Since posting has been light due to other commitments, there are a few things I haven't had a chance to write about. So I'm going to step outside the normal form and combine a few posts into one.
ADIB soft commodity note
An article describing the Abu Dhabi Islamic Bank soft commodity note struck my attention because I think it offers an example of a product that I view as problematic. This product is not problematic on its own--it offers exposure to an investment class that is otherwise hard to find in the Islamic space--but the complex structure these products use (and the high potential upside with capital protection) suggests hidden risks. Given the risk-return profile of the note, there has to be something else (which is present in most Islamic structured notes) that makes the product worth the bank's time (probably the high fees).
The structure is described as "provide[ing] an opportunity for investors to invest in this Murabaha based note, the profit of which is determined by the prices performance of cotton, corn and sugar." This structure is common for structured notes. The investor puts money with the bank which is invested in a murabaha (to provide the capital protection). The returns, which the bank says have a "maximum upside return of up to 18 per cent over 2 years with an annual payout", are usually generated using the wa'ad total return swap with an external counterparty (swapping the returns on the murabaha with the returns on an index of the commodity price). The investor is paid either the return on the index or their invested capital (likely less a fee).
There are plenty of products that offer returns and on which the institution offering the product earns a fee. That is how investing works. But the capital protected notes offer something that is too good to be true. Either you get your money back if the commodity prices fall or you get a return up to 18% according to the bank offering the product.
The key point with these types of products is to look at how the bank makes its money (and mitigates the risk of paying the return which is not generated by any profit-making activity, but by the behavior of an index). If the product were as simple as possible, you would appoint the bank as your agent under a wakala contract and they would buy the commodities on your behalf and you would profit if prices increased and face losses if they fell. However, this product offers the upside in prices (up to 18%) with no downside. If this structure were used, the bank would expect the prices to rise more than 18% in 2 years and would capture the upside where you would be on the hook for the downside.
But the product is structured to take away the downside risk from your investment. That means the bank is either able to hedge its downside risk on the commodity prices or foolishly expects that prices will keep rising (so it can capture the upside if it is greater than 18%). Banks are not in the business of speculating on commodity prices; they profit on the difference between their cost of funds and the returns on what they invest in (i.e. loans). That is where the wa'ad-murabaha structure comes in, which both adds risk to the investor and somewhat subverts the Shari'ah-compliance of these types of products (in my layman's opinion).
From the bank's perspective, they are borrowing funds with no guaranteed return (i.e. no direct cost to them) and receiving the fee charged for the product. They are paying the murabaha profits to another institution that takes the risk of rising prices (most likely a conventional bank). As long as the fee is larger than the murabaha profits (plus the profits that can be made using the funds in the interim, less the structuring fees), they make money on the transaction. The counterparty will hedge itself against the commodity price risk. For the counterparty, as long as the cost of hedging is lower than the murabaha profit, they make money.
The impact this has on the investor is that there are likely to be relatively high fees for these products and it adds a risk that is not apparent in its brief description. Specifically, the risk is counterparty risk with the bank and (for the bank) with its counterparty in the wa'ad total return swap. This risk is not unique to Islamic finance. For example, Exchange Traded Notes (ETNs) carry the same risk. They usually offer a return based on an underlying commodity index, but legally they are unsecured debt of the issuing institution.
Besides the hidden risks in these products (admittedly, these risks are minimal in normal times), they also raise questions about whether the structures are designed to work within the framework of Shari'ah-compliance or to avoid the restrictions of Shari'ah-compliance. I have moved further into the viewpoint that the replication of conventional products is fine because they serve real needs of the Muslim consumers of the product, but there is a limit and structured products are on the border between serving a need and creating the solution to a problem that is not apparent.
Exposure to commodity markets is difficult within the bounds of Shari'ah-compliance, but a structured product to offer that exposure seems unnecessarily complicated (although profitable for banks offering the product). Offering exposure to commodity markets through non-bank financial institutions seems like it would offer a simpler way to offer this type of exposure because bank regulation is not really suited towards taking or facilitating commodity risk so a bank-based product will try to turn it into a credit risk.
Dubai comeback
There are two pieces of news out of Dubai, both of which support an idea that rumors of its death have been greatly exaggerated. First, Nakheel is coming to a resolution on $11 billion in debts which need to be restructured. These debts include a $1.85 syndicated Islamic loan that will be extended seven years according to Reuters. The new development that I see in this is that Reuters reports that Nakheel "will eventually be separated from Dubai World to become a full government subsidiary". The main problem with Nakheel's sukuk was that (besides being subject to a standstill), they were viewed as being guaranteed by Dubai's government, despite only being guaranteed by Dubai World, a government-related entity.
With the support from Abu Dhabi through the Dubai Financial Stability Fund (which was used to pay off the 3 Nakheel sukuk), the Dubai government has returned from its pariah status in the credit markets and has been considering issuing a bond or sukuk in Malaysia.
In more positive developments (rather than news about fixing old problems), Dubai Ports World's sukuk reached record low yields after it was upgraded to the lowest investment-grade rating. DP World has always appeared to be on more stable footing than Dubai, Inc. because of its role in global trade (where recovery from the severe recession was less in doubt than Dubai's recovery from its property boom and bust).
The combines effect of Nakheel restructuring and the DP World upgrade (and Bahrain's continuing turmoil) should support Dubai's ambitions to expand its prominence as a center of Islamic finance in the GCC region. This point will be contested in Saudi Arabia (which has a larger economy but which offers less availability to international investors) and Qatar (which is still working through the central bank's decision to prohibit conventional banks from offering Islamic banking products). Compared to the sentiment towards the end of 2009 when the Dubai World standstill was announced, the competitive situation facing Dubai is far more favorable.
