UFANA, Rusdhi Siddiqui on UK Islamic banking, inter-bank money markets, Indonesia sukuk

The Usury Free Association of North America (UFANA) held an event concurrent with the G-20 meetings in Toronto which was well covered in the local media. Investment Executive has an article. In addition, several speakers were interviewed by BNN: Shahzad Siddiqui (UFANA Executive Director), Guy David (Partner, Gowling Lafleur Henderson) and Stephen Ranzini (President & CEO, University Bank)

Rushdi Siddiqui provides what I think is the best analysis of the article that called Islamic banking in the UK a flop (although an article by Mushtak Parker in Arab News does also make some good points). I provided my analysis of the article in earlier blog posts and offered my oown suggestions in my latest newsletter (subscribe on the blog or email me at blake@sharingrisk.org). Rushdi Siddiqui, with his long and prominent experience in the Islamic finance industry, provides his usual clarity to the issue.

The need for interbank money markets for Islamic banks is put into context with a news story that almost one-third of all the UAE's central bank certificates of deposits are held by Islamic banks which cannot accept any return on the CDs because they pay interest. The central bank has been developing an Islamic CD to offer to Islamic banks. Out of the central bank's total outstanding CDs, AED20 billion (of AED68.5 billion) are held by Islamic banks. With such a substantial holding of non-interest bearing CDs, Islamic banks are missing an opportunity to generate a return on its capital, which is in part so large because they are not able to avail themselves of the liquidity facilities of the central bank because those are interest-based. The planned Islamic CDs would be based on murabaha (likely commodity murabaha) and, although an imperfect solution, would at least make an impact towards helping Islamic banks compete with conventional banks on price. In contrast to Islamic banks, the conventional banks holding CDs with the central bank earn interest (however meagre currently) on their capital. A great article in Arabian Business describes the situation, although it lists the deposits of Islamic banks at the UAE central bank at 19% (in contrast to the one-third in the previous article). It also points out the alternative to the additional capital held by many Islamic banks: hoping for the best. Instead of holding excess cash on the balance sheet, many Islamic banks may be maximizing their profitability at the expense of their stability by relying on short-term deposits to fund themselves while investing in longer-dated sukuk and other assets. Those institutions risk either a conventional run by depositors or a Lehman-style run by short-term investors who lose confidence in an institution.

A similar issue to the inter-bank money market is whether LIBOR should be replaced by an 'Islamic' metric. An article by Joseph DiVanna provides a good overview of the problem and some interesting potential solutions. However, in my opinion it is a waste of time. The Malaysian experience, where there is an Islamic and conventional yield curve determined by market forces from secondary market trading in debt instruments is largely similar. The difference in yields can be ascribed to the tax incentives provided by the Malaysian government for Islamic instruments. Pricing using LIBOR may be one more similarity to conventional finance that needs to be explained when it arises, but the cost of capital has much more to do with a specific company or market than it does with an Islamic versus conventional structure. When there are sukuk or other Islamic finance debt products that do not behave identically to debt, then the issue may need to be revisted. However, until then, there are more pressing problems like Islamic inter-bank money markets to be dealt with.

Indonesia's problems attracting investors to its sovereign sukuk continue as it rejected all bids for its latest $111 million sukuk offering. The total bids were only 474 billion rupiah compared with the target for 1 trillion rupiah in sukuk. The Reuters article that describes the failed auction correctly points out that previous failed auctions have been the result of investors demanding higher yields than for comparable maturity conventional bonds due to the lack of liquidity in the secondary market for sukuk compared to conventional debt. There is now 24.5 trillion rupiah in sukuk outstanding compared to 590 trillion rupiah in conventional bonds. The most recent failed auction may be somewhat disturbing because it failed to attract the planned issuance (although only one data point). This may suggest that investors are concerned that a viable secondary market may not develop in the sukuk where in the past investors only wanted a higher yield to offset this possibility. However, in the case of Indonesia, which has had success issuing conventional bonds, this should just serve as added impetus to develop its domestic sukuk secondary markets further, which a stronger Islamic banking sector could provide.

Other news

• Nakheel began to pay the cash portion due to trade creditors with the sukuk for the remaining balance coming later.
  
• Political concerns in Egypt, along with many fradulent companies in the 1980s that operated under the 'Islamic' label has slowed the growth in the country. Despite the headwinds, many GCC Islamic banks are eyeing Egypt as a possible growth area.
  
• Malaysia's banking system is now 19.6% Islamic with MYR303 billion ($93.6 billion) in assets.
  
• Gulf Finance House continues to work to extend the maturities of its debts after it ran into trouble following the financial crisis. The latest is a $100 million murabaha due in August.
  
• Malaysia may see a number of its cooperative banks convert to be Shari'ah-compliant.
  
• There was an article about the Northern New Jersey credit union that became the first credit union that I know of to to offer Islamic finance products.
  
• Kuwait Finance House was removed from CreditWatch Negative by S&P but with a negative outlook that reflects its "weakening asset quality" but with greater likelyhood of "extraordinary support" from the Kuwait government. A greater likelihood of government support amid weakening asset quality is not great news following the dismissal of a ratings agency that considered downgrading KFH Malaysia.
  
• Dow Jones offers its latest monthly commentary on the Dow Jones Islamic Market Indexes.
  
• The latest updated list from Bloomberg of upcoming sukuk issues.
  
• Some estimates target growth in the Islamic finance industry to $2 trillion in the next 3-5 years. By the most optimistic estimates, Islamic finance is currently nearing the $1 trillion mark.
  
• CIMB Islamic head Badlisyah Abdul Ghani says that Malaysia has developed Islamic alternatives to more products because of its' "effective product-development approval process". There has also been more government support for Islamic finance, a greater take-up by the non-Muslim population and also the benefit of a centralized Shari'ah board, which also has its own costs. CIMB recently lost its top spot as top underwriter of sukuk to HSBC, which either reflects a growing share taken by the banking giants or further globalization of Islamic finance based on HSBC's greater geographical reach.
  
• Among other things, the Islamic Development Bank expanded its capital from ID16 billion to ID18 billion. 1ID (Islamic Dinar) is equal to one Special Drawing Right (SDR) of the IMF.
  
• Reliance Capital is launching two Islamic funds in Malaysia by July and unveil other products at a later date. It is a sign of the underdevelopment of the Islamic finance market in India that the company has avoided its home market for Malaysia.
  
• Kenyan firm ApexAfrica Capital is considering expansion into Islamic investments.
  
• OSK-UOB Islamic Fund Management Bhd plans to launch equity-based ASEAN-centril Islamic financial products.
  
• Sri Lankan firm LB Finance is launching an Islamic unit.
  

Islamic finance can learn from the credit crisis, Malaysia mandates rebate in mortgage products

The CEO of Capinnova Investment Bank had some interesting comments about Islamic finance in an interview with Emirates Business 24/7. He believes that there should be a unified Islamic banking authority to create more standardization and facilitate cooperation between different entities. He also suggested that it is "worth looking at the current credit crunch in conventional finance to see how easily one problem can spiral out of control. This is something that Islamic finance practitioners need to take on board and make sure that they are prepared to expect the unexpected". I think this is essential because Islamic finance institutions, particularly banks, can be subject to a crisis that could impair the confidence in their ability to survive which could turn into a destabilizing process where depositors 'run' on the banks. If this happened, the bank would have one of two choices: fail or turn to a conventional lender of last resort.

