBB sukuk are all denominated in Bahraini dinars, so the UAE Islamic CDs will offer the option of currency diversification for banks that have assets and liabilities with exchange rate exposure. In addition, the UAE Islamic CDs will have greater maturity diversification with 1 week and 1, 2, 3, 6, 9 and 12 month bills in addition to the 2, 3, 4, and 5 year sukuk. Both the CBB sukuk, which have been issued for several years, and the new UAE Islamic CDs are precursors to the International Islamic Liquidity Management Corporation (my thoughts on the ILMC) short-term sukuk, which will be issued in US dollars and Euros.

What will interest me is whether the ILMC sukuk will follow the murabaha model (used in the UAE) or salam (in Bahrain), both of which are not tradable in the secondary market except at par. The CBB sukuk al-ijara sukuk are tradable, although I don't know whether there is a market for them. The non-tradability of murabaha sukuk is a limitation in terms of establishing a pricing benchmark (my thoughts on an Islamic pricing benchmark) as an alternative for LIBOR, but if the ILMC were issued daily like the UAE Islamic CDs will be, it would reduce significantly the drawbacks of the murabaha model. The next 6 months should be interesting as information is released on the ILMC's methodology.

What should the Islamic Development Bank do to help Islamic finance?

The Islamic Development Bank is now taking on the 'Islamic mega bank' envisioned by Saleh Kamel, according to Arab News. As Mushtak Parker writes,

"But [Kamel's] failure to get the project started off through the support of both government and private investors saw the project somehow passed on to the IDB. Instead of mega commercial, investment or universal Islamic bank, the plan is to launch a mega bank that will effectively be an Islamic Interbank bank, with the aim of providing short-term liquidity to the global Islamic banking market and of promoting the trading of sukuk in the secondary market by acting as a market maker."

The failure to launch an Islamic mega-bank (although there may be one launched by other groups in Malaysia) is likely due to the recession limiting investors' willingness to invest in a new Islamic bank. However, the idea that the IDB bank would focus on short-term liquidity tools and secondary market sukuk trading may be good, as long as its focus is not spread too thin. It may be a duplicative effort for the bank to develop government-supported liquidity management tools when the ILMC has just been established (with shareholders from the GCC as well as Asia) to develop just such a thing.

In my opinion, it would be much more beneficial for an IDB-sponsored initiative to focus on only one thing, secondary markets for sukuk, where there is not another effort underway to address an issue. However, I suspect that the IDB would have trouble addressing the lack of secondary market liquidity in sukuk by acting as a market maker. The problem in the secondary markets is not a lack of market maker. The spreads between bid and ask in sukuk markets are large enough to bring a private firm into the market if there were enough volume to support it. The problem is the lack of sukuk--primarily the lack of sellers. With a shortage of sukuk available, most investors who hold sukuk are hold-to-maturity investors and unless that problem is dealt with, either by providing an 'offer' in the market or by issuing more sukuk, a new market maker will have a limited impact. The IDB is probably better served by continuing its now regular issuance of sukuk.

However, the article from Arab News adds a potentially troubling detail. The article cites an unnamed Islamic banker:

"However, with all these issuances, the IDB is building up a sound asset pool base. Some of the proceeds of the new offerings will also be used to redeem earlier issuances. So it is a virtuous circle of financing, according to one Islamic banker."

In my opinion, this is not necessarily a virtuous circle. If the Islamic Development Bank is taking on long-term assets and using these as collateral to issue new sukuk to repay the existing sukuk, it places the institution in a potential crunch unless it can depend on its member governments to finance it if its assets lose value.

This criticism is somewhat unfair. The business of banks is to borrow short-term and lend longer-term and the IDB likely has no future liquidity worries given the oil wealth of many of its member states (which is reflected in its AAA rating). However, it does lead to questions about why it doesn't use these assets to provide a greater diversification in maturity profile of its sukuk, if not for anything but to help the market for sukuk, which is dominated by 5-year sukuk. The IDB could, for example, add 3-year, 7-year and 10-year sukuk offerings to the 5-year offerings (matching the mid-range of maturities of another AAA rated issuer, the US Treasury).

If the IDB focused on creating more maturity diversification through its new issues, it would both support the development of sukuk secondary markets by increasing the sukuk available (which would help create business for market makers), but it would also not compete (but rather supplememnt) the ILMC's efforts to develop the short-end of the curve. Large multilateral institutions can provide valuable services, but when they leave their primary mandate, their impact is usually diluted. The IDB is a development bank, and it should concentrate on that activity. In doing so, it can use its assets to issue sukuk (to finance itself), which can benefit the Islamic finance industry. Moving beyond this role sets it up to spread itself too thin.