Indonesia sukuk
Indonesia just sold $2.5 billion in 10-year dollar-denominated bonds at a yield of 4.875%, reflecting international interest in the country's debt. 49% of the debt was sold to US-based investors. The strong issuance reflects interest in strong emerging markets and the strengthening of the Indonesian Rupiah. The Indonesian Finance Ministry director of Islamic finance, Dahlan Siamat, told Bloomberg that the country is considering issuing dollar-denominated sukuk in the second half of 2011. While the growth in external debt issuances is positive (the total for 2010 as a whole was $3 billion), the issuance presents risks if the currency depreciates significantly like in 1997/1998.
Live blogging the Gulf News article about Gatehouse Bank
"competition has to be fair in the context of pricing and taxation [...] taxation rules [...] favoured financing through debt compared to equity, but in the aftermath of the financial crisis that exposed the weaknesses of excessive leverage there is a move to create a level playing field for equity funding and asset-backed financing which lies at the core of Islamic finance."
There is not really a market for equity finance within the Islamic finance industry (except for the equity finance that most of us know--common stock). Most banks including investment banks use debt-alternatives, which should be competitive with conventional debt, but for added structuring costs. The main obstacles are double-taxation of the ownership transfer in Islamic financial structures, which have been legislated in most Western countries (e.g. the UK).
"[Richard] Thomas [CEO of Gatehouse] said the recent decision by the Central Bank of Qatar not to allow conventional banks to offer Islamic financial services is a move in the right direction to create a level playing field for pure Islamic institutions to compete with conventional institutions."
I agree with some of the concerns of the central bank in terms of leakages between Islamic and conventional arms of banks that offer both. However, requiring conventional banks to close their Islamic windows creates a bad precedent that will discourage conventional banks from offering Islamic windows, which could offer competition. The commingling of assets cited by the central bank are Shari'ah issues and should be addressed by the Shari'ah boards. The central bank should, at most, force these units to be spun off into stand-alone subsidiaries with Islamic banking licenses from the central bank. Otherwise it just looks like a move to protect the banks in the local market.
"Thomas believes that Islamic banks will continue to have good growth prospects in the UK as long as their offerings do not imitate those of their conventional peers."
The replication of conventional products offers an alternative to consumers, but the financial needs remain the same. Trying to fit a square peg of equity-based products into the round hole of current regulations is impracticable. The Islamic Bank of Britain's problem (from my review of their financial statements) was that they could not find enough people to offer financing. This may be a reflection of rejection of products that replicate conventional products, but those types of products are relatively well accepted in other parts of the world (including the US). Perhaps it is a failure in its marketing strategy or the ability to offer a cost-competitive product.
Thomas: "We are now taking business from conventional banks because we have a different business model and are not part of that mega-debt culture. We have seen a pick-up in business mainly in corporate asset finance, real estate, also the trade-related business."
I hope they are able to take business from conventional banks, but it is not because Islamic finance as it operates now gives a non-debt alternative. There are plenty of non-debt (i.e. equity) alternatives available. Hopefully it is the case that the Shari'ah restrictions on the financing provides a more equitable relationship between financier and those receiving financing.
In the end, I do want to see Islamic finance thrive in the UK, but the signs so far are not great. The Islamic finance institutions there--not just Gatehouse, but all of them--need to recognize their limitations in terms of size and not try to compete with the established conventional banks. The Shari'ah-compliance requirements can be a part of the appeal if they give a superior product at a competitive price. However, just appealing to Islamic finance as the opposite of conventional debt won't do it. Most of the Islamic financial products replicate debt nearly perfectly in economic outcome and there are conventional alternatives to debt (e.g. equity financing). Islamic finance has to come up with some reason that it is better that doesn't rely upon mis-informing about how the industry actually works. Otherwise it won't succeed except in providing Shari'ah-compliant alternatives to conventional financial products to Muslims.
DIB fraud case
I don't know enough about the DIB fraud case that has been ongoing for several years, so I will present the link to an FT article with no other comment than it is likely to reflect badly on Dubai's judicial system for its unwillingness to offer bail to the defendants, one of whom was acquitted after serving 3 years in jail.
Wednesday, April 27, 2011
Sunday, April 24, 2011
Making Islamic financial institutions "most admired companies"
In a recent column, Rushdi Siddiqui discusses his talk at the Bold Talks 2011 and focuses on an area that is overlooked too often within Islamic finance: corporate social responsibility and environmental impact analysis of projects financed by Islamic financial institutions. He notes that "not one Islamic bank is a member of the Equator, Carbon and/or Climate Principals, yet, the GCC has one of the largest carbon footprints".
I lamented this fact a little over 2 years ago and it is somewhat disheartening to see so little (read: nothing) be done to move Islamic finance into an area where it can claim to be taking the lead on something. While there are a number of financial institutions that do pay attention to their environmental responsibility, Islamic finance could be unique if they incorporated environmental stewardship within its core values.
I cannot offer a definitive opinion either way about whether incorporating environmental responsibility into the Shari'ah standards could be an option. However, one of the ways to approach it would be to treat environmental stewardship as a form of fulfilling our responsibility to protect the source of everything we have (which we are not allowed to destroy without destroying ourselves).
The reason why this would be an important step forward is that it would allow the Islamic financial industry to say with confidence that its values are inherently different from other industries. Not only is environmental responsibility important for the financial impact it can play in the industry's growth, it is one of the core values underpinning the industry and Islamic finance does not just promote environmental conservation because it makes good PR.
Environmental considerations are not the only area where this could be incorporated into the industry, but it is probably one of the easiest to explain. Ease of explanation of why Islamic finance differs from other financial sectors is key if we are to make Islamic financial institutions into "'most admired companies' that young people want to work for". Let's hope I'm not writing the same blog post 2 years from now!
I lamented this fact a little over 2 years ago and it is somewhat disheartening to see so little (read: nothing) be done to move Islamic finance into an area where it can claim to be taking the lead on something. While there are a number of financial institutions that do pay attention to their environmental responsibility, Islamic finance could be unique if they incorporated environmental stewardship within its core values.