In both cases, the Islamic banking industry would be hurt. If a large Islamic bank failed, it could lead to questions about the solvency of other Islamic banks and make it harder for them to attract and retain deposits. This would force them to turn to other sources of capital which could be either more expensive or shorter-term, or both. The other alternative--an Islamic bank turning to a conventional lender of last resort--would raise questions about the bank's Shari'ah-compliance and also create questions about what other Islamic banks would do in a similar situation (with added confusion from the impact of different country's regulatory systems). For example, banks offering Islamic deposit products in the US are required to have those deposits FDIC insured (for banks) or NCUA insured (for credit unions). If the institution were to be seized by the regulators, would depositors have a choice about whether they wanted to avail of the non-Shari'ah-compliant deposit insurance?

The best time to determine what needs to be done in a future crisis is now, before a crisis starts. Once a crisis is in full swing, there will not be sufficient time to consider these potential pitfalls. This was demonstrated in the recent financial crisis. The cause of the crisis was not addressed; the focus was entirely upon preventing it from spiraling further out of control.

Malaysia's central bank, Bank Negara, has said that Islamic mortgage products offered using bai bithamin ajil (BBA), and murabaha must include language in the contracts that make the rebate (ibrar) mandatory. Previously, in a default followed by an asset sale (or a prepayment), the lender was entitely to the entire loan amount (cost plus profit) for the entire term of the mortgage. Most banks granted the rebate of what in a conventional mortgage would have been future accrued interest. However, when the rebate was not granted, it often led to court cases.

Other News

• Mushtak Parker criticizes the article about Islamic banking being 'a flop'. He places much of the blame for IBB's loss-making on the bank itself being undercapitalized and without an experienced Islamic banker running it. He also criticizes the product mix that was offered by the bank. In a different article, Mr. Parker describes the progress being made in Australia towards equal regulatory treatment for Islamic and conventional financial products.
  
• The UAE Ministry of Economy issued a law that regulates the takaful industry. It had been previously regulated under a law for conventional insurance companies.
  
• Sukuk prices are at their six-month highs following a number of sukuk restructurings, according to the Dow Jones Citigroup Sukuk Index. The yield on the Malaysian sovereign sukuk has fallen to 3.61%, a spread of 175 basis points over similar maturity US Treasuries.
  
• One of Nakheel's largest trade creditors Arabtec expects the inital payment by Nakheel soon with the remaining amount in a sukuk within a few months.
  
• Funds continue to flow into US-based socially responsible funds, including faith-based funds like the Amana Funds.
  
• Jordan is speeding up the issuance of a planned sukuk as its borrowing costs rise.
  
• Kuwait Finance House (Malaysia) set up an internal department to control non-performing financings, which were 6.72% in September 2009. It also defended its dismissal of one of the firms which rated it, RAM Ratings. KFH Malaysia's parent company is expected to post a higher profit in the second quarter compared to the first, which was 21.4% from the first quarter of 2009.
  
• Dubai-based Fajr Capital will invest in Bank Islam Brunei Darussalam (BIBD), an Islamic bank in Brunei.
  
• The Islamic Bank of Britain won a dispute in the World Intellectual Property Organization (WIPO) with a technology service company that had decide to auction the domain name used by the IBB.
  

Dar al-Arkan swap, sukuk fund diversification

Dar al-Arkan, which issued a 10.5% sukuk in February to refinance its debts, has entered into a Shari'ah-compliant swap agreement to lower its financing costs. The arrangement swaps the current financing cost of 10.75% with a floating rate of 7.95% over 3-month SAIBOR (I would appreciate if someone could email me a source of SAIBOR rate data) for half of the sukuk, $225 million. The article discusses that the swap lowers the cost of financing, however, it should be remembered that if Dar Al Arkan is now exposed to interest-rate risk on this portion of the sukuk. If interest rates rise, the costs of the floating rate side of the swap to which Dar al-Arkan is exposed will rise. The sukuk matures in 2015 (the length of the swap was not included in the article) and interest rates are currently very low so if the swap covers the entire period of the sukuk, it could expose Dar al-Arkan to substantial additional financing costs.

European Finance House, an affiliate of Qatar Islamic Bank, released the performance of its EFH Global Sukuk Plus Fund. The performance was higher than its benchmark (3m USD LIBOR + 2%) by 780 basis points and the fund says it has experienced lower volatility than the sukuk markets as a whole in its first year. The article describes the diversification the fund was able to achieve across 13 sukuk in nine jurisdictions. This is not surprising, but it is also not very diversified. This is not a problem specific to this one fund; there are far too few sukuk that are available for sukuk funds. Until the growth in sukuk issuance increases--and it has rebounded this year--it will be difficult for sukuk funds to achieve diversification anywhere comparable to conventional bond funds. For comparison, one of the world's largest bond funds, the PIMCO Total Return Fund, has 11,619 holdings according to Morningstar.

Other News

• The Dubai bailout has increased demand in secondary markets for GCC-based sukuk.
  
• Gas pipeline company Trans Thai Malaysia, a joint venture of Petronas and PTT pcl, is likely to issue a sukuk.
  
• Bank Negara Malaysia, on behalf of the government, issued MYR2.4 billion ($743 million) of three-year Sukuk 1Malaysia notes with a 5% coupon. The transaction was facilitated through Bursa Suq Al-Sila', the commodity murabaha platform.
  
• Pakistan's government plans to issue $410 million in short-term (1-, 2- and 3-year) sukuk shortly once it receives government approval from the Sindh government and the Ministry of Defense. The sukuk will be based on land at a terminal at the Karachi airport.
  
• An article in a Turkish newspaper describes sukuk. The description included: "Sukuk are not debts of the issuer". This is technically correct because even asset-based sukuk involve the transfer of beneficial ownership, however, they are structured to be treated pari passu with the unsecured debts of the issuer and often provide recourse to the issuer through a purchase undertaking.
  

Islamic finance 'flops' in the UK? New sukuk and AAOIFI standards

Junaid Bhatti wrote an article saying the Islamic finance industry in the UK has 'flopped' based on its inability to achieve rapid growth and profitability using his experience working at the Islamic Bank of Britain from its founding. The article describes, in addition to IBB's losses notes that:

"Well, the UK’s first 'Halal' insurance firm, Salaam Insurance, spectacularly shut up shop in 2009 after less than 18 months of trading. Lloyds TSB, which made a half-hearted stab at Shariah-compliant products in 2004, doesn’t seem to have promoted its offering for years. alburaq – owned by Arab Banking Corporation – has effectively withdrawn its savings and mortgage products from the mass market and now serves only the wealthiest of customers. Even HSBC Amanah, probably the most credible and efficient provider of Halal banking in the UK, has dramatically reduced its dedicated Islamic banking staff in Britain, and its marketing volume has been turned way down. "

Salaam Takaful was sold in April 2010 to Al Salam Group Holding Company, which is based in Kuwait, following its closure to writing new policies.