An Islamic pricing benchmark?

Within the Islamic finance industry, the use of interest rate benchmarks has led to occasional hand-wringing about the need for an 'Islamic' pricing benchmark. Several academics were commissioned by ISRA to study the issue and they write a paper[1] that was recently released (available on the ISRA website).

In their analysis, the authors created an alternative pricing benchmark based for Malaysia that they compared to KLIBOR based on industrial production, the money supply, equity prices and the Ringgit exchange rate (plus a suggestion for incorporating firm- and sector-specific factors). Using historical data, they found that their benchmark was more stable than the KLIBOR alternative.

However, there were a number of questions that the article raised about whether the effort was productive in terms of giving the Islamic finance industry a useful alternative to interest rate benchmarks like LIBOR/KLIBOR/etc. One of the biggest issues that I have with their methodology is that they use 'real' economy factors to determine their benchmark when it is not clear that the cost of financing in the Islamic finance industry as it operates today should be based on these factors and not an interest rate. What I mean by this is that the structure of Islamic banks' financing are much more debt-like and resemble the products offered by conventional banks in their risk (and return) profiles.

For example, the most common financing contract is murabaha, where a good is sold with a markup and deferred repayment. Although the bank is technically liable for some brief period of time, their main risk is the same as a conventional bank that loans money to a customer for the purchase of that good. The bank is concerned with the probability of default and its returns compared with its own cost of funds. To be fair, there is something to the argument that the cost of capital of Islamic banks should be different than conventional banks because their sources of capital may be forced to endure losses without creating a 'default'.

For example, most depositors are profit-sharing account holders, who are liable for loss of principal (although the regulatory regime in many regions limits the ability of depositors to be forced to accept a loss of principal and in others, the bank and its shareholders are in some ways subordinated to the depositors through reserve accounts that smooth the distributions to depositors, as well as absorb any losses. In addition, with the changes instituted by AAOIFI on mudaraba and musharaka sukuk, the sukuk holders may also be forced to receive redemption below par without a default if the underlying bank's profitability is not sufficient to pay the full value of the coupon plus final redemption. In both these situations, the bank does not have to absorb losses entirely and so their cost of capital is effectively lower than a conventional bank. This would make a conventional benchmark the incorrect metric to use when pricing loans (although the bank could adjust the spread over the benchmark it charges customers to compensate for this lower cost of capital).

However, apart from the possibility that an Islamic bank could have lower cost of capital from profit-sharing deposit accounts and debt financing, the interest rate benchmark may be more appropriate. For one thing, as the authors note, if there were a different benchmark for Islamic banks, it could attract arbitrageurs who would trade away any difference in the benchmark between conventional and Islamic banks, at least in normal conditions where the loss-sharing features of deposit accounts and sukuk were not in force. This would eliminate the benefit of having two different benchmarks because in most cases the benchmark rate would be identical.

While the article provided an interesting look at potential benchmarks for Islamic banks distinct from the interest-based rates they use now, the necessity of such a benchmark seems lacking. The use of an interest-based benchmark does not taint the Islamic banking industry and an attempt to create a distinct Islamic pricing benchmark could distract the industry from other, more pressing challenges, like liquidity management and deciding the place for profit-sharing and non-profit-sharing products. It would also deprive the industry of the ability to tap the knowledge of a much broader group of participants in the global financial system for information on the baseline cost of capital. Moving away from the interest-rate benchmark might impose costs on the industry's growth and would provide few apparent benefits except for those around 'perception' of the industry and its relationship with the conventional banking industry.

[1] Omar, Mohd Azmi, Azman Md Noor and Ahamed Kameel Mydin Meera. 2010. "An Islamic Pricing Benchmark", ISRA Research Paper No. 17/2010.

The role of Shari'ah advisory firms

A Reuters article deals with an interesting topic: the role of Shari'ah advisory firms as a way to 'outsource' the Shari'ah supervision and approval for Islamic financial institutions. I think this is an interesting topic and the article included one thing that I disagreed with: criticism of Shari'ah advisory firms for diluting the Shari'ah approval process. I would argue that, in contrast to the criticism, an outside Shari'ah advisory board would strengthen, not weaken, the Shari'ah approval process by making the scholars more independent of the companies for which they work, just like lawyers and accountants are.