I cannot offer a definitive opinion either way about whether incorporating environmental responsibility into the Shari'ah standards could be an option. However, one of the ways to approach it would be to treat environmental stewardship as a form of fulfilling our responsibility to protect the source of everything we have (which we are not allowed to destroy without destroying ourselves).
The reason why this would be an important step forward is that it would allow the Islamic financial industry to say with confidence that its values are inherently different from other industries. Not only is environmental responsibility important for the financial impact it can play in the industry's growth, it is one of the core values underpinning the industry and Islamic finance does not just promote environmental conservation because it makes good PR.
Environmental considerations are not the only area where this could be incorporated into the industry, but it is probably one of the easiest to explain. Ease of explanation of why Islamic finance differs from other financial sectors is key if we are to make Islamic financial institutions into "'most admired companies' that young people want to work for". Let's hope I'm not writing the same blog post 2 years from now!
Thursday, April 14, 2011
Form vs. substance or pragmatism vs. idealism?
Last Saturday I attended and spoke at the Berkeley Islamic Finance Forum. It was a good event, although the number of topics and subjects seemed a bit cramped for a 1-day event. However, I suppose that is a good problem to have (more thought provoking than some of the for-profit conferences I have attended). I don't take good enough notes to provide a full overview of the conference and that would likely be rather boring as well, so I'll just have to stick to sharing some thoughts that I had from some of the speakers' presentations.
The overarching theme that got me thinking at the conference was the form vs. substance debate in Islamic finance. Specifically, does Islamic finance need to offer something completely different in economic outcome from conventional finance or is it ok for products to be offered that are Shari'ah-compliant (in so far as the scholars decide they are) even if they replicate conventional products?
The frequent criticism of Islamic finance is that it just offers a financially engineered alternative to conventional finance. When one looks at the economic outcome of most of the Islamic finance products, the criticism makes sense. The products create cashflows that mirror conventional products, although the form of the products is different. The critics use this as evidence that Islamic finance is nothing more than conventional finance repackaged to pass the Shari'ah boards' approval process.
However, there is some nuance that they miss in this analysis. First, many Muslims (rightly or wrongly) will not use conventional products and will use Islamic products, even if they cost more. Perhaps there is some slick marketing that leads to this, but there may not be for many consumers of financial products. However, that leads down a line of discussion that I am not qualified enough to offer an opinion (specifically, whether the structure of a product to avoid interest per se is permissible or not).
That is also more of an academic argument than I care to engage in on Islamic finance. The situation exists that some Muslims demand an alternative to interest-based financing and there are institutions that cater to this need and those institutions are governed by regulations mostly created with interest-based financing in mind. The parts of the economy that are not governed by those regulations don't offer interest-based financing and operate differently.
After that rather long-winded introduction, I think that Islamic finance operates the way it does today because of what is demanded and what is allowed within the regulatory framework which exists today. Islamic banks do what they are permitted to do, which in most countries is debt-based financing. The structure is modified to be murabaha or ijara instead of interest-based lending to comply with the Shari'ah restrictions. Investment companies offer products like mutual funds using what could be compared best to a mudaraba or wakala structure. Private equity and venture capital companies take direct equity stakes (mudaraba or musharaka), and add in some Shari'ah-compliant debt financing to juice their returns. Leasing companies do what they do with ijara and appoint the tenants as their agent to perform the maintenance.
Outside of Islamic finance, companies are set up as joint-ventures or rely on angel financing (mudaraba and musharaka). They are not connected with Islamic finance except perhaps as consumers of the financial products they need like murabaha-based trade finance, ijara or istisna'a finance for capital expendituress and wakala for investing surplus funds and pensions that invest in stocks (mudaraba). People and businesses need to protect themselves against future risks (using takaful).
The point is that the economy as it works does not impose needs on Muslims any different than other economic actors. These needs fall into a couple areas that are met by different types of institutions that specialize in that area of finance. Banks provide trade finance and can intermediate between diverse depositors into specific projects to generate returns and they specialize in managing credit and liquidity risks. Leasing companies are focused on the ability to own equipment where they can make a profit on leasing equipment and selling used equipment after the lease ends. Mutual funds provide specialized investment management services on behalf of others. Takaful companies provide insurance against an unknowable future. Venture capital and angel investors (as well as entrepreneurs working with their own funds) provide financing to businesses.
At what point are these essential needs different for Muslims and non-Muslims? I don't see any; I see the substance of the transactions as identical. The Shari'ah screening provide a form of prudential regulation of the relationship between the parties in transactions and try to avoid areas where one party can take unfair advantage of another. It cannot prevent speculative bubbles because people are always subject to the same fear and greed that leads to bubbles and busts.
The form versus substance argument is mostly a pragmatic versus idealistic argument and I see beneficial points on both sides of the argument. However, the Shari'ah screening is mostly present on the pragmatic side of the equation: finance. Very few companies would on their own decide to hire a Shari'ah board to decide if their partnership were Shari'ah-compliant. If venture capital was prevalent it might, but it is still nascent.
Islamic banking in particular has been singled out for not using more profit-sharing structures and instead relying on debt-based Shari'ah-compliant alternatives. However, if a bank were using the profit-and-loss sharing structure, it wouldn't be a bank as banks are conceived of today. It would be a venture capital partnership. Islamic banks are on the one hand forced to make sure they don't lose depositors' money and also generate a profit on these funds (and profits to their shareholders). How are they supposed to provide daily liquidity and capital protection if they offer equity products on the other side of the balance sheet?
Maybe the idealists are expecting the whole concept of banking as we know it to fall by the wayside and be replaced by venture capital-style financing. Perhaps it is the second coming of the economists who promoted import-substitution economics. If you think the existing order is not done in a way that supports what you want to see, then you should create a complete substitute to it. However, that idea did not work; in fact, it created white elephants across the developing world. Industries designed to substitute for foreign imports operated inefficiently to support an idealism that everything can remain self-contained.