Mr. Bhatti's article is rather gloomy, however, he does not cite any significant obstacle to Islamic finance in the UK, but rather focuses on their poor marketing effort as a way to attract the Muslim consumers who may prefer Shari'ah-compliant financial services, but are not willing to sacrifice in cost, customer service and who are attracted by marketing that focuses on their emotional rather than rational side. I don't want to get too much into the marketing side, because it is far ouside my expertise. However, his criticism does mesh with my own concern about the Islamic finance industry's work in the West to attract non-Muslims. Cost competitiveness is one factor but the experience in Malaysia has demonstrated that costs of Shari'ah-complaint products can become competitive.

Beyond the issue of cost, there is a significant portion of people in the West, particularly younger people like myself, who are interested in the ethics of their financial activities. I moved my own bank accounts from one of the big banks to a local credit union recently, in part based on costs, but primarily because my money is more likely to be recirculated in my own community. If I had the option between a conventional credit union and an Islamic or other ethically-based credit union, I would (and I suspect many others like me would also) choose the ethical alternative. That is an area where conventional banks have a distinct disadvantage and an area within the West where Islamic finance could focus on to attract both Muslims and non-Muslims. Islamic finance may be focused on religious criteria important to Muslims, but they are not that different from the religious or ethical criteria of non-Muslims and that remains an untapped market in the West for banking services. The business case has been demonstrated by sustainable/socially responsible investment products, now it is time for banking. With that, I will step off my marketing soapbox.

The Malaysian firm Axiata will issue MYR 4.2 billion (1.32 billion) of sukuk by the end of July to refinance variable rate, 2-year debts. The sukuk will be based on commodity murabaha with maturities of 5, 7 and 10 years. While the prospect for new, longer dated sukuk is encouraging, the use of a commodity murabaha structure is less encouraging. I don't know how the Malaysian Shari'ah standards treat commodity murabaha for secondary market trading, but standards in the GCC, which are applied by most other issuers outside of Malaysia, do not permit trading in murabaha sukuk except at par because they represent a debt rather than ownership of a tradable asset.

AAOIFI adopted three new Shari'ah standards covering disposal of rights, bankruptcy and the management of liquidity, collection and use. These standards cover important subjects. However, it is somewhat disappointing that AAOIFI has not published the standards online like the IFSB. The publication of the standards in printed form only makes it difficult for consumers of Islamic financial products to see the standards under which the products they consume have been issued. Without either the AAOIFI standards or detailed publicly-available fatawa, consumers are hard pressed to understand the basis for the Shari'ah-compliance of the products being offered.

An article in The Star newspaper in Malaysia questions "What's going on in Kuwait Finance House?". The Malaysian subsidiary of the bank has discontinued the ratings services of RAM Ratings. The bank has retained Malaysia Rating Corp Bhd (MARC). The bank says it is part of a cost rationalization move. The questions arise because in November 2009, RAM put a negative outlook on KFH (Malaysia) based on the deterioration in the financial metrics of the bank and its parent institution while MARC said in April that it did not expect a status audit to affect the rating it has for KFH (Malaysia).

Other News

• Islamic mortgage company Tamweel returned to profit based on lower depositors' share of profits and lower expenses while Amlak Finance lowered its losses for the first quarter from AED 68.1 million to AED 2.7 million. The two institutions' futures remain in question with no definitive news on a possible merger of the companies.
  
• NASDAQ OMX launched two Islamic indexes, the NASDAQ-100 Sharia Index and the OMX Stockholm Benchmark Sharia Index with Shari'ah monitoring provided by BMB Islamic.
  
• Brunei issued two ijara sukuk totalling $58 million at the end of April and May. The sukuk mature in 91 days. An Islamic finance expert in Malaysia, Sri Anne Masri, said that Brunei's large firms could issue sukuk to finance their businesses.
  
• Three lawyers from Clifford Chance provide their thoughts on the Islamic finance industry.
  
• Credit default swaps on Dubai's debts have fallen 30% while Nakheel's $750 million sukuk maturing in January 2011 has risen to $106.75 from a low of $35 on December 10, 2009.
  
• The blog Credit Slips asks for input and information on the concept of bankruptcy in Islamic law.
  
• Bloomberg has an update on the future issuance of sukuk.
  
• The National Bank of Abu Dhabi issued a MYR 500 million ($156.9 million) sukuk with a 4.75% coupon, one of a few GCC-based issuers who have issued sukuk in Malaysia. The expected coupon range had been 3.5% to 5.9%. The sukuk was oversubscribed 3.6 times. The bank received a banking license on June 17.
  
• The Islamic Bank of Thailand is still planning to issue its first sukuk, a 5-7 year issue of Baht 5 billion ($155 million) this year, although it said the process had been held up by political unrest.
  
• The Central Bank of Bahrain's latest Sukuk al-Ijara was oversubscribed by 300%.
  
• Maybank Singapore is offering a commercial property financing product for up to 10-years.
  
• Some Dubai-based financial institutions are considering expanding into Ghana according to a senior director at the Dubai Chamber of Commerce. Uganda will make changes to its banking laws to allow financial institutions to offer Shari'ah-compliant financial products.
  
• Irish law and accounting firms need to improve their knowledge of Islamic finance to attract the industry to the country, according to Eamonn Walsh, a professor of accounting at University College Dublin.
  

IFSB-IRTI IDB report on financial stability

The IFSB-IRTI-IDB paper on financial stability within the Islamic financial industry provides a good overview of the development of Islamic finance over the past forty years and provides eight "building blocks" for the Islamic financial industry. Before getting to those building blocks with my thoughts, there was one passage of the report which I think is a clear description of the areas of the financial crisis that the Islamic financial industry was able to avoid followed by the a description of how the industry was affected. A lot of ink has been spilled over the past two years claiming that the Islamic financial industry is immune from crisis and was not affected by the most recent crisis. Besides being flatly untrue, it leads to a dangerous level of complacency about the real risks that the Islamic finance faces. Having a report issued by three large multi-lateral institutions face up to these challenges and recognize the harm the credit crisis did to the Islamic finance industry (albeit far less damage than was absorbed by its conventional counterpart) is refreshing. The report describes:

"Islamic financial institutions, which are subject to Shari’ah regulations, are forbidden from investing in such derivative instruments and therefore did not have exposure to such derivatives. Also the holding of shares or the investment in conventional financial institutions which are involved in usury or riba’ are not permitted. The combination of these factors minimised the impact of the financial crisis on Islamic financial institutions. However, the subsequent tightening of liquidity and credit in the global financial markets did adversely impact all financial institutions in general, including Islamic financial institutions. As the financial crisis become prolonged, the global recession, the collapse in commodity and oil prices, and the sharp erosion of asset values that followed, affected the performance of the Islamic financial institutions." (p. 28)

The key part of this summary is that "the subsequent tightening of liquidity and credit in the global financial markets did adversely impact all financial institutions in general including Islamic financial institutions. As the financial crisis become prolonged, the global recession, the collapse in commodity and oil prices, and the sharp erosion of asset values that followed, affected the performance of Islamic financial institutions".

Moving on through the report to the eight building blocks. I will give my thoughts on each building block although I would recommend reading at least this part of the report, which begins on page 43 of the PDF. The report ends with a suggestion of the creation of an Islamic Financial Stability Forum.

