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.