I don't mean to condemn the idealism of those who want a profit-sharing financial system, but based on the needs of financial consumers, the idea of creating a totally parallel system that avoids on principle any conventional banking structures is far fetched. In some situations a debt-based financial product is superior for consumers (if it is sufficiently regulated) to an equity product. That doesn't mean it has to be interest based per se. However, it has to have the same characteristics as interest-based debt (periodic payments, fixed term, redeemable on maturity at par or amortized across the length of the loan). Equity products are superior in others (and are used widely across the financial markets, conventional and Islamic).
My point is not to say that Islamic finance is something that is either doomed to forever trail behind conventional products or that it can't succeed if it differs from conventional finance. It is that the Shari'ah restrictions placed on Islamic finance should be taken as a form of prudential regulation that can protect the Islamic financial system if they are not stretched too far. They also provide the basis for other changes to conventional products that make whatever product offered more fair to consumers. In the wake of the financial crisis, where many, many consumers were abused by the financial system--not just by debt--there is a fairly low bar for an industry to step forward that can provide the same types of products in a more ethical way. This "more ethical way" should be the focus of Islamic finance. Some institutions may focus on different products (debt with banks, equity with venture and angel capital, mudaraba with mutual funds), but they should focus on offering a better product, not something completely different.
The overarching theme that got me thinking at the conference was the form vs. substance debate in Islamic finance. Specifically, does Islamic finance need to offer something completely different in economic outcome from conventional finance or is it ok for products to be offered that are Shari'ah-compliant (in so far as the scholars decide they are) even if they replicate conventional products?
The frequent criticism of Islamic finance is that it just offers a financially engineered alternative to conventional finance. When one looks at the economic outcome of most of the Islamic finance products, the criticism makes sense. The products create cashflows that mirror conventional products, although the form of the products is different. The critics use this as evidence that Islamic finance is nothing more than conventional finance repackaged to pass the Shari'ah boards' approval process.
However, there is some nuance that they miss in this analysis. First, many Muslims (rightly or wrongly) will not use conventional products and will use Islamic products, even if they cost more. Perhaps there is some slick marketing that leads to this, but there may not be for many consumers of financial products. However, that leads down a line of discussion that I am not qualified enough to offer an opinion (specifically, whether the structure of a product to avoid interest per se is permissible or not).
That is also more of an academic argument than I care to engage in on Islamic finance. The situation exists that some Muslims demand an alternative to interest-based financing and there are institutions that cater to this need and those institutions are governed by regulations mostly created with interest-based financing in mind. The parts of the economy that are not governed by those regulations don't offer interest-based financing and operate differently.
After that rather long-winded introduction, I think that Islamic finance operates the way it does today because of what is demanded and what is allowed within the regulatory framework which exists today. Islamic banks do what they are permitted to do, which in most countries is debt-based financing. The structure is modified to be murabaha or ijara instead of interest-based lending to comply with the Shari'ah restrictions. Investment companies offer products like mutual funds using what could be compared best to a mudaraba or wakala structure. Private equity and venture capital companies take direct equity stakes (mudaraba or musharaka), and add in some Shari'ah-compliant debt financing to juice their returns. Leasing companies do what they do with ijara and appoint the tenants as their agent to perform the maintenance.
Outside of Islamic finance, companies are set up as joint-ventures or rely on angel financing (mudaraba and musharaka). They are not connected with Islamic finance except perhaps as consumers of the financial products they need like murabaha-based trade finance, ijara or istisna'a finance for capital expendituress and wakala for investing surplus funds and pensions that invest in stocks (mudaraba). People and businesses need to protect themselves against future risks (using takaful).
The point is that the economy as it works does not impose needs on Muslims any different than other economic actors. These needs fall into a couple areas that are met by different types of institutions that specialize in that area of finance. Banks provide trade finance and can intermediate between diverse depositors into specific projects to generate returns and they specialize in managing credit and liquidity risks. Leasing companies are focused on the ability to own equipment where they can make a profit on leasing equipment and selling used equipment after the lease ends. Mutual funds provide specialized investment management services on behalf of others. Takaful companies provide insurance against an unknowable future. Venture capital and angel investors (as well as entrepreneurs working with their own funds) provide financing to businesses.
At what point are these essential needs different for Muslims and non-Muslims? I don't see any; I see the substance of the transactions as identical. The Shari'ah screening provide a form of prudential regulation of the relationship between the parties in transactions and try to avoid areas where one party can take unfair advantage of another. It cannot prevent speculative bubbles because people are always subject to the same fear and greed that leads to bubbles and busts.
The form versus substance argument is mostly a pragmatic versus idealistic argument and I see beneficial points on both sides of the argument. However, the Shari'ah screening is mostly present on the pragmatic side of the equation: finance. Very few companies would on their own decide to hire a Shari'ah board to decide if their partnership were Shari'ah-compliant. If venture capital was prevalent it might, but it is still nascent.
Islamic banking in particular has been singled out for not using more profit-sharing structures and instead relying on debt-based Shari'ah-compliant alternatives. However, if a bank were using the profit-and-loss sharing structure, it wouldn't be a bank as banks are conceived of today. It would be a venture capital partnership. Islamic banks are on the one hand forced to make sure they don't lose depositors' money and also generate a profit on these funds (and profits to their shareholders). How are they supposed to provide daily liquidity and capital protection if they offer equity products on the other side of the balance sheet?
Maybe the idealists are expecting the whole concept of banking as we know it to fall by the wayside and be replaced by venture capital-style financing. Perhaps it is the second coming of the economists who promoted import-substitution economics. If you think the existing order is not done in a way that supports what you want to see, then you should create a complete substitute to it. However, that idea did not work; in fact, it created white elephants across the developing world. Industries designed to substitute for foreign imports operated inefficiently to support an idealism that everything can remain self-contained.