• Building block 1: Develop cross-sectoral prudential standards. There has been much talk of developing a set of global standards in Islamic finance so this section is not new. However, it provides a focus on covering all aspects of Islamic finance including banking, investment and takaful. The standards for takaful are noted as being especially deficient. Takaful is still dwarfed by the other areas of Islamic finance, particularly banking, in its development so it is not surprising that its prudential standards development is also lagging behind banking. One of the most important areas where I think regulation should focus most in takaful is in the investment of the premiums. There are currently far to few sukuk or other fixed income products to even accommodate the industry's current size. As it grows, this deficiency will grow. The role of prudential standards is to ensure that the takaful funds do not become too exposed to real estate and equities. However, the regulation has to avoid being too constrictive, which could hurt the growth of takaful. That being said, if a large proportion of takaful funds are invested in equities, the next large decline in equities could leave takaful funds holding assets below their needs in terms of meeting claims, which could spark a crisis in confidence among consumers of takaful, which would set the development back significantly.
  
• Building block 2: Develop liquidity management tools. This is one of the areas where I have been most concerned and I have written extensively about this risk area for Islamic finance. The lack of a lender of last resort is particularly troubling because it creates a situation where a liquidity problem (not having enough liquid resources to meet depositor withdrawals) can turn into a solvency problem (where institution's assets fall below its liabilities due to its need to sell assets at fire sale prices to meet depositor withdrawals). It is heartening that there are more liquidity management tools being developed (UAE, Pakistan and privately within the UK) to complement a few countries which have taken the lead in this area (Bahrain and Malaysia).
  
• Building block 3: Developing a lender of last resort and depositor insurance. Most of the inter-bank financing (either murabaha or wakala) works most of the time. However, as the recent financial crisis demonstrates, these markets can freeze up when they are most needed, which creates liquidity problems for institutions that can morph into solvency problems. There is an additional problem where Islamic banks' depositors are not insured. The lack of deposit insurance can make an inter-bank money market freeze up worse if depositors 'run' on the bank. The lack of funding in inter-bank markets forces Islamic banks to sell assets at whatever price they can get. As I mentioned above, this can turn a liquidity crisis into a solvency crisis.
  
• Building block 4: Develop crisis management tools. This building block is one that is very similar across conventional and Islamic finance. What should be done with institutions that become undercapitalized, particularly when there are large institutions or a large number of institutions that are undercapitalized? The common aspects of liquidation (who has priority over whom?) and recapitalization (including from the sovereign) raise additional issues relating to Shari'ah-compliance. As important as this building block is, I think it is among the most difficult because every crisis is different and there are so many factors (legal regimes, economic characteristics, etc.) that could impact the specific response so that planning in advance is nearly impossible except on the most general points.
  
• Building block 5: Transparency of accounting, auditing and disclosure. This is an area where, in contrast to building block four, there is already an institution in place that can take the lead in this development. There is also a global standard (Basel 2 and the to-be-released Basel 3) that applies to all financial institutions. These are clearly not adequate on their own and will have to be incorporated within other prudential standards for Islamic financial institutions (if an apple is rotten, no amount of auditing or disclosure about the apple will make it any less rotten). However, greater auditing and disclosure can bring problems to the fore earlier which can in some cases make them easier to deal with than if they are hidden until the market sniffs them out.
  
• Building block 6: Macro-prudential supervision. This is the section of the report which received the most attention. The risks to the Islamic financial system do not come just from one institution. As mentioned above, the risk that liquidity dries up in inter-bank lending can bring down even the healthiest Islamic banks. However, when it comes to monitoring systemic risks and remedying them, there are issues with: who will do it? how will they spot systemic risks? what can they do once they spot a risk? how will they enforce their decisions across multiple countries and regulatory systems?
  
• Building block 7: Strengthen ratings of Islamic finance. This is an issue that has been significant in the conventional industry as well. However, within the Islamic finance industry, it takes on another dimension. As much as the products used by Islamic financial institutions are designed to replicate conventional financial products, they do have unique risks that ratings agencies may or may not be incorporating into their ratings. Is a AAA sukuk different from a AAA bond? In many ways, this discussion is a replication of the arguments about whether the AAA rating on CDOs and other mortgage securitizations was used identically to the same rating on a corporate bond. Different products (conventional and Islamic) have different risks so forcing them into the same ratings scale may lead to situations where a AAA sukuk performs far differently than a AAA rated bond would. Avoiding this situation before there is another financial crisis is imperative.
  
• Building block 8: Capacity building. The Islamic financial industry has to continue growing the number of skilled individuals to allow for this growth to continue without overstretching its human capital resources. I don't have much to comment on this except that I agree.
  

Islamic finance and the credit crisis, Muslim group in Chicago helps Muslim convenience store owners

The President of the Islamic Development bank said that the global financial crisis has no influence on Islamic banks "because it was linked to debt operations [and] Islamic banks do not hold such [debt] obligations". While it is true that Islamic banks don't (can't) hold the debt products that led to the financial crisis, it is short-sighted to say that Islamic banks do not have exposure to the global financial crisis. One significant example of how it does have exposure was the Dubai World debt crisis which began with problems at Nakheel around the maturity of its sukuk. Sukuk are debt instruments (for the most part) and Islamic banks had exposure to this sukuk and also were faced with difficulty in raising capital during the financial crisis, despite not having any direct exposure to the subprime-based debt products. The Islamic Development Bank is staring a fund to finance affordable housing.

A Muslim group in Chicago is helping Muslim owners of convenience stores to move their businesses away from selling liquor and pork, among other products, by providing a source for fresh foods instead. The article describes the difficult choice that many Muslims who own convenience stores face: to remain in business, they must sell liquor and pork although they are generally uncomfortable about selling haram items. Instead, the grants will provide them with access to fresh foods that could allow them to remove liquor and pork products from their shelves without jeopardizing their businesses and also helping their communities. One of the well documented problems in low-income urban areas is the lack of grocery stores, which is blamed for causing health problems including obesity. The approach taken by the Council of Islamic Organizations of Greater Chicago is beneficial because it not only helps the business owners avoid selling haram products, but will provide their neighborhoods with fresh foods, which are sorely lacking. This seems like an area where Islamic finance could be able to contribute by providing the financing, which could be a good business opportunity as well as a way to educate Americans about Islamic finance.

Other News

• Rushdi Siddiqui discusses the difficulty (and importance) of finding alternatives to LIBOR for pricing Islamic finance products.
  
• A Jewish fund in the US provides another example of the growth in ethical-based finance.
  
• An Islamic fund in India has done surprisingly well at attracting non-Muslims as well as Muslims based on its performance. This is not a new trend. In the US, the Amana funds received significant investor interest from non-Muslims based on its strong performance.
  
• A court in the DIFC ordered the liquidation of Tabarak, the first Islamic financial firm to be liquidated by the DIFC.
  

Pakistan central bank explores interbank money markets, Indonesia to issue global sukuk in October

Pakistan's central bank is developing Shari'ah-compliant interbank money market products. This follows the announcement that the UAE central bank is also developing inter-bank liquidity management Islamic certificates of deposit. This is a welcome trend to allow Islamic banks to manage their surplus liquidity and will help to provide greater stability to Islamic banks.

Global sukuk issuance is expected to rebound in 2011 as infrastructure projects begin in Asia and the Middle East following a significant slump since the credit crisis affected Islamic finance in 2008 and 2009. Indonesia is planning a global sukuk in October that could be as large as $500 million to $600 million, less than its $650 million sukuk issued in 2009. The government may issue 5-year sukuk, but would prefer 7-10 year sukuk, which would be beneficial as a benchmark for domestic corporate sukuk. This would be complementary to the possible tax holiday for sukuk to boost the domestic Islamic finance industry.