There is a clear discrepancy between the role of lawyers and accountants on the one hand, and Shari'ah scholars on the other: there are many of the former, while relatively few of the latter. This is important because of the overlap between Shari'ah scholars on financial institutions' boards and those on the boards of the standards setting bodies like AAOIFI and the IFSB. This is important and will become more so if those bodies expand their work into determining broader standards about what is and what is not Shari'ah-compliant, as they appear to be doing. The overlap between the individuals devising the standards and those working for the financial institutions in approving new products poses a potential conflict of interest that will be difficult to overcome if the scholars are hired directly by the financial institutions.

With a Shari'ah advisory firm, the scholars work for the advisory firm, which handles the workflow and is hired by the financial institution. It can then assign Shari'ah scholars based on the needs of the client institution. This provides efficiency relative to each institution hiring a Shari'ah board by handling the contractual relationship with the client, but should also make it easier to handle any issue that might arise where the client needs to consult the Shari'ah scholars. It will be able to have the documentation behind each individual fatwa ready if one of the scholars who provided the original fatwa is not available.

However, there are benefits beyond just the issue of efficiency in reducing the costs of Shari'ah supervision. Having one organization that coordinates the client's need for Shari'ah review and supervision, it can provide a way to integrate younger scholars and provide them with experience working with more senior scholars at the firm. This can provide a way to reduce the bottleneck associated with too few top name scholars to accommodate the industry's growth, which was becoming acute before the financial crisis slowed the growth in Islamic finance.

However, with regards to the criticism that outsourcing Shari'ah review and supervision functions to a Shari'ah advisory firm, I think the trend of Shari'ah advisory firms can limit this. Rather than selecting a set of Shari'ah scholars that are the most likely to approve a product, the firms will hire the Shari'ah advisory firm with the most competent group of scholars and those firms will determine which scholars are most appropriate for each financial institution or product. The 'scholar shopping' that was credited with leading to controversial products being approved will be mitigated if the firms are more limited in their ability to directly hire--and pay--the scholars who review their products.

The Shari'ah advisory model is not without its potential flaws. For example, an advisory firm may essentially do the same scholar selection based on the likelihood of a given product being approved in order to maintain or gain market share. However, when there are many advisory firms to choose from, there will be a reputational risk for advisory firms that are associated with more controversial products (or even ones which were viewed as permissible at one time and then later viewed as impermissible). The same reputational risk is present with individual scholars, but it is more difficult to track whether a given scholar was on boards that approved controversial products (although services like Zawya's Shariah Scholar database, which it launched in partnership with Funds@Work are designed to help). With an advisory firm coordinating the Shari'ah review, it is much easier to track whether one advisory firm is known as relatively 'easier' to receive approval or for which there is a track record of approving more controversial products. The reputation and track record these firms accumulate will in turn affect their ability to recruit and retain scholars. An advisory firm with a high turnover rate of Shari'ah scholars will be a red flag for future clients about the quality of advise it can provide. Finally, it will be easier to implement some of the proposed certification and regulations over actual or perceived conflicts of interest with advisory firms rather than individual scholars.

The advisory firm model still presents many of the same issues that the direct hiring of Shari'ah boards by institutions, but it also presents several advantages from a monitoring, regulation and efficiency standpoint compared to the status quo of banks hiring their own boards. The criticism may be warrented in some cases, but the advisory firm setup can contribute to the development of the Islamic finance industry.

IMF working paper on Islamic banks in the financial crisis

The IMF released a working paper by Maher Hasan and Jemma Dridi, titled: "The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study (Working Paper 10/201) in September 2010. The article is an econometric study of whether Islamic banks performed better than conventional banks during the credit crisis. It is an important topic because the standard line after the crisis began was that Islamic banks were inherently stable than conventional banks and, in the mind of a few commentators, even 'immune' to crisis.

I have long expressed the view that Islamic banks are no less exposed to financial crisis--including the recent one--based on the features unique to Islamic banking. In fact, from the very features touted as providing the 'buffer' (e.g. profit-sharing in deposit accounts and in contracts), the Islamic financial industry is more exposed to crisis than conventional banks. If banks were placed in a more 'equity' position with respects to the financing they provide, a fall in the value of the businesses they finance (from which their repayment comes in an equity-type structure) will decline by more than if the banks are debt-holders, as they generally are in conventional finance. On the other side, if depositors are forced to bear the losses, then Islamic banks could be less stable than conventional banks because they would be more vulnerable to a 'run' on the bank by depositors worried they will lose their money when the bank reveals the first signs of trouble. The run by depositors (that thing that deposit insurance is designed to stop by guaranteeing depositor's money, at least to a certain limit) could force the bank to sell in a fire sale its assets, which would result in greater losses to depositors and the bank's creditors than if it were liquidated in a more orderly process.