I don't mean to condemn the idealism of those who want a profit-sharing financial system, but based on the needs of financial consumers, the idea of creating a totally parallel system that avoids on principle any conventional banking structures is far fetched. In some situations a debt-based financial product is superior for consumers (if it is sufficiently regulated) to an equity product. That doesn't mean it has to be interest based per se. However, it has to have the same characteristics as interest-based debt (periodic payments, fixed term, redeemable on maturity at par or amortized across the length of the loan). Equity products are superior in others (and are used widely across the financial markets, conventional and Islamic).
My point is not to say that Islamic finance is something that is either doomed to forever trail behind conventional products or that it can't succeed if it differs from conventional finance. It is that the Shari'ah restrictions placed on Islamic finance should be taken as a form of prudential regulation that can protect the Islamic financial system if they are not stretched too far. They also provide the basis for other changes to conventional products that make whatever product offered more fair to consumers. In the wake of the financial crisis, where many, many consumers were abused by the financial system--not just by debt--there is a fairly low bar for an industry to step forward that can provide the same types of products in a more ethical way. This "more ethical way" should be the focus of Islamic finance. Some institutions may focus on different products (debt with banks, equity with venture and angel capital, mudaraba with mutual funds), but they should focus on offering a better product, not something completely different.
Monday, April 11, 2011
"Thought leadership" in Islamic finance
The director of the Islamic Finance Knowledge Center for Deloitte in the Middle East, Dr. Hatim El Tahir, wrote an article for their "A Middle East Point of View" called "Thought Leadership in Islamic Finance" (pdf) (ht Islamic Finance Resources blog). I don't know whether it is the brevity or the jargon that I don't understand, but the article left me scratching my head a bit. He identifies six areas--Shari'ah governance, liquidity management instruments, corporate governance, risk management, investment and capital markets strategy and financial reporting procedures--as "broad areas of thought leadership proposals for benchmarking research, assessment and improvement of practices".
Despite my head-scratching about the paper, I do agree that these are areas that the industry as a whole needs to work on and that they are largely areas where no one institution can make a significant change to the industry's operations. Dr. El Tahir proposes "develop[ing] a specialist think-tank to provide innovative intellectual programs in Islamic finance practice and foster[ing] authentic practice synergy through knowledge transfer across industry stakeholders globally". Are we on the same page now?
I'm not there yet. However, the paper begins with a more understandable summary of the problem facing the industry (posed as a question): "Have Islamic financial institutions around the world, including the Gulf region, been so busy structuring products and services that they have overlooked the importance of communicating the essence of Islamic finance?"
That is a question that fits in better with the six areas of focus for industry-wide work. There has been a significant deficiency in communicating with practitioners, consumers and those sitting on the sidelines of "what it all means" for the Islamic finance industry.
Back when things were running smoothly pre-financial crisis when the Islamic financial institutions were all making money, property markets were rising and all the focus was on the next "innovative product", there wasn't much demand for public introspection. But now that the wheels have fallen off the bus for many institutions and the property markets in several countries, other questions have come to the fore and there are (legitimate) questions about what the industry is really doing to improve on conventional finance.
Now, where does that leave an industry-wide think tank that is proposed? Honestly, while some coordinated voice for the industry would be helpful, there are other institutions that are working on more than an institution-by-institution basis like AAOIFI and IIFM and IILM and IFSB and others. They have taken the lead in different areas. IIFM has worked to standardize contracts (including for liquidity management), IILM is working on better multi-lateral ways to provide liquidity management separated from the counterparty risks of inter-bank lending. IFSB and AAOIFI are working on the financial reporting and to some degree also Shari'ah and corporate governance standards. The remaining items--investment and capital markets strategy and risk management--are not as prominent in current developments.
Everyone knows that sukuk secondary markets are illiquid and each country's exchange is trying to facilitate more trading. The London Stock Exchange may be best positioned to make something happen on secondary market liquidity because of the requirement of their Alternative Finance Investment Bond legislation that the sukuk be listed on the LSE. However, it covers only a portion of the sukuk issued and, without market makers, is no guarantee of liquidity.
Risk management is more of an institution-specific basis, along with the global Basel standards. On this issue, I risk speaking beyond my knowledge, particularly as the Basel 2 standards blend into the planning for implementation of Basel 3.
However, after running through the institutions that are already in existence and working, there are a few things missing that all boil down to one issue. Who speaks for Islamic finance and who explains how all of these different things work together? For the most part, it is spread around the world. Perhaps the most comprehensive source of information of the "higher level" discussions are coming out of ISRA in Malaysia. They put out a regular journal and also have other industry information, although when I went to their website, they were still promoting the latest issue from December 2010.
As much as they provide information about the industry as a whole, it is still largely academic and thus not always relevant to enough people. It may be of interest to academics and I may find articles interesting, but it doesn't do much for the CEO of an Islamic bank or for the general public trying to find a source that "communicat[es] the essence of Islamic finance".
I am not sure exactly what type of organization could provide that. A trade group or self-regulatory organization could help institutions take the existing standards from other bodies and develop a "best practice", but that type of institution would probably do a poor job at communicating the "essence of Islamic finance". Or there could be an organization that focuses on explaining how everything fits together in Islamic finance, but it would probably end up becoming similar to the trade groups in the West that spend more time cheerleading and too little time addressing the concerns people have about how Islamic finance works today.
As far as what comes next, maybe I haven't illuminated anything about what should be created, but I hope that I have perhaps raised some awareness of what I think is definitely not needed. Creating organizations that don't meet a need or are duplicative of existing organizations will serve as a distraction to the process of development within the industry as it continues the recovery from the financial crisis.
Despite my head-scratching about the paper, I do agree that these are areas that the industry as a whole needs to work on and that they are largely areas where no one institution can make a significant change to the industry's operations. Dr. El Tahir proposes "develop[ing] a specialist think-tank to provide innovative intellectual programs in Islamic finance practice and foster[ing] authentic practice synergy through knowledge transfer across industry stakeholders globally". Are we on the same page now?