Other News

• Islamic finance is gaining popularity among bankers looking to "change some terms here and there" according to Andrew White, the director of the International Islamic Law and Finance Center in Singapore.
  
• Lahem Al-Nasser of Asharq Al-Awsat believes that an Islamic central bank is needed and that Islamic banks should have their reserves linked to gold. I disagree: bringing the gold standard to Islamic finance would be no more successful than it was in conventional banking and would limit greatly the growth potential of the industry while offering limited benefits as the price of gold fluctuates significantly.
  
• Ithmaar Bank, which recently converted to be an Islamic bank says it is fully Shari'ah-compliant and denied reports about disagreements with its Shari'ah board over conventional assets being converted to be Shari'ah-compliant.
  
• The governor of the Central Bank of Afghanistan is working with Pakistani experts to implement regulations for Islamic banks within the next two months.
  
• Indonesian bank Bank Permata launched an Islamic mortgage product based on ijara mutahiyah bittamlik (lease ending in ownership).
  
• Malaysian Prime Minister wants Bank Islam to expand the Islamic pawnbroking system Ar-Rahnu from urban areas to rural areas.
  
• A Bahraini investment house, Tharawat, plans to launch a $50-$60 million private equity fund investing in Saudi Arabian real estate in the third quarter.
  
• After delaying a planned bond issue, SABIC received $1 billion in Shari'ah-compliant credit from Alinma Bank.
  
• CNBC Europe has an interview with a professor of Islamic finance in Spain, Celia De Anca of IE Business School in Spain.
  
• The Nigerian Deposit Insurance Corporation is introducing Islamic deposit insurance using Malaysia as an example.
  

Are sukuk prospectuses too complex, other product needs in Islamic finance, possible Dubai sovereign sukuk

The head of the Islamic Financial Services Board, which is based in Malaysia, says that there should be greater investor protection in Dubai and other regional financial centers. Rifaat Abdel Karim, the IFSB's secretary general, pointed specifically to the uncertainty over the ability of investors to have recourse to the underlying asset citing the "200 pages of documents, which most investors don't [read]". While the complexity of sukuk and the dichotomy between asset-based and asset backed structures could provide some confusion, most sukuk prospectuses that I have read clearly delineate whether the investors have recourse on the underlying assets (versus being unsecured creditors in a default). It is incumbent, I believe, that investors use the information presented in the documentation to make an informed decision about whether the risk-reward relationship is acceptable. The head of Islamic finance at Simmons & Simmons, Muneer Khan, said in an interview quoted by Emirates Business 24/7 that the sukuk defaults were "not a Shariah issue" and that the investors had legal and financial advice sufficient to distinguished between secured and non-secured deals adding that "I think some of the claims have been a bit disingenuous".

There are other issues that have more bearing on whether sukuk will work out well in cases of default like the legal environment where the assets are located that are equally as important and less certain than the structure of the sukuk. If there are material misstatements in the prospectuses, that is a different matter, and greater investor protection for this possibility are definitely needed.

The IFSB held a seminar last week on sukuk market prospects in London, on which Mushtak Parker provides an interesting overview. Many of the issues I have raised (and others have as well) were covered in the seminar. CIMB-Principal Islamic Asset Managemenet Bhd recently said that the issuance of sukuk has failed to keep pace with industry growth. Other areas of Islamic finance like money markets and a more diversified asset base for Islamic financial products are needed according to a different article discussing the World Islamic Banking Forum Asia, which quoted the central bank heads of Bahrain and the UAE as well as Islamic financial industry practitioners. The heads of those two central banks called for greater reform within the Islamic finance industry including a "standard formula to calculate profit in an equitable and fair way at all Islamic Banks". At the same WIBC conference, the UAE central bank governor Sultan Bin Nasser Al Suwaidi said that the development of short-term liquidity management tools represent a "challenge". The UAE central bank is expected to finalize an Islamic CD product for Islamic banks in the next week.

Following a non-deal roadshow, Dubai may issue a 7-10 year sukuk in the next few months with "more generous pricing than a conventional bond" according to fund managers quoted by Arabian Business. If the issue were successfully brought to market, it would reflect a vote of confidence in Dubai despite the continued uncertainty about the final approval of the Dubai World restructuring plan. In addition to being a follow-on sukuk to Dubai's sukuk that was issued shortly before the Dubai World crisis began, it would be notable because there are few issues (much less sovereign sukuk) from the GCC longer than five years. One would hope this would lead to other longer-dated sukuk from the GCC and elsewhere if this sukuk issue succeeds.

Other News

• WealthBriefing has a good article on the lack of diversification options open to ultra-high net worth investors. If these products are not available for ultra-high net worth investors, it is no wonder that there is a lack of options for less wealthy Muslim investors.
  
• An article in Malaysian newspaper The Star touts the recent Malaysian sovereign sukuk. Maybank Islamic recently complained about the lack of scholars "who are well-versed in banking practices".
  
• Moody's estimates that Islamic finance will pass the $1 trillion mark this year. However, accurate statistics about the size of the Islamic finance industry are generally not available, so it is likely an educated guess.
  
• BNP Paribas is expanding its Islamic unit's staffing by 50%, with most of the growth occurring in Asia. The fund management arm of BNP Paribas said it favors sukuk from sovereign issuers in the GCC based on their debt ratings and the oil-generated wealth.
  
• CIMB Niaga, the Shari'ah-compliant subsidiary in Indonesia is planning to expand its lending.
  
• The National Bank of Kuwait's latest ijara fund was fully subscribed in a day.
  
• Ireland wants to capture EUR40 billion in Islamic finance business.
  
• Singapore wants to expand its existing strength as a financial center to expand its role in Islamic finance, although DBS shrank its Islamic unit in Singapore, which was reported to be based on a slow growth in the industry in the city-state. The deputy chairman of the Monetary Authority of Singapore, Lim Hng Kiang, spoke at the World Islamic Banking Conference, Asia Summit.
  
• Edcomm Banker's Academy, a training organization in banking has partnered with the Ethica Institute of Islamic Finance, which offers the Certified Islamic Finance Executive certification.
  

TID, Islamic CDs, the halal market and sustainability

The Investment Dar
The Investment Dar case became more complex with the Shari'ah board of TID requesting that the bank stop contesting the claim by Blom Bank based on the wakala contract's non-compliance with Shari'ah. In addition, the Shari'ah board asked that a similar defense not be used in the future without first consulting the Shari'ah board to determine the legitimacy of its contracts. An article in Arabian Business comments that "While the sharia board's statement puts a wrench in Investment Dar's ability to move forward with a case against Blom regarding the deal, legal experts say the reputational damage to the industry has already been done".

I disagree with the contention that TID's case has damaged the Islamic financial industry. In contrast, the UK courts held a skeptical view of TID's defense and now the institution's Shari'ah board has come out in support of the wakala product's Shari'ah-compliance. This accomplishes two things for the industry. First, the court's skeptical ruling on TID's defense provides another secular court precedent that a party to an Islamic contract cannot, ex post, argue that the contract is not Shari'ah-compliant to get out of their obligations. I have argued before that the court's ruling provides Shari'ah scholars and boards with more freedom to change their mind on Shari'ah-compliance without worrying about upsetting existing contracts.