However, the industry of course does not operate along the back-to-back mudaraba that is described above. Islamic banks have generally tried to structure themselves as closely to conventional banks (for a number of reasons). The primary reasons are that the people running the bank have backgrounds in conventional banking and therefore adapt their experience in conventional banking and want to move away from conventional-type products only incrementally. The secondary reason is that almost all Islamic banks globally are regulated the same way as conventional banks and it would be difficult (if not impossible) for them to diverge significantly from the activities associated with 'banks' in the conventional sense. In the real world sense of Islamic banking, it would be logical that Islamic banks outperformed conventional banks primarily by not losing as much money as the conventional banks with exposure to the worst performing investments at the heart of the credit crisis.

The first set of results (looking at the change in bank profitability) did indeed find this. Islamic banks outperformed their conventional counterparts (accounting for country-level differences), particularly in 2008 compared with 2007 (the results were not as strong when comparing 2009 with 2007). The authors attribute this result to "the impact of the crisis [moved] to the real economy, [Islamic banks] in some countries faced larger losses compared to their conventional peers" (p. 17). For me, the reading of this is correct; conventional banks were more exposed to the investments that soured in the first year, while Islamic banks were less directly exposed, but saw their profitability dip by more during 2009, once the impact of the crisis spread to the real economy.

The alternative explanation is that their geographical exposure was more highly concentrated in the GCC than their conventional peers within the GCC and therefore the performance lag in 2009 compared to 2008 (both measured against 2007 levels was more of a factor of the lag between the crisis in the U.S. and Europe and its impacts on the GCC. In particular, the effect of the price of oil (which another paper found evidence was the driving force for the Islamic finance industry) may have had a greater impact on Islamic (versus conventional) bank performance. Because the price of oil did not peak until mid-2008, the effect of the price collapse would be less strong in 2008 with the background of collapsing prices of assets held only by conventional banks. In 2009, by contrast, the decline in asset prices held only by conventional banks had slowed or reversed, while oil prices remained low.

The authors run several other regressions using different variables with differing results (including the finding that larger Islamic banks performed better than smaller Islamic banks, in contrast to the findings of Cihak and Hesse (2009)). The findings of the paper were summarized by the authors: "Our analysis suggests that [Islamic banks] fared differently than did [conventional banks] during the global financial crisis. Factors related to [Islamic banks' business model helped contain the adverse impact on profitability in 2008, while weakness in risk management practices in some [Islamic banks] led to larger decline in profitability compared to [conventional banks] in 2009." (p. 33).

The conclusions of the empirical analysis are followed with an overview of the areas that Islamic finance can improve to increase its stability in future crises. These include "adherence to Shariah principles [precluding Islamic banks] from financing or investing in the kind of instruments that have adversely affected their conventional competitors", "the importance of neutral regulatory framework for [Islamic and conventional banks]", "strengthening risk management", "establishing large and well managed [Islamic banks] that can compete with existing banks", "higher solvency", "lending to the less affected consumer sector", "the importance of liquidity risks, and the need for efficient bank resolution framework", ensuring that "supervisory and legal infrastructure [...] remains relevant" and "greater convergence and harmonization of regulations and products".

All of these recommendations should be considered in the long-term development of an Islamic financial system that is as robust (if not more so) than the conventional system. There are some that are more relevant and more important than others. For example, liquidity management is a key area that is receiving some well deserved attention from the IFSB membership with the formation of the International Islamic Liquidity Management Corporation, as well as single-country initiatives. The efforts to make regulation of conventional and Islamic financial institutions equivalent is also the focus in several countries, including France and South Korea. The 'bigger is better' idea that is spreading through Islamic finance even as the 'too big to fail' problem is at the fore of the discussion in conventional banking may lead to an Islamic 'mega-bank' in Malaysia. This idea is of more debatable merit; there are certainly advantages to larger banks in some respects, but as Cihak and Hesse found, there may be greater challenges for Islamic banks to retain as high risk management standards as those institutions grow larger. Even in areas where I might question the recommendations by the authors, this is a valuable first step to apply rigorous econometric methods to the question of "Have Islamic Banks Outperformed Conventional Banks in the Crisis?" There should (and likely will) be more studies tackling this subject and refining the data and the methodology used.