I'm not there yet. However, the paper begins with a more understandable summary of the problem facing the industry (posed as a question): "Have Islamic financial institutions around the world, including the Gulf region, been so busy structuring products and services that they have overlooked the importance of communicating the essence of Islamic finance?"
That is a question that fits in better with the six areas of focus for industry-wide work. There has been a significant deficiency in communicating with practitioners, consumers and those sitting on the sidelines of "what it all means" for the Islamic finance industry.
Back when things were running smoothly pre-financial crisis when the Islamic financial institutions were all making money, property markets were rising and all the focus was on the next "innovative product", there wasn't much demand for public introspection. But now that the wheels have fallen off the bus for many institutions and the property markets in several countries, other questions have come to the fore and there are (legitimate) questions about what the industry is really doing to improve on conventional finance.
Now, where does that leave an industry-wide think tank that is proposed? Honestly, while some coordinated voice for the industry would be helpful, there are other institutions that are working on more than an institution-by-institution basis like AAOIFI and IIFM and IILM and IFSB and others. They have taken the lead in different areas. IIFM has worked to standardize contracts (including for liquidity management), IILM is working on better multi-lateral ways to provide liquidity management separated from the counterparty risks of inter-bank lending. IFSB and AAOIFI are working on the financial reporting and to some degree also Shari'ah and corporate governance standards. The remaining items--investment and capital markets strategy and risk management--are not as prominent in current developments.
Everyone knows that sukuk secondary markets are illiquid and each country's exchange is trying to facilitate more trading. The London Stock Exchange may be best positioned to make something happen on secondary market liquidity because of the requirement of their Alternative Finance Investment Bond legislation that the sukuk be listed on the LSE. However, it covers only a portion of the sukuk issued and, without market makers, is no guarantee of liquidity.
Risk management is more of an institution-specific basis, along with the global Basel standards. On this issue, I risk speaking beyond my knowledge, particularly as the Basel 2 standards blend into the planning for implementation of Basel 3.
However, after running through the institutions that are already in existence and working, there are a few things missing that all boil down to one issue. Who speaks for Islamic finance and who explains how all of these different things work together? For the most part, it is spread around the world. Perhaps the most comprehensive source of information of the "higher level" discussions are coming out of ISRA in Malaysia. They put out a regular journal and also have other industry information, although when I went to their website, they were still promoting the latest issue from December 2010.
As much as they provide information about the industry as a whole, it is still largely academic and thus not always relevant to enough people. It may be of interest to academics and I may find articles interesting, but it doesn't do much for the CEO of an Islamic bank or for the general public trying to find a source that "communicat[es] the essence of Islamic finance".
I am not sure exactly what type of organization could provide that. A trade group or self-regulatory organization could help institutions take the existing standards from other bodies and develop a "best practice", but that type of institution would probably do a poor job at communicating the "essence of Islamic finance". Or there could be an organization that focuses on explaining how everything fits together in Islamic finance, but it would probably end up becoming similar to the trade groups in the West that spend more time cheerleading and too little time addressing the concerns people have about how Islamic finance works today.
As far as what comes next, maybe I haven't illuminated anything about what should be created, but I hope that I have perhaps raised some awareness of what I think is definitely not needed. Creating organizations that don't meet a need or are duplicative of existing organizations will serve as a distraction to the process of development within the industry as it continues the recovery from the financial crisis.
Sunday, April 10, 2011
Prepared speech for the Berkeley Islamic Finance Forum (April 9th)
These are what I planned on saying at the conference, which I diverted slightly from (there will eventually be a video, I am told). The conference was great, with a good mix of speakers.
Thank you for asking me to speak at the forum.
Microfinance institutions of all types have demonstrated innovative means of differentiating themselves from conventional finance to address issues of poverty alleviation, but Islamic microfinance is just beginning to offer something unique to both conventional finance and microfinance.
The Islamic microfinance industry will face the same criticisms as its macro counterpart if it relies too heavily on murabaha and ijara—debt based methods of finance—over equity-based financial products. However, the type of financing provided to each client will need to be determined based on the client’s needs, not a belief that either equity or debt are inherently superior.
A few years ago, I presented a model of Islamic microfinance at the Harvard Islamic finance conference. While I was ambitious in believing that equity-based products could be incorporated into Islamic microfinance, I was aware that it is also difficult to administer these equity-based products. A product where the microfinance institution assumes some of the business risk creates an incentive for the client to under-report profits. This would hurt the profitability of the MFI and slow the growth in equity-based products. This is in part why macro Islamic financial institutions use debt-based products for most of their financing.
The idea I had to mitigate this problem was to use murabaha as a “screening mechanism” for a mudaraba microfinance product. A group of clients will build a reputation with the MFI of being trustworthy and could also receive the training necessary for the mudaraba product, mostly experience keeping adequate, accurate accounting records.
That paper generated a lot of conversation with some ambitious social entrepreneurs around the world and looking back, I think I was probably being overly conservative in my model, much like bankers who refused to provide loans to the entrepreneurs that Muhammad Yunus sought out.
I was too focused on the risks of mudaraba rather than the opportunities. Focused on avoiding the “worst case scenario”, I added too many caveats to the type of model I started out trying to create. The more I thought through the “two-stage murabaha-mudaraba” model, the more it tries too much to force a solution that reduces risks for the MFI rather than finding the best way to help the clients expand their business. In many ways, it voluntarily gave up the innovative aspects of Islamic microfinance that I wanted it to showcase.
Smart diligence on the ground can recognize entrepreneurs who will work best with each type of finance and also choose the product most appropriate to their business. One example, which wasn’t strictly speaking an Islamic microfinance institution but which used an equity-based approach, was the ESB Group. In one case, they provided financing to women in Malawi who wanted to start a business growing and selling mangoes, but had not been able to get financing from a conventional microfinance institution. The conventional MFI was not interested in financing this type of business. Instead, the women were told they would be better off raising chickens, despite the greater costs and risk of the chickens dying from disease.