Second, I believe it is positive is that TID's Shari'ah board came out against the institution and upheld their initial ruling. There is always a potential conflict of interest between a Shari'ah board and the institutions for whom they work. However, this provides one example of a Shari'ah board publicly demonstrating that their duty to ensure Shari'ah-compliance and preserve the integrity of their ruling is placed above their employment with one institution. The only clear loser in this development is TID, who are stuck between an adverse court ruling in a secular court and their own Shari'ah board's ruling that contradicts their claims in that court.

UAE central bank to offer Islamic CDs to Islamic banks
The UAE central bank is planning to offer Islamic CDs as short-term money market instruments for Islamic financial institutions. The lack of short-term money markets outside of Malaysia (and to a limited extent in Bahrain) hampers the Islamic banking industry because it leads banks to hold excess reserves in cash, which lowers Islamic banks' returns compared to conventional banks because they cannot generally generate returns from this cash. The Islamic CDs received preliminary approval last week from the Shariah Coordination Committee with what Hussain Hamed Hassan, the committee's chairman, described as "minor changes". It may receive final approved next week according to Mr. Hassan. Islamic CDs are offered in the US by one institution, the University Islamic Financial Corp and are used by some of the Islamic mutual funds in the US as a way to generate a return on their cash balances.

The halal market and social responsibility
The Managing Director of Al Islami said that Islamic branding is a "myth" at a halal market conference in Brunei. The point being made was that the halal brand--the certification--was important but without a quality product, it is not likely to succeed. The point was expanded by Shahed Amanullah, the founder of Halal Media, as a way to expand the market to non-Muslims as well either from incorporating organic and socially responsible halal certifications in food and through social responsibility in the broader marketplace so that "non-Muslims can see Muslims promoting halal values which includes social responsibility, stewardship of the earth and economic justice". I think that this is an often understated point. Although Islamic products, particularly in the financial world, were created to cater to Muslims' needs, they do not need to remain constrained to just Muslims. However, to reach out to non-Muslims, incorporating other shared ethical values and leverage the success of sustainable finance to expand the potential market for Islamic financial products.

Other News

• Hussain Hamad Hassan said it was "not a far-fetched reality" for a Gulf-wide Shari'ah board to be in place by 2013.
  
• Gulf Finance House continues to restructure its debts. In May, Mohammed Khnifer, Aatef Baig and Frank Winkler released an article called "The Rise and Fall of Gulf Finance House", which analyzes the pre-crisis years and how they might have led to GFH's current problems.
  
• Cagamas Bhd, the Malaysian national housing company, may issue up to RM1 billion ($303 million) in sukuk that are designed to be acceptable in Malaysia and the GCC.
  
• The Shari'ah-compliant non-bank financial company being established in the Indian state of Kerala has received significant interest from GCC- and Indian-based institutions (Doha Bank and Reliance Capital, respectively), although the government has said it will not sell more than 20% of the NBFC to any single investor.
  
• The Islamic Bank of Thailand became a major shareholder of a Thai leasing company, Nava Leasing Plc, in which it will own 49%.
  
• A Malaysia law firm has released a booklet in Australia to explain commonly misunderstood aspects of Islamic finance among Muslims as well as non-Muslims. The headline writers, of course, took the most sensationalistic topic titling the article: "Islamic finance not jihad".
  

New sukuk issues, Rushi Siddiqui on Islamic development indicators, update on AIG lawsuit

Ahmed Salem Bugshan (ASB) Group is planning a five-year, $100 million ijara sukuk. In addition to this sukuk, a number of other sukuk have been announced. The Bahrain branch of the Kuwait Turkish Participation branch is among the issuers planning a sukuk, with their $100 million sukuk expected to be issued "within the next two or three months". Indonesia is planning on issuing its next sukuk for 1 trillion rupiah ($108 million) on June 15. The sukuk will be sold with maturities of 5, 7, 10 and 20 years, which adds to the small number of sukuk with longer (10+ year) maturities. The issue is a part of what the government expects to be $1.082 billion in sukuk issued this year. About half of that amount has already been issued. The sukuk will make up nearly 5% of Indonesia's sovereign debt issuance this year to fund a deficit targeted at 2.1% of GDP. Indonesia's central bank and Ministry of Finance are working on tax incentives for Islamic financial institutions.

Rushdi Siddiqui contemplates the need for a development indicator to measure the 'pulse' of the Islamic financial industry. Besides his hypothetical BBC World News anchor's statement that the "TR Islamic Business confidence was up 2 per cent", he covers some important issues in the Islamic finance industry. He asks whether the sukuk defaults/restructurings are credit issues or something more. In general, I think that they are primarily credit risk issues, although the Investment Dar court case, which he raises, indicates the presence of Shari'ah risk if institutions in the future attempt to use a secular court like the UK to repudiate contracts based on ex post Shari'ah-non-compliance. He also asks whether the reduction in operations at the Islamic Bank of Asia reflect a point of concern as well as concerns about the lack of integration between the standards-setting bodies AAOIFI and IFSB. HIs article in Gulf News is a wide ranging, questioning piece that very thought-provoking. An article describing a recent conference in Brunei quotes Rushdi Siddiqui as saying that the sukuk market could be an important source of funding for the halal sector. It has been notable to me that there has not been much sukuk activity to finance the halal industry even when there have been sukuk issued to provide financing to conventional financial companies like GE Capital.

The plaintiffs in a lawsuit against the US government about AIG's Islamic finance business have requested a summary judgement. The lawsuit, which legal scholars with expertise in first amendment cases said was unlikely to succeed, challenges the legal right of AIG to engage in Islamic finance after the US government bailed it out taking an 80% equity stake. The press release from the plaintiff's lawyers also repeatedly invokes the bogus claim that Islamic finance is connected with terrorism. Readers could easily find better uses for their time than reading this press release.

Other News

• Amlak and Tamweel are considering alternatives in case the planned government-backed merger does not happen.
  
• Arcapita expects a "sizeable financial loss" for the year ended June 30 and plans to publish its third quarter (ending March 31) results on Friday, a month after the date set by its regulator.
  
• A speaker at a conference in Bahrain raised the important issue of the tension between management goals and the requirements in Islamic financial institutions for Shari'ah-compliance.
  
• The National Bank of Kuwait launched another series of its Thahabi Ijara Fund that will lease equipment primarily to the 1,000 largest companies in the US.
  
• The latest monthly update is available about the Dow Jones Islamic Indices performance. There was one misstatement: "Germany issued a ban on short-selling for certain financial stocks, a move which is coincidentally in line with Islamic Law. Short-selling is haram since Islam, in addition to riba, denies excessive speculation (i. e. gambling) called maysir." The most often cited reason why short-selling is prohibited in Islamic finance is that it involves selling something that the seller does not own. Maysir is often cited as a reason why conventional options and derivatives are prohibited.
  
• Russia is slowly seeing growth in its Islamic finance sector.
  
• Standard Chartered is planning to enter Saudi Arabia to increase its Middle Eastern business.
  
• A fund manager in Malta is trying to enter the GCC.
  
• The Islamic Development Bank launched an online database on Islamic financial institutions, IBIS.
  