More thoughts on the ILMC

There are still few details about the International Islamic Liquidity Management Corporation that was established in Kuala Lumpur, Malaysia by the members of the Islamic Financial Services Board (IFSB). One new piece of information is that the ILMC will issue short-term papers in international reserve currencies (starting with the US dollar and Euro). I don't have any source for other than my own intuition, but I would suspect that the short-term issuance will be based on commodity murabaha (perhaps using the facilities at Bursa Suq Al-Sila'). The Bursa Suq Al-Sila was established in late 2009 as a Shari'ah-compliant trading platform in crude palm oil in Malaysia to facilitate Islamic financial institutions' liquidity management. That platform has already been used by international Islamic banks like Al Rajhi Bank's Malaysian subsidiary, which became a Commodity Trading Participant in August.

The use of commodity murabaha (if this were the choice made for the short-term issuance) would provide some benefits, but it would be outweighed in some areas by the costs of using the murabaha structure. First, the benefit is that commodity murabaha is globally recognized as being Shari'ah-compliant and therefore would sidestep any potential debate about whether the Shari'ah standards used were globally recognized. Even without using the commodity murabaha product, the difference in Shari'ah opinions is somewhat overstated as it relates to the ILMC because it would follow a well established trend for Islamic finance institutions to have a diverse Shari'ah board to command global respect for their rulings. Recently, Al Rajhi Bank worked with Cagamas, the Malaysian housing agency, to develop the Sukuk ALIM to be acceptable in both Malaysia and the GCC. And long before that sukuk, the Dow Jones family of Islamic indices was launched with a Shari'ah board composed of scholars from many regions, including both the GCC and Malaysia. In addition to the Shari'ah-compliance issue, using murabaha would be familiar to bankers who currently use inter-bank murabaha to manage liquidity. The ILMC would formalize this and reduce the counterparty risk associated with short-term interbank lending.

While the benefit would be substantial of using a structure that everyone accepts, even if there is debate about the appropriate level of reliance on murabaha by the industry as a whole, it would impose costs. The largest cost would be that the short-term bills are generally not tradable, except at par, because they represent a debt from the issuer and do not provide the investor with ownership of an asset that would be the basis for any secondary market trading. I recall (although I may be misremembering) that these bills would be issued with maturity of up to 1 year and therefore the absence of a mechanism for their secondary market trading would deprive the industry of a benefit from having a global, multi-currency short-term issue. This is not a problem that would be unique to the ILMC; in addition to its short-term ijara sukuk, the Central Bank of Bahrain issues sukuk al-salam, which have a similar limitation. The cost of not having secondary trading is that the ILMC would miss the opportunity to provide a reference rate of return that--by virtue of its shareholders being central banks and regulators--would be close to a risk-free rate of return on which other pricing could be based.

While it is easy to offer a criticism of the ILMC if it were in fact to choose commodity murabaha as the structure for its short-term bills, it would be difficult to develop an alternative that addresses the concern. First, it would have to probably be either a wakala, mudaraba, musharaka or ijara contract to be tradable and thus offer a reference pricing benchmark for other short-term financing. From these structures, there would have to be an easy, and relatively costless, way to issue short-term financing to attract widespread usage. All four of these contracts raise issues for which I don't have an easy answer for. The wakala structuure would benefit from using a structure that is relatively common in inter-bank liquidity management. However, with one of the parties (the one borrowing money by issuing sukuk) being a multi-lateral institution owned by central banks and regulators, there would have to be some use of the funds that would generate a return to pay for the wakala return or else the structure would raise issues of Shari'ah-compliance (with the ILMC acting as agent for the provider of funds, the return would have to be based on some activity). The mudaraba and musharaka would raise similar issues: what activity is being financed by the ILMC that generates the return paid to investors in the short-term sukuk?

The ijara structure would be easier to structure because their returns can be based on the rental of property or some other good. However, the ILMC is expected to be located inside the Petronas towers in Kuala Lumpur and would therefore not have sufficient assets on which to base the ijara sukuk. Even if the ILMC owned assets like its headquarters building, it is hard to see how it could have sufficient assets to issue the level of sukuk necessary to fill the demand for short-term sukuk. Every increase in the demand for the short-term sukuk would require the expansion of the assets held by the ILMC (not to mention the expansion necessary if they were wakala, mudaraba or musharaka sukuk). This would increase the cost and limit the demand for the sukuk, which would defeat the stated goal of providing liquidity management products to Islamic banks. With the alternatives posing difficulties, it seems likely that the ultimate structure will be commodity murabaha and despite the issues raised with this structure, it is the 'least costly' setup for creating better liquidity management tools, and the need for the product makes accepting the limitations of a commodity murabaha structure.