Although I didn’t have real life experience with chickens at the time, I have since lived in a house and saw first hand, the risks that raising chickens could present to the client. The chickens could stop laying eggs or even die suddenly. It is a real business risk that growing mangoes doesn’t have to the same extent. The idea of raising chickens sounds like a solid business idea—and it may be in some situations—however, the MFI should not determine ex ante that raising chickens is ok and another type of business suggested by the client is not.
The Malawi example shows the benefit that local knowledge can play in determining the best microbusiness opportunities. Their financing was provided to women who saw an opportunity and just needed the money to get it started. The financing was equity-based because profits from the business were used to buy out the investor, but only as they were generated. A similar business idea could be financed using mudaraba.
Another person I spoke with Saif Ahmed of Infinity Consultants. He is currently setting up an Islamic microfinance institution in Bangalore, India using musharaka, partially inspired by the paper I presented at Harvard. While it is not yet operational, it will also not use the murabaha component and focus just on equity investments.
It will use a group methodology and take advantage of local knowledge from community leaders, who would recommend entrepreneurs for each 3 to 4 person group receiving financing. In addition, the entrepreneurs will be required to contribute some money to the business, even if it is only a very small portion.
The plan for monitoring the investments will rely to a large part on the daily recordkeeping of all income and expenses of the business using a handheld device provided by the MFI. The repayment will be funded by a portion of the client’s profit paid to gradually buy out the MFI’s ownership percentage.
One of the main goals of the MFI, which Saif describes as “livelihood financing” will be to foster independence by the clients. Rather than building something that leads the client to repay one loan and then return to the MFI for another loan, the goal of the financing is to create a business that ends up 100% owned by the client and which generates enough profit on its own to sustain the client and his or her family.
Both of the MFI models which I have described use equity-based financing, and I am encouraged that this is their focus. However, I think that using murabaha in some situations could be beneficial. As I was reminded recently discussing the Malawi experience of the ESB Group, profits are a function not only of the business’ margins on the products sold, but also on the velocity, the number of time that the inventory is turned over.
If a business focuses on buying a product wholesale and selling it retail—whether that is buying fruits and vegetables or mobile phone minutes—then the murabaha financing could make more sense to the client because it is easier to administer. The time freed up using murabaha could be devoted to more productive activities like maximizing turnover. If I just need someone to finance the purchase of the good and I can pay the cost plus profit out of my margins, then it benefits me as the client to simplify the financing structure.
Returning to equity-based financing, both examples are based on offering funding to a business that might not initially be profitable or generate immediate cash flows. This challenges the setup of conventional microfinance. Either a loan is provided and regular payments of principal and interest begin immediately, or there is a grace period where interest will still accrue.
Assuming the business model makes sense, the equity-based MFI can be more patient. For example, it takes time to cultivate mango trees, but as long as the trees are kept healthy, there will be a self-sustaining source of revenue and profits that can be split between the MFI and the client.
The microfinance industry is facing challenges and many of them have become acute particularly in India. Making microfinance Shari’ah-compliant will have its own specific challenges, but can also benefit from the experience of conventional microfinance. The biggest thing that I learned that has re-shaped my thinking about the model described in my paper is that flexibility is key and rigidity is a risk. If Islamic microfinance is developed as flexibly as possibly, it will evolve to create new ways of helping clients, which at the end of the day is what microfinance is all about.
Thank you.
Thank you for asking me to speak at the forum.
Microfinance institutions of all types have demonstrated innovative means of differentiating themselves from conventional finance to address issues of poverty alleviation, but Islamic microfinance is just beginning to offer something unique to both conventional finance and microfinance.
The Islamic microfinance industry will face the same criticisms as its macro counterpart if it relies too heavily on murabaha and ijara—debt based methods of finance—over equity-based financial products. However, the type of financing provided to each client will need to be determined based on the client’s needs, not a belief that either equity or debt are inherently superior.
A few years ago, I presented a model of Islamic microfinance at the Harvard Islamic finance conference. While I was ambitious in believing that equity-based products could be incorporated into Islamic microfinance, I was aware that it is also difficult to administer these equity-based products. A product where the microfinance institution assumes some of the business risk creates an incentive for the client to under-report profits. This would hurt the profitability of the MFI and slow the growth in equity-based products. This is in part why macro Islamic financial institutions use debt-based products for most of their financing.
The idea I had to mitigate this problem was to use murabaha as a “screening mechanism” for a mudaraba microfinance product. A group of clients will build a reputation with the MFI of being trustworthy and could also receive the training necessary for the mudaraba product, mostly experience keeping adequate, accurate accounting records.
That paper generated a lot of conversation with some ambitious social entrepreneurs around the world and looking back, I think I was probably being overly conservative in my model, much like bankers who refused to provide loans to the entrepreneurs that Muhammad Yunus sought out.
I was too focused on the risks of mudaraba rather than the opportunities. Focused on avoiding the “worst case scenario”, I added too many caveats to the type of model I started out trying to create. The more I thought through the “two-stage murabaha-mudaraba” model, the more it tries too much to force a solution that reduces risks for the MFI rather than finding the best way to help the clients expand their business. In many ways, it voluntarily gave up the innovative aspects of Islamic microfinance that I wanted it to showcase.
Smart diligence on the ground can recognize entrepreneurs who will work best with each type of finance and also choose the product most appropriate to their business. One example, which wasn’t strictly speaking an Islamic microfinance institution but which used an equity-based approach, was the ESB Group. In one case, they provided financing to women in Malawi who wanted to start a business growing and selling mangoes, but had not been able to get financing from a conventional microfinance institution. The conventional MFI was not interested in financing this type of business. Instead, the women were told they would be better off raising chickens, despite the greater costs and risk of the chickens dying from disease.
Although I didn’t have real life experience with chickens at the time, I have since lived in a house and saw first hand, the risks that raising chickens could present to the client. The chickens could stop laying eggs or even die suddenly. It is a real business risk that growing mangoes doesn’t have to the same extent. The idea of raising chickens sounds like a solid business idea—and it may be in some situations—however, the MFI should not determine ex ante that raising chickens is ok and another type of business suggested by the client is not.