Islamic pricing benchmark, Khazanah sukuk

The International Shariah Research Academy for Islamic Finance (ISRA) in Malaysia is planning to release a study on a proposed Islamic benchmark pricing rate in 2011. The proposal received criticism about the practicality of having two different pricing benchmarks within Malaysia. The criticism has merits and the development of a separate Islamic yield curve would provide limited benefit compared to other areas that the effort required could be directed towards like strengthening Islamic financial institutions' liquidity management. However, if Islamic financial products move beyond replication of conventional financial products and take on different risk characteristics than conventional products, a separate pricing benchmark could be useful for new issuers because the pricing would reflect the balance between supply and demand for Islamic financial products in the secondary markets.

Malaysian state-owned Khazanah Holdings may issue S$500 million ($354 million) in sukuk to finance its purchase of Parkway Holdings, a hospital operator. The sukuk would be the largest issued in Singaporean dollars passing a S$200 million issue from the Islamic Development Bank.

Other News

• The final decision on Tamweel and Amlak, two troubled Dubai-based Islamic mortgage companies could come this month. It is reported that Dubai Islamic Bank is seeking to increase its share of Tamweel to over 50%. Tamweel's statement on its restructuring did not confirm or deny Dubai Islamic Bank's reported plans.
  
• Saturna Capital, the fund manager of the Amana Funds received a fund license in Malaysia.
  
• A credit union in the US is offering Islamic financial services.
  
• Gulf African Bank, one of the first Islamic banks in Kenya, reported a profit in the first quarter of 2010 and expects its first full-year profit this year.
  
• Pakistan hopes to double the share of Islamic banks in the country over the next 3 years, to 12% of total assets. For comparison, Malaysia is set to reach the 20% mark this year.
  
• An article discusses the idea that Dubai World attracted more attention than its overall impact in the financial markets and points out that the reason for the near-default was the financial and economic conditions as well as company-specific factors that were not related to Nakheel using a sukuk rather than a conventional bond to raise financing.
  
• Nakheel has begun paying contractors and may resume construction on some projects "within weeks".
  
• A Malaysian bai bithaman ajil (BBA) sukuk was placed on negative ratings watch. The BBA structure is used extensively in Malaysia, but not accepted in most other countries.
  
• The government of Kazakhstan is supporting Islamic finance in the country with the assistance of Abu Dhabi, whose government owned bank Al Hilal opened an Islamic bank in Kazakhstan.
  

Sun Finance sukuk and Islamic securitizations

I took a good look at the Sun Finance (Sorouh) sukuk documents which were issued at the beginning of the intensification of the financial crisis (late 2008). The sukkuk was a sukuk-al-mudaraba and was issued after the AAOIFI guidance on sukuk, meaning it could not stipulate repurchase at par, which was included through the purchase undertaking not specifically referencing the repurchase price for the portion of sukuk repurchased under the amortization schedule. The sukuk, despite the challenging environment for the global economy and the securitization market, has been successful so far and none of the three rated tranches have been downgraded despite a collapse in the securitization markets.

In the transaction, Sorouh Real Estate ('Sorouh') was seeking to securitize receivables from plot sales to sub-developers in two of its developments, Shams-Reem Island and Saraya. The proceeds of the sukuk were used to fund the mudaraba and those were used by the mudarib, Sorough Abu Dhabi Real Estate LLC ('SPV'), an SPV set up as a distinct entity from Sorouh, to purchase the full title to the underlying plots from Sorouh. The SPV provides the sukuk certificate holders with a beneficial ownership of the plots, while the SPV executed a 'true sale' of the assets from Sorouh. A portion of the sukuk proceeds were placed in various reserve accounts to make up any shortfall in profit payments (Liquidity Reserve), to fund expenses of the SPV (Senior Expense Fund) and to finance the construction of infrastructure on the plots (Infrastructure Fund). The profit sharing ratio between the mudarib (SPV) and rabb ul-mal (sukuk certificateholders) was 1% and 99%, respectively.

The receivables from the sub-developers (all 109 plots were sold by Sorouh to sub-developers before the sukuk was issued) will be paid to the SPV and used make periodic payments on the sukuk. The remainder will be paid to the mudarib (the SPV) as an incentive payment. This amount will then be used to repurchase a portion of the beneficial interest held by the sukuk holders (described in the offering documents as a 'constructive dissolution'). This leads to payment of both the profit on the sukuk assets as well as a principal redemption. The interest rate risk (the payments to sukuk holders of all tranches is based on EIBOR plus a spread) from changes in the benchmark is hedged by the SPV in a separate transaction where it acts in its own capacity and not as the mudarib. At some point, if the sub-developers continue to make payments or the plots are resold in case of sub-developer bankruptcy, the entire beneficial interest held by the sukuk holders will have been extinguished and the SPV will retain the right to the remaining payments.

The unique feature of this sukuk is that it offered three different rated tranches, each with different priority rights and coupon amounts. The three tranches (A, B and C) had successively higher return (spread over 1 month EIBOR) of 200, 250 and 350 basis points, respectively. The three tranches were also accorded different priority for periodic payments with the A tranche senior to the B tranche which was senior to the C tranche. The way the seniority over periodic and principal payments was structured was using a musawama (cost-plus sale where only the final amount is agreed between the parties). At each periodic payment date, each class is paid 2.5 percent of the rabb ul-mal's profit allocaiton and the remainder of both profit and amortization payments are made according to seniority with a musawama between the tranches used to create a non-pari passu payment outcome.

The sukuk has performed well with payments passed on from sub-developers to the SPV and used to redeem the sukuk (see table below which reflects the amounts included on Sorouh's balance sheet, which does not break down the results for each tranche of the sukuk, nor does it provide a way to measure the performance of the sukuk as a whole). However, it does show that the carrying value of the debt on Sorouh's balance sheet has declined throughout the life so far of the sukuk as the cumulative payments made rises.

When the sukuk is viewed in more detail, the structure was clearly made to mirror a multi-tranche securitization deal and the fact that it is Shari'ah-compliant had limited impact on its performance. The use of a non-recourse securitization removes the issuer's financial strength from the picture so long as it is able to continue servicing the receivables (there was a back up servicer specified in the offering documents). The performance of the sukuk reflects the ability of the underlying plot sub-developers to continue paying installment payments on the plots (where the total value of the securitized assets provided overcollateralization for sukuk investors).

This type of sukuk, while in limited use so far, does not provide any additional security compared to a conventional securitization. The quality of the assets used in creating the securitization will ultimately determine its success or failure. However, the general conservative nature of (most) Islamic financial institutions' lending will make it less likely that future securitizations using this model would include questionable assets. Despite this caveat, securitizations could present an opportunity to create debt instruments for investors while also providing Islamic financial institutions with additional capital to expand their lending. Of course, as the subprime meltdown reiterated, if the quality of the securitized assets is poor, then the performance of the securitization is also likely to be poor. There is always the possibility for a securitization crash in Islamic finance if the standards used to evaluate recipients of future financing that is then securitized.

In a rapidly growing industry like Islamic finance, the ability to free up capital on bank balance sheets through securitization could provide a way for additional capital to be lent out while also broadening the number of sukuk for investors looking to Islamic finance. There is an additional potential: conventional investors looking for private-label securitizations will be hard pressed to find conventionally securitized mortgage-backed securities and they could provide additional capitla for Islamic mortgage companies that can demonstrate high lending standards. That would benefit those investors as well as the Islamic finance industry that, for example in the US has relied upon conventional securitization through Freddie Mac and Fannie Mae. Creating an Islamic securitization market for home finance could further expand Islamic finance in Western countries where it is currently limited.

The potential for Islamic securitization is nothing new. Back in 2007, Standard & Poor's released its approach to rating sukuk [1] and stated that:

"We expect that this type of sukuk [sukuk with no credit enhancement from the issuer] will become more popular in the foreseeable future in response to the huge number of projects in the planning stage, particularly in Gulf countries. Changes to regulation in the Gulf could give a boost to this type of sukuk. Banks and regulators in the Gulf are currently considering enhancing the legal framework surrounding mortgage financing for both commercial and residential properties. In the longer run, once sufficient mortgage loan volumes are booked on banks' balance sheets, Islamic securitization will become more attractive."

. The topic of Islamic securitizations was also raised by Andreas Jobst of the International Monetary Fund [2]. He wrote that:

"Since most Islamic financial products are based on the concept of asset backing, the economic concept of asset securitization is particularly amenable to the basic tenets of Islamic finance. [...] Islamic securitization transforms bilateral risk sharing between borrowers and lenders in Islamic finance into the market-based refinancing of one or more underlying Islamic finance transactions. In its basic concept, originators would sell existing or future revenues from lease receivables (asset-based), 'sale-back profit' (debt-based) or private equity from a portfolio of Islamically acceptable assets to a special purpose vehicle (SPV),31 which refinances itself by issuing unsecured securities to market investors, who are the 'capital market corollary' to a singular lender in Islamic finance."

However, those articles were written before the onset of the financial crisis that saw conventional markets for securitization nearly completely shut down. Investors may be more wary of securitizations than they were when interest rates were low and economies strong and anything providing higher yields was sought after. However, the Islamic finance industry may provide an opportunity for securitization to re-emerge with more secure backing and without the additional re-securitizations that were the main impetus for the collapse in the securitization markets. There still remain several obstacles to Islamic securitizations although the relatively successful outcome of sukuk like the Sun Finance (Sorouh) sukuk can provide an example for future securitizations that comply with the new AAOIFI rules on mudaraba sukuk.

[1] Standard & Poor's. 2007. "Standard & Poor's Approach To Rating Sukuk," September 17, 2007.
[2] Jobst, Andreas A. 2007. "The Economics of Islamic Finance and Securitization," Journal of Structured Finance, Volume 13, Number 1. (Working paper)

Sun Finance Sukuk Payments & Remaining Balance, 2008Q4 - 2010Q1

Quarter	Cumulative Payments	Balance	Accrued Profit
2010Q1	AED 2,494,500	1,497,213	98,967
2009Q4	2,041,666	1,940,643	89,563
2009Q3	1,691,923	2,279,300	78,477
2009Q2	n/a	2,843,853	n/a
2009Q1	820,546	3,123,973	51,773
2008Q4	320,873	3,609,919	38,030
At Issue		4,016,000

All figures in AED '000.
Source: Company financial statements.

Takaful shortfalls, Islamic money markets, Shari'ah scholars

Takaful
Reuters has a fascinating article about takaful and specifically what happens if the policy holders' pool is in deficit. The article highlights a discrepancy between the regulatory view and the Shari'ah view. The regulatory view says that the shareholders of the takaful provider should be responsible for shortfalls (through a letter of guarantee for any shortfall) and the policyholders should benefit from the gain on any investments financed by the shareholders' funds. However, the Shari'ah view, as articulated in the article, says that policy holders should contribute to finance any shortfall and if there is a letter of guarantee but no cash drawn, the shareholders should receive the benefit. This is an issue that I had not spent much time thinking about, although I have acknowledged that the lack of sukuk and other fixed income products have made a shortfall more likely because the funds contributed by policy holders are invested in riskier assets than the premiums paid into conventional insurers (which are typically invested in bonds). There are no specific examples mentioned, which increases the risk to takaful companies and policy holders without significant experience where shortfalls are actually experienced and managed. However, based on the general trend for Islamic financial products to mirror conventional products, I think it is extremely unlikely that policy holders would be forced to make additional contributions to cover a shortfall.

Islamic finance needs money market to grow
Bloomberg has an article with several interesting comments from Mohamad Nedal Alchaar, secretary-general of AAOIFI. In addition to his comments about the need for more Shari'ah-compliant money market products to facilitate better liquidity management, he warned about "overexposure" to a single industry by Islamic financial institutions. His call is welcome given the fallout from the global financial crisis and property boom and bust in parts of the GCC, and it adds to the recognition that Islamic finance was hurt by the global financial crisis but this damage was accentuated by a concentration of investments in a few industries. He also warned that if there is not more done to create a more transparent forum for Shari'ah scholars to reach consensus from an industry body on products where there are no existing fatawa, the industry would remain dependent on a "fatwa-by-fatwa basis". While it is not surprising to hear the head of a standard setting body call for Shari'ah standards to involve an industry body, his point could strike a healthy balance between individual institutions being able to develop new products if their Shari'ah boards approve and the need for greater consensus among scholars through a central forum without requiring what could become rigid standardized fatawa.

Shari'ah scholars
Another article on the development of a younger group of Shari'ah scholars includes a profile of Taha Abdul-Basser, a scholar and the Muslim chaplain at Harvard University. Congratulations to him for being recognized and profiled as one of the prominent younger Shari'ah scholars who will be responsible for continuing the growth in Islamic finance that the senior scholars helped create during the past 35 years.

Other News

• Qatar issued its first local-currency bond of the year yielding 6.5% and sukuk of the year with a $2.75 billion issue split evenly between a conventional bond subscribed by five conventional banks and sukuk, which was purchased by four Islamic banks.
  
• A firm with links in the Middle East is planning to launch an Islamic REIT in Singapore. There is currently one Islamic REIT in Singapore and plans for another later this year.
  
• Four mostly state-owned companies in Abu Dhabi are cooperating to launch a takaful company in the Emirate.
  
• Tabreed, the National Cooling Company in Dubai which missed a payment on its sukuk, may sell conventional or Islamic debt as a part of its recapitalization program.
  
• A Malaysian firm is planning an Islamic gold ETF in the country. There is currently only one Islamic gold ETF, the Dubai Gold Securities. In addition, companies like Bullion Management Group in Canada offer a gold bullion fund that is Shari'ah-compliant.
  
• The CIS has potential for Islamic finance, but there is little legislation in place that enables Islamic finance, according to a summary of a conference in Moscow written by Mushtak Parker in Arab News.
  
• Indonesian sukuk issuance is expected to rise 10-20% compared to last year according to the CEO of HSBC Amanah, Mukhtar Hussain. He said that the Asian economies have had a limited impact from the European debt crisis. Sukuk issuance was $23.3 billion in 2009, which was lower than the peak of $34.3 billion issued in 2007 according to Standard & Poor's.
  
• The Central Bank of Bahrain short-term sukuk al-salam issue was oversubscribed by over 400 percent. The sukuk matures in 91 days and has an expected return of 0.85%.
  
• Khaleej Times has an article on Islamic finance business education.