The Myth of Immunity in Islamic Finance

A book review in the Asia Times describes how the book being reviewed contains insights on the Islamic financial system and its inherent stability. While I cannot dispute that the authors have great credibility, I do believe that the book review's claims are not accurate in describing the Islamic financial system. I would welcome if the publisher sent me a copy of the book to review and post my own review. Because I have not read the book, I will limit my criticism specifically to the review.

I will present my comments after short quotes from the book review:

"Certainly Islamic finance and banking institutions are thriving relative to conventional finance. The Banker's 2009 survey of Islamic finance found the volume of sharia-compliant assets of the Top 500 grew by an extremely healthy 28.6%, rising to US$822 billion from $639 billion, in 2008 (forecasts are that this figure will top $1 trillion in 2010)."

I don't know whether the statistics on the size of the industry are accurate and I would not be comfortable myself relying on statistics of growth down to the tenth of a percent when the industry has been described often has having a size of $750 billion or $1 trillion for several years with growth rates usually quoted at 15% to 20%. The vagaries of the statistics, in my opinion, mean that there is really no data on the true size of the industry globally.

"Advocates claim Islamic finance has been immune because sharia-compliant institutions are focused on the fundamentals, with simple products bearing robust mechanisms for risk mitigation. Market analysts have stressed the correlation between asset quality in Islamic institutions and their conservative approach to risk as an insulating factor."

While I consider myself an advocate for Islamic finance, the idea that Islamic finance is immune from anything related to economic downturns is flatly wrong. It would contradict even the theoretical claims that the industry for it to be immune from economic downturn affecting its customers. If the industry were 100% profit-and-loss sharing, it would suffer a downturn comparable to the rest of the economy, depending upon the underlying leverage of the financial institutions. Even with ijara and murabaha making up most of the financing available, Islamic finance will still be susceptible to downturns through rising default rates and asset value depreciation.

"Many conventional bankers contend the success of Islamic finance in riding out the financial storm can be attributed to the fact it is underpinned by tangible assets such as real estate."

This, in my mind, has been completely disproven by the near-deafult of Nakheel, which relied almost entirely upon rising property values for its solvency and used sukuk to fund a large portion of its projects (and to add leverage). Besides Nakheel, many Islamic financial institutions suffered greatly when the Dubai real estate boom turned to a bust, whether they were conventional or Islamic.

"First, credit losses from debt default to the depreciation of assets may create a large divergence in relation to the liabilities that remain fixed in nominal value."

This is true in Islamic finance as in conventional finance. Even institutions that use Shari'ah-compliant debt financing retain the same economic characteristics as conventional finance. Those that use profit-and-loss sharing financing may be somewhat insulated from the fixed liabilities side, but the sukuk are typically structured to protect the creditors from a decline in the assets on which the sukuk is based or backed.

"Second, bank credit has no fixed relation to real capital in the economy and bears no direct relation to the real rate of return."

The rate of return in LIBOR or other interest rate benchmarks are affected by changes in the economy and Islamic financial products typically use these benchmarks to price Islamic financial products because the benchmarks provide guidance on the risk-return trade-off as viewed by creditors in the market.

"Third, banks caught in a credit freeze, with a drying up of liquidity. may default on their payments."

With fewer methods of liquidity management and no lender of last resort, Islamic financial institutions are more--not less--vulnerable to liquidity-driven crises.

"Fourth, banks are fully interconnected with each other through a complex debt structure; in particular, the assets of one bank instantaneously become liabilities of another, leading to fast credit multiplication. A credit crash causes a dramatic contagion and a domino effect that may impair even the soundest banks. "

With fewer Islamic banks offering the large majority of sukuk (at least prior to the AAOIFI ruling which restricted the issuance of mudaraba and musharaka sukuk), there is more counterparty risk to Islamic financial institutions. There are fewer issuers which leads to each issuer having a greater spillover effect on other banks' balance sheets if they were to fail or have their solvency questioned.

"In an economy governed by the principles of Islamic finance, the rate of return on equities is determined by the marginal efficiency of capital and time preference, and is positive in a growing economy. This implies that Islamic banks are always profitable provided that real economic growth is positive. "

As I mentioned above, interest rates are determined so that they represent the balance between the needs of recipients of capital and the providers of capital, incorporating the rate of return of the funds used (which affects the probability of repayment), as well as the risk-return ratio on the debt itself (the return balanced against the probability of default). Islamic financial institutions can make bad investments just like conventional financial institutions and can lose money even when economic growth is positive.

"A critical feature noted by the authors, and one consistent with the Austrian ideal for banking, is the fact that the Islamic system operates on a 100% reserve requirement. In this system, investment banking operates on a risk/profit sharing basis, with an overall rate of return that is positive and determined by the real economic growth rate."

Islamic finance is not based on 100% reserve requirements. An increase of $1 in equity or deposits is met with a larger expansion of assets by an Islamic bank through the use of debt-financing through sukuk issue. Also, nothing guarantees that any investment, whether financed using a risk/profit sharing method or not, will be profitable. The closer the asset side of an Islamic financial institution is to risk-sharing, the closer its profitability will be to an equity investment. The return on these investments--and stock markets or economic growth can be used as a proxy for the rate of return--can and often are negative.

While these criticisms are rather harsh, I do still believe Islamic finance can provide a positive example to the financial system. Limits on leverage will on their own make a financial system more stable because of the magnifying impact of leverage on returns, both positive and negative. There remain, however, many issues that Islamic finance as an industry needs to deal with to become fully mature so it has at least an equivalent risk management system including liquidity management and finding an Islamic way to provide lender of last resort financing, as well as Shari'ah-compliant hedging. The Islamic banking industry in particular has demonstrated the ability to be profitable and sustainable while adhering to Islamic ethics. Even as the financial system globally was on the verge of melting down, many Islamic financial institutions were able to weather the storms through a conservative approach to risk and high levels of liquidity (in part due to a lack of lender of last resort and adequate liquidity management tools). That is not to say that they remained profitable: many did not. However, they were able to remain in business and live another day even as banks that had been around for decades collapsed. As economies and financial systems recover, Islamic financial institutions will once again move in to the black, but they should not adopt the complacent attitude that by virtue of their Islamic nature they are immune from future downturns.

Dubai World, Saad Group

The Dubai World debt negotiations hit another potential snag with the repayment of the Nakheel sukuk maturing in May becoming more likely even without a restructuring deal. This compounds the issues caused by the offer of a 1% interest rate for banks who are owed money by Dubai World at the same time that trade creditors are offered 40% cash payment with the remaining 60% paid through a sukuk yielding 10%. A top official at Al Ghurair, which is described as a 'key trade creditor' by Emirates Business 24/7, said the 10% profit was "very generous".

I have previously questioned whether the restructuring would incorporate Shari'ah-complaince and there still has not been a complete reporting of this aspect of the restructuring. However, the use of a sukuk to repay trade creditors indicates that Dubai World remains interested in Islamic finance. The big potential problem is the differential treatment of different creditors, most of which are unsecured creditors. Banks are offered 1%, trade creditors offered 10% on a portion with the remaining being repaid while sukuk holders of the sukuk maturing next month receive full repayment. This differential treatment does no favors to Islamic finance because it reinforces the uncertainty about the rights of creditors in one of the largest geographical concentrations of sukuk issuers. This will make it more difficult for issuers to bring new sukuk to market because although the problems are largely Dubai-related, the uncertainty is generalized to the UAE, if not the GCC. Although the debt holders would suffer delays and would probably come out worse for it, for the Islamic finance industry, it may have been preferable for the whole Dubai World mess to end up in the tribunal in front of internationally recognized judges under DIFC law, which closely resembles English law.

Sukuk holders of the Saad Group have agreed to dissolve the sukuk trust. According to a Reuters factbox, the Saad Group sukuk was an asset-based sukuk, which would mean that the dissolution of the sukuk trust does not provide investors with an avenue to recover their money except through a bankruptcy proceeding as unsecured creditors of Saad Group, where they would be treated equally (pari passu) with other unsecured debt holders and subordinated to any secured creditors.

Khalil Jarrar has an interesting column in the latest Opalesque Islamic Finance Intelligence.

My latest article on the East Cameron sukuk was published by Islamic Business & Finance in the latest issue.

Other News

• The World Bank and the International Finance Corporation will be in Malaysia to discuss a Shari'ah-compliant fund for green technology investments.
  
• The relative strengths and weaknesses of using equity vs. debt in Islamic finance acording to an executive at Elaf Bank in Bahrain.
  
• Arcapita is planning to build a fund management business to reduce the cyclicality of revenues in the private equity business. I believe this is something that more Islamic investment banks and private equity houses will undertake to smooth their revenues and reduce the prospects of being severely harmed in future downturns and this is good for the industry as a whole.
  
• The Abu Dhabi Stock Exchange may begin to indicate which investments are Shari'ah-compliant and which are not.
  
• The CEO of a Malaysian invesmtent bank, Alliance Investment Bank, says that sukuk have a promising future.
  
• Kencana Petroleum Bhd, a Malaysian oil and gas services company, is planning to issue $78 million (MYR250 million) in sukuk sales. Cagamas issued $156 million (MYR500 million) in 5 year sukuk that were rated AAA by MARC because Cagamas is state-owned.
  
• Indonesia issued $22 million in sukuk, about 20% of its planned offering. Demand was limited, according to reports, because of limited liquidity in the sukuk.
  
• KPMG in India has expressed support for the development of guidance from the central bank for Islamic financial institutions in the country which have been slow to develop.
  
• The latest monthly commentary abou the performance of the Dow Jones Islamic Market Indexes for April is now available.
  
• Dundee University in Scotland will offer a postgraduate degree in Islamic finance.
  
• AsiaOne has a summary of Islamic finance structures that are commonly used.
  
• The company offering Salaam Halal, Principle Insurance Holdings, has been sold to a Kuwaiti buyer who was one of the largest shareholders.
  
• AAOIFI will hold its annual meeting at the end of May.
  
• The new Christian ETFs will not be a competition to Islamic financial products, but will encourage greater uptake of ethical products, according to an article in the Malaysian Insider.
  

Dubai World update and more

In contrast with the 1% rate offered to debt holders by Nakheel, the company has offered trade creditors tradable sukuk with a 10% coupon. The distinction, as described in a Reuters article is that it will allow trade creditors to monetize the sukuk at a better price. However, this could also make debt holders reject the restructuring plan. The price trade creditors could receive from selling the sukuk would depend not only on the coupon, but on the perceived ability of Nakheel to make good on its obligations following the approval of the restructuring plan. Local banks are seeking better terms in the Dubai World restructuring plan.

Rushdi Siddiqui writes in Gulf News about the need for Islamic financial institutions to view public relations as an important part of business development to expand their appeal.

Other News

• A contributor to TwoCircles.net describes the potential for Islamic microfinance and laments the shortage of Islamic banks becoming involved with microfinance.
  
• The sukuk market is not expected to regain its growth until 2011-2012 according to analysts. 2010 is expected to be flat compared with 2009, where there was significant recovery after a multi-year low in 2008.
  
• The Saad Group has yet to reach an aggrement with the banks to whom it owes at least $6.5 billion.
  
• Without naming The Investment Dar, Lahem al-Nasser, writes a damning criticism of their challenge in the case surrounding the wakala agreement with Blom Bank in Asharq Alawsat calling their legal claims 'Machiavellian". Andrew Cunningham, the managing director of the Financial Services Volunteer Corps adds his thoughts in a Financial Times opinion piece.
  
• Islamic banks in Malaysia and the UK plan further cooperation to increase the number of cross-border transactions.
  

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.
  

Sunday bullets

• Nakheel will pay $8.2 billion to its creditors in June according to an article from Reuters. This represents roughly a third of the $23 billion Nakheel's creditors are owed.
  
• The Financial Times has an article about the sukuk market in the wake of the default by the International Investments Group on a $200 million sukuk. The Economist also published an article on sukuk suggesting that Islamic finance is not broken, but is "dented". Malaysian company Senai-Desaru Expressway Bhd is restructuring $457 million (MYR1.46 billion) in sukuk. If it defaults, it would be the largest Malaysian sukuk default in over two years.
  
• Deutsche Bank launched a Shari'ah-compliant home finance company, Deutsche Gulf Finance, in Saudi Arabia with Saudi investors.
  
• The head of Islamic finance at Barclay's Capital, Harris Irfan, says that Islamic retail banking is in the "stone ages" compared to the product availability for conventional retail banking consumers.
  
• The Investment Dar released its financial results for 2008, the year before it began working on a restructuring plan with its creditors.
  

What does 2010 hold for sukuk?

The primary sukuk markets will see growth this year according to both Moody's and KFH Research with the latter expecting over $30 billion in new issuance. KFH Research predicts, according to senior analyst Tursina Yaacob, that private sector projects will see a revival, especially in Asia. The sovereign Indonesian sukuk for $889 million that was recently issued (triple the planned amount on significant demand with a bid-to-cover of over 7 times) is the largest sukuk issued this year according to KFH. Moody's projects that the first half of the year will see sovereign, supranational and government-related sukuk issues (which were the largest share in 2009) make up the largest share before private sector issuance recovers in the second half of the year. Emirates Business 24/7 has a detailed analysis of Moody's predictions for issuance by country. The Moody's press release focuses on the impact of legislative and regulatory changes as a source of a boost in new issuance, particularly from the sovereign or quasi-sovereign issuers. In addition to the legal and regulatory changes, the Central Bank of Bahrain is providing training on banking to Shari'ah scholars, while the Bank Negara Malaysia, the central bank, is launching a new Shari'ah governance framework to be effective beginning in 2011.

The Financial Times recently provided a short FAQ on sukuk which is a good introduction. As a part of the legal and regulatory environment being changed to accommodate Islamic finance, the Monetary Authority of Singapore revised its banking regulations to clarify its position on istisna'a financing, which was described in the opening remarks at the Singapore Islamic Finance News Roadshow 2010. Business Week notes the planned sukuk issuances, which include a $1.9 billion issue from Saudi Electric Comapny. Ernst & Young also released its World Takaful Report which predicts that the takaful market will surpass $8.8 billion this year.

Dubai Civil Aviation used a new ijara facility in April 2009 to repay a portion of the maturing $1 billion ijara facility that was due at the time. Recently, the first of three equal installment payments of $227 million was paid on this ijara facility, which included three tranches (in Emirati Dirhams, US Dollars and Euros).

Other News

• The AFP has an article on UM Financial's new iFreedomPlus MasterCard.
  
• Kuwait Finance House is exploring investment opportunities in alternative energy over the next two years. It's expansion into Canada through a recent joint venture after amendments to the tax law and was delayed by the credit crisis.
  
• The International Investment Group, based in Kuwait, has defaulted on its $200 million sukuk and a dissolution event (for the trust) will occur if the sukuk default is not remedied within three days. The IIG sukuk was a mudaraba sukuk and was exchangeable into either shares in IIG or cash and was listed on the NASDAQ Dubai (formerly DIFX) in June 2007.
  

What does Islamic finance provide and how can it be improved?

With some of the criticism of Islamic finance as nothing more than a replication of conventional finance, I took a chance to think over what the goals of Islamic finance should be and where the current state of the industry fits within the larger idea.

First, the criticism of Islamic finance as a replication of conventional finance does have merits. The way Islamic finance works today is not one that is seeking to completely overhaul the conventional financial industry. Instead, it seeks to provide the basic financial products like bonds and banking services to Muslim consumers who don't want to work within an interest-based financial system. For the most part, these consumers want to have the same opportunities as those who are comfortable working with the interest-based financial system.

The basic products are replications of conventional financial products and in most cases, that is not a bad thing. Using modified contracts to achieve the same ends as conventional finance will make it more likely that the products are comparably priced with conventional financial services, which is important. That these products are priced accordingly with conventional financial products is a benefit not a cost. There should be a goal within the industry to make the plain-vanilla products equally priced so there is no premium paid for using Islamic versus conventional financial products. The important thing is that the means and the intent by which these products are delivered is that they should be put together in a way that is broadly accepted by scholars as Shari'ah-compliant.

There are limits to how far this replication can proceed. There are financial innovations that are detrimental to society at large and if these are replicated in Shari'ah-compliant forms, then there is clearly a problem. The main deficiency with the Shari'ah review process as I understand it is that there is a focus on the specific contractual form, not necessarily as thorough a review of the social implications of a given product. If a product is created (e.g. in the conventional space, the negative amortization mortgage) which relies upon a continually rising house price to benefit the consumer and in any other case will harm him on average, then it would not be appropriate to create a Shari'ah-compliant version of the product.

It is not certain that the use of murabaha or tawarruq financing necessarily produces this social harm because in its absence, there will be a voluntary decision by many consumers to not receive financing at all. This will avoid some of those consumers from entering into a situation where they endanger their financial health, but it will also create hardship for some consumers who could benefit from receiving credit to finance education, healthcare, or a new business. On balance, there is not enough evidence that the use of murabaha or tawarruq creates net social harm.

Similarly, the use of asset-based sukuk which replicate an unsecured bond may not create anything different from a conventional product, but it provides an investment opportunity, for example, for an investment portfolio managed in a Shari'ah-compliant way for a pension fund or takaful provider that can introduce diversification in the way that a profit-and-loss sharing equity investment cannot. The product will not necessarily create a new type of financial system, but it will provide benefits to the investors who are not able to diversify using a conventional bond allocation. In its absence, there will be overallocation to real estate or equities, which are much more volatile and can lead to significant harm if (read: when) there is another significant market downturn.

That is the 'good' type of replication that I see. There is also some that is negative. The creation of products (particularly some of the structured products) that come with high fees for investors and these fees may leave them worse off than if the products had never existed in the first place (although providing significant income to the financial institutions and law firms which created them). As the real estate boom in some areas of the Gulf turned into a bubble which eventually burst, there were plenty of Islamic financial products which fall into the category of what I described. This distinction should be made clear between the over-structured products that are accompanied high fees from the basic banking products which promote inclusion within the financial systems for Muslim consumers that choose to avoid the interest-based conventional financial system.

However, that perspective alone feels a bit empty in terms of what the Islamic financial system is supposed to provide and the similarities it shares with socially responsible and ethical finance. There is one aspect that is omitted from the above discussion that is key for the Islamic finance industry to live up to its billing as another form of ethical finance. There should be a proactive and positive approach to financing ethical businesses and doing good for the world through its operations. Right now, it is too focused on avoiding that which is prohibited while ignoring doing what is encouraged. There are two areas where I think a start should be made: 1) make an extra effort to finance businesses that are environmentally responsible and those that are focused on making businesses more environmentally friendly (companies that provide products that make more efficient use of energy and those that can help develop and integrate renewable energy); 2) use some of the profits and expertise from creating Islamic financial products to help those who are less well off, through focusing on providing financing to small and micro-businesses.

These two areas are important for Islamic financial institutions because they promote beneficial activities for the world and people in need while not forcing the industry from leaving its core area of expertise, which is in financing businesses and individuals. There are many charitable organizations that can provide other services where they have better skills at how to do this efficiently. In the financial area, Islamic financial institutions can work more closely to use their role as a financial intermediary to improve the state of the world. If they choose not to do this, then it would be fair to accuse them of being little more than a re-structured version of conventional banks without a special feeling of obligation to pursue a more ethically focused form of business.

Islamic finance and financial stability

The Islamic Financial Services Board meeting recently saw the launch of the IFSB-IRTI-IsDB report on financial stability in the Islamic finance industry. I have not had a chance yet to read the report, but my initial impression of their effort is supportive. It recognizes that the global financial crisis did impact the Islamic financial system and can provide lessons as institutions grow larger. There have been many times, most recently a couple weeks ago where I question whether too big to fail is not a problem that could afflict Islamic finance. I argued (and still maintain) that because the industry is concentrated in small countries in the Gulf, a big institution (like the planned Islamic mega bank or institutions like Dubai World, which is not an Islamic financial institution, but has received significant Shari'ah-compliant funding) could endanger the financial stability of the country it is based in. This problem is heightened because there are no Shari'ah-compliant options for 'lender of last resort', the role the US Federal Reserve played to keep healthy banks from being destroyed as global liquidity dried up. The potential problem does not end there. There is inter-bank funding occurring (although not generally overnight funding which caused virtual runs on conventional institutions) and so one bank's trouble spills over to other banks with exposure to the troubled bank. If a few large lslamic banks became insolvent, it is likely that their debt would be held on other banks' balance sheets and the writedown of the insolvent bank's debts held by other banks could put stress on the solvency of the other banks. This could be heightened if this caused retail banking customers to withdraw their money, which could cause a liquidity squeeze that would put the previously healthy banks at risk of insolvency. With that rather gloomy (although relatively unlikely) prospect in mind, I think it is a good thing for the establishment of an Islamic Financial Stability Forum, which was recommended in the report.

Other News

• Rushdi Siddiqui, the global head of Islamic finance for Thomson Reuters, argues in a column in GulfNews that there should be more linkages between the halal industry and Islamic finance.
  
• Dar Al-Arkan made a periodic coupon distribution on one of its sukuk.
  
• To broaden its investments, Kuwait Finance House signed an agreement to invest $450 million in Canadian real estate working with Killiam Properties.
  
• The first takaful policy for a space satellite was announced recently.
  
• The Investment Dar is fighting over the buyback option on shares in Boubyan Bank it lost.
  
• Asharq Alawsat's columnist Lahem al-Nasser says that Shari'ah boards should be treated like external auditors and should be liable for their decisions.
  
• Pakistan will sell domestic sukuk within the next three months. The central bank is also considering ways to provide short-term sukuk for Islamic banks' liquidity management.
  

Islamic wealth management, avoiding future crises, Moody's says Islamic finance could reach $5 trillion

The Islamic wealth management report from Bank Sarasin raises one point which I believe is true across the Islamic finance industry: the diversification of assets is not nearly as expansive as in conventional finance and in many cases leaves investors with too much exposure to real estate. It also is too focused on transaction-based compensation for Islamic bankers. The emphasis is placed on deals and there is too little focus (and compensation based on) the long term needs of Muslim investors. As an asset manager myself, I have watched the Islamic finance industry expand, particularly in the issuance of sukuk, with much of the focus on new financial products that expand the financial structures used in conventional finance. That is not necessarily problematic because good diversification relies on different asset classes from which investors can choose. However, when the focus is on creating a diverse set of structures and not on the types of investments, there will be an unmet need. For example, the equity asset class has been the easy part with Islamic indexes being around for over 10 years now. However, there remains a shortage of fixed income-like products that is only partially filled by sukuk (for example, there is still no fixed income-substitute within the United States). A lot of the other structures being created have still focused on property finance. There can be many different ways created to provide investors with exposure to real estate markets, but that still only addresses one asset class. It may create diversification (e.g. geographical) within that asset class, but a focus on real estate markets as a predominant investment area leaves asset managers struggling to create a diversified portfolio for Muslim clients (whether or not they are exclusively focused on Muslim clients). Perhaps the (nearly) global property bust will will make other areas more attractive, but it may just create a new area where activity is concentrated. That would be a shame and would harm the investors that are the source for the Islamic finance business.

The CEO of Fajr Capital, Iqbal Khan, said that Malaysia can provide an example for reform within the Islamic finance industry, particularly to separate the utilitarian and financial intermediation roles to prevent the problems that arose during the credit crisis. Mr. Khan said that there should be a separation to prevent the need in a future crisis for Islamic investment banks to be bailed out the government to preserve the basic payment systems within the banking system. Those payment systems could then be backstopped if necessary but ""Everything else - Mudharabah-based, asset-based, unit trust and investment fund - goes into separate business. These two, never the twain shall meet, they have to be kept separate". I believe he is absolutely correct. The flaw with the universal banking model and allowing the investment banks and commercial banks to merge (in the U.S., this was through the Gramm-Leach-Bliley Act) forced the government to bail out all or none of the banks and the combination of the two into large financial holding companies meant that in order to keep the payment systems intact, the investment banks had to be bailed out lest their losses endanger the institutions as a whole, which led to the crisis within the 'boring' areas of the credit markets unrelated to the investment banks' operations.

Moody's says that Islamic finance assets could grow to $5 trillion without providing a date by which this could be reached. They said assets were $950 billion in 2009, which is higher than previous estimates from other groups which were in the range of $800-$850 billion. Moody's says that Shari'ah-compliant derivatives, if 'employed with care', could provide a useful purpose for hedging purposes. The recent IIFM master agreement on Islamic derivatives includes a requirement that they only be used for hedging, not speculation. Moody's VP and Senior Credit Officer Anwar Hassoune cautioned that "IFIs aim to utilize derivative instruments to hedge against risk and to improve risk monitoring practices. However they are keen to do so in a Sharia-compliant manner, rather than imitating conventional derivative instruments, in order to avoid losing their special status as Sharia-compliant banks, which makes them very attractive to a large population of Muslims." Moody's warns that IFIs have weak asset-liability, investment, and liquidity risk management. An article published by the Wharton School at the University of Pennsylvania discusses the role of ratings agencies within the Islamic finance industry, specifically within the sukuk market.

Other News

• An article in the Financial Post (Canada) discusses the recent UFANA conference in Toronto (at which I was a speaker).
  
• $4.67 billion in sukuk were issued in the first quarter of 2010 according to Zawya, compared with $0.63 billion in the same period in 2009. Malaysian issuers accounted for 53% of all new issues, Indonesia for 33.5% and Saudi Arabia with 9.6% from the Dar Al Arkan sukuk of $450 million. Malaysia is planning a US dollar-denominated sukuk.
  
• An opinion column in the Kuwait Times asks whether Islamic banking has enough focus on providing a competitive and quality product to ordinary people.
  
• A GCC-based VP at iShares offers an interesting view of the current state of Islamic indices.
  
• Just as private equity has faced significant headwinds over the past 2 years, so has the Islamic private equity industry and things are just starting to get back to doing deals.
  
• The New York City Bar is planning a seminar on Islamic law including a portion of the seminar covering Islamic finance.
  
• Indonesia's efforts to expand the share of its banking system made up by Islamic banks is described in an article from the Oxford Business Group. The government is planning a 5 trillion rupiah sukuk (555 million) issue on April 13.
  
• Standard Chartered's Islamic finance window has avoided Islamic hedge funds based on a concern that the arbun structure used to create short-selling-equivalent has not been widely accepted among Shari'ah scholars.
  
• An article describes what AAOIFI does and what it is working on now.
  
• Sudan, which has been largely cut off from capital markets since US economic sanctions were imposed in 2007 because of the genocide in Darfur, is issuing $300 million in sukuk.
  

What do accusations of 'scholar shopping' tell us?

There is an interesting discussion about 'scholar shopping' going on at the Global Islamic Finance Resources group on LinkedIn. Without trying to summarize the discussion, I think it is an interesting topic that merits a brief outline of my opinions.

The practice of 'scholar shopping' is usually described where a financial institution asks multiple scholars to approve a given product until they are able to find a scholar who will approve it. Usually it is put forward as with negative connotations towards the industry as a whole, particularly with regards to the industry's legitimacy or authenticity. I don't necessarily agree with this perspective. While scholars hold relatively similar views on what is and is not Shari'ah-compliant, there are differences and this is healthy. There would be no debate if there were not any differences in opinion, and also no innovation.

However, the greater question that I believe underlies the concern over scholar shopping is a question of whether there are (real or perceived) conflicts of interest introduced by the process through which a product is approved. I believe there is a perceived conflict of interest. It can be viewed as an example of regulatory capture: the regulators (Shari'ah scholars) are to some degree reliant on the industry they are supposed to regulate for their compensation. It may be that in the vast majority of cases, scholars act entirely based on their own interpretation of the Shari'ah and their compensation has no impact at all on their rulings. However, there remains a perception that there is some conflict of interest between their role as regulators (working on behalf of the consumers) and their status as employees or consultants of the institutions selling the financial products.

This perception of a conflict of interest does not mean that there is a conflict of interest, nor should Shari'ah scholars be forced to work for free. They have a specialization beyond that of most people within their field of expertise. However, the particular way in which they receive compensation is tied to their approval for a given product and that leads to reports of 'scholar shopping' which could reduce the level of trust between consumers and the Islamic finance industry generally that is beneficial to no one.

There are three possible solutions in my eyes to this problem, two of which are practicable and one of which is likely not (at least globally). The solution that is impracticable is to have a global regulatory body which approves all Shari'ah-compliant financial products and where the Shari'ah scholars are paid directly by that global body and not by the institutions that make up the industry. This is impracticable because there will likely never be complete agreement on a global set of Shari'ah standards and this would hamper the growth of the industry and bias it towards using the most basic products in use now for which there is more or less consensus. This would set back by many years the solutions to the significant problems facing Islamic banks like liquidity management and transactions used to hedge against currency, interest rate and commodity price fluctuations.

The two that are more feasible in my eyes are:
1) The development of more Shari'ah advisory firms that are structured like law firms. The Shari'ah scholars are paid by the advisory firm, which coordinates the Shari'ah approval process and the Shari'ah scholars are paid for the time they spend on a given product, whether or not it is granted approval as being Shari'ah-compliant. This insulates the scholars from the perceived conflict of interest in the current system, particularly if they receive per-project fees which are more tightly linked with approval of a given product. This solution would also present an opportunity for multiple scholars' views to be put forward within the process without the cost of expanding the Shari'ah board by a full member. This would also allow the rotation of scholars or Shari'ah advisory companies throughout the life of a product to allow for the the greatest degree of oversight about a product's Shari'ah compliance.

2) The development of a centralized body which keeps track of the products approved by each Shari'ah scholar as well as the details of the structure of each product that would be publicly available. There could be some window of time (1-2 years) where product structures are kept confidential to prevent their adoption immediately by competing Islamic financial institutions who would be able to free-ride on the costs borne by the developer of the product structure. This centralized database could provide consumers and industry participants with a way to see whether a given Shari'ah scholar had consistently approved products which other scholars objected to. However, the real value (and use for the database) would be to create a paper trail which could be offered as a defense against claims of 'scholar shopping'. The Shari'ah scholar's credibility has (and always has) depended upon him being viewed as an impartial judge of a product's Shari'ah compliance for the benefit of consumers and creating a forum that can show this through the history of his approvals would be extremely valuable. It could bolster the credibility for scholars by demonstrating that the majority of their approvals are within the bounds of what other Shari'ah scholars are approving and this evidence would severely undermine future claims of 'scholar shopping'. If all scholars approve of a given structure in different contexts, then there is not likely to be any need for institutions to 'scholar shop'. It would also provide a forum where less well recognized scholars can establish a track record that they can use to become more well recognized, which could help add to the body of globally-recognized scholars.

Neither of these ideas is entirely new, nor would they represent a panacea, but accusations of 'scholar shopping' reveals that there are questions about perceived conflicts of interest that need to be addressed. The sooner they are addressed (and shown to be generally only perceived and not actual conflicts), the better for the Islamic financial services industry as a whole.

Catching up after the UFANA 2010 conference

Apologies for the light blogging recently. I was speaking at the Usury-Free Association of North America conference in Toronto, Ontario. As the editor of the UFANA newsletter, I was very impressed with the conference and it was well organized and well attended. It was one of the more stimulating Islamic finance conferences I have attended. There will be more information, including all of the presentations with video available on the UFANA website shortly. It is an honor of mine to work with an organization working to promote Islamic and other usury-free financial services within North America and one of my most interesting conversations was with the Rev. Lindsay King who shared his interpretation of the Biblical verses in Deuteronomy that restrict interest-based lending by Christians and Jews. I look forward to continuing to work with UFANA as the organization builds on this recent conference.

Investment Executive newspaper provided a summary of the conference. One of the announcements at the conference was the launch of the pre-paid iFreedom MasterCard.

There are three news articles about the Dubai World and Nakheel situation:

• "Nakheel seen offering sukuk to trade creditors", Reuters
  
• "The Calculus Behind Dubai's Nakheel Repayment", Wall Street Journal
  
• "Dubai offers $9.5 billion for debt deal with no haircuts", The Gazette (Montreal, Canada)
  

News

• Rushdi Siddiqui has an editorial in Gulf News that is very much worth reading, "Upgrading to Islamic finance 2.0"
  
• Islamic banks in the UK launched a lobbying group with a part of their mission being to encourage the UK government to issue a sukuk.
  
• A Citi Private Bank report says that Western groups working in real estate should become more familiar with Islamic finance.
  
• Arab News has an article about the forthcoming ShariahShares ETF family being launched in the US.
  
• Ithmaar Bank is reorganizing as a retail Islamic bank.
  
• An advisor to the Bank of London and the Middle East says that regulators should encourage smaller Islamic banks to merge.
  
• Indonesia sold 620 billion rupiah ($68 million) in sukuk, which was below the target of 1 trillion rupiah. Despite the disappointing auctions so far, if the sukuk issuance continues to be as frequent as it has been recently, it could spur the development of secondary markets within the country.
  
• Bank Sarasin released a report on Islamic Wealth Management, which follows a report recently released by Yasaar Media.
  
• Qatar Islamic Bank is working on a joint-venture to offer Islamic financial services in France.
  
• Bahrain Saudi Bank is rebranding itself as Bahrain Saudi as it becomes a fully Shari'ah-compliant bank following its acquisition by Al Salam Bank.
  
• Dubai Financial Markets, which recently acquired NASDAQ Dubai, is planning to launch an Islamic index.
  
• Emirates NBD launched an Islamic money market fund.
  
• A Japanese financial services company signed a joint venture with the Ministry of Finance in Brunei to offer Islamic financial services including private equity.
  
• The Central Bank of Bahrain's Sukuk Al-Salam were oversubscribed by nearly 400%.
  
• The only Islamic bank in the Philippines is working with PetronBulilit Station to offer dealership opportunities for small businesses.
  
• Franklin Templeton recieved a license to offer Islamic funds in Malaysia.
  
• Kuwait Finance House-Malaysia is going to increase its investments in Malaysia.
  
• Friends Provident, a UK insurance company, may offer takaful in the Gulf.
  
• Pakistan is planning to offer Rs100 billion in sukuk in May.
  
• The Huffington Post blog has another article on Islamic finance.
  
• Yemeni banks should apply common standards to issue Islamic instruments according to a recent conference.
  
• Malaysia's sukuk markets are expected to be RM60 billion ($18.5 billion) in 2010, up about a quarter from last year according to RAM Ratings.
  
• Shari'ah Capital's DSAM fund of funds returned 41% last year using their arboon-based short-selling product, which remains controversial.