The Malawi example shows the benefit that local knowledge can play in determining the best microbusiness opportunities. Their financing was provided to women who saw an opportunity and just needed the money to get it started. The financing was equity-based because profits from the business were used to buy out the investor, but only as they were generated. A similar business idea could be financed using mudaraba.
Another person I spoke with Saif Ahmed of Infinity Consultants. He is currently setting up an Islamic microfinance institution in Bangalore, India using musharaka, partially inspired by the paper I presented at Harvard. While it is not yet operational, it will also not use the murabaha component and focus just on equity investments.
It will use a group methodology and take advantage of local knowledge from community leaders, who would recommend entrepreneurs for each 3 to 4 person group receiving financing. In addition, the entrepreneurs will be required to contribute some money to the business, even if it is only a very small portion.
The plan for monitoring the investments will rely to a large part on the daily recordkeeping of all income and expenses of the business using a handheld device provided by the MFI. The repayment will be funded by a portion of the client’s profit paid to gradually buy out the MFI’s ownership percentage.
One of the main goals of the MFI, which Saif describes as “livelihood financing” will be to foster independence by the clients. Rather than building something that leads the client to repay one loan and then return to the MFI for another loan, the goal of the financing is to create a business that ends up 100% owned by the client and which generates enough profit on its own to sustain the client and his or her family.
Both of the MFI models which I have described use equity-based financing, and I am encouraged that this is their focus. However, I think that using murabaha in some situations could be beneficial. As I was reminded recently discussing the Malawi experience of the ESB Group, profits are a function not only of the business’ margins on the products sold, but also on the velocity, the number of time that the inventory is turned over.
If a business focuses on buying a product wholesale and selling it retail—whether that is buying fruits and vegetables or mobile phone minutes—then the murabaha financing could make more sense to the client because it is easier to administer. The time freed up using murabaha could be devoted to more productive activities like maximizing turnover. If I just need someone to finance the purchase of the good and I can pay the cost plus profit out of my margins, then it benefits me as the client to simplify the financing structure.
Returning to equity-based financing, both examples are based on offering funding to a business that might not initially be profitable or generate immediate cash flows. This challenges the setup of conventional microfinance. Either a loan is provided and regular payments of principal and interest begin immediately, or there is a grace period where interest will still accrue.
Assuming the business model makes sense, the equity-based MFI can be more patient. For example, it takes time to cultivate mango trees, but as long as the trees are kept healthy, there will be a self-sustaining source of revenue and profits that can be split between the MFI and the client.
The microfinance industry is facing challenges and many of them have become acute particularly in India. Making microfinance Shari’ah-compliant will have its own specific challenges, but can also benefit from the experience of conventional microfinance. The biggest thing that I learned that has re-shaped my thinking about the model described in my paper is that flexibility is key and rigidity is a risk. If Islamic microfinance is developed as flexibly as possibly, it will evolve to create new ways of helping clients, which at the end of the day is what microfinance is all about.
Thank you.
Sunday, April 03, 2011
Islamic finance in Indonesia
I thought the op-ed from Josh Franken, the editorial manager for the Oxford Business Group laid out a good opportunity for Islamic finance to grow in Indonesia, both domestically and internationally. His main premise is that the growing Islamic finance sector domestically and policy reforms to attract international investors can combine to help finance the public-private partnerships needed to complete the infrastructure projects the government is planning.
The article says that $140 billion of infrastructure projects are planned over the next five years and the government can only fund one-third of those projects directly. That leaves about $19 billion to be funded annually and Islamic banks only reported assets of $11.2 billion last year (albeit growing at 45% over the previous year). Some of that--the bulk of it--will be financed by conventionally-financed loans. But even if one-quarter is financed through sukuk (either directly from government sukuk or from public-private partnership-issued sukuk), there will be a gap between what Islamic banks can finance and what is issued (or could be issued).
The short-term T-bills sukuk planned (which I wrote about in my latest newsletter) will help allow Islamic banks be able to invest in more longer maturity sukuk than they otherwise could. However, other investors with long horizons will need to fill in the gaps. This could come from global investors, in particular from investors in the GCC looking for diversification. It could also come from non-bank sources within Indonesia.
The most logical non-bank source would be takaful funds (and also some pension funds). There has been an acute shortage of longer-dated sukuk for takaful funds to invest in. Infrastructure-based sukuk with government involvement (and the other government-issued debt from its directly financed infrastructure projects) would provide an investment for takaful funds. This would be particularly beneficial for the local industry because most sukuk from Indonesia are denominated in rupiah and domestic investors don't have to be worried about currency risks like international investors do (accentuated by an appreciating rupiah).
These infrastructure projects coupled with the short-term liquidity management tools forthcoming from the government could help international investors some, but most likely they would benefit the domestic Islamic finance industry. This would be a positive for Indonesia, where the domestic industry got a late start, particularly compared with neighboring Malaysia. With such a large population compared to Malaysia (not to mention a GDP of about 2-1/2 times as large), the Islamic finance industry in Indonesia has the potential to be equally as significant in Indonesia as it is now in Malaysia. It may just take a decade to develop.
The article says that $140 billion of infrastructure projects are planned over the next five years and the government can only fund one-third of those projects directly. That leaves about $19 billion to be funded annually and Islamic banks only reported assets of $11.2 billion last year (albeit growing at 45% over the previous year). Some of that--the bulk of it--will be financed by conventionally-financed loans. But even if one-quarter is financed through sukuk (either directly from government sukuk or from public-private partnership-issued sukuk), there will be a gap between what Islamic banks can finance and what is issued (or could be issued).
The short-term T-bills sukuk planned (which I wrote about in my latest newsletter) will help allow Islamic banks be able to invest in more longer maturity sukuk than they otherwise could. However, other investors with long horizons will need to fill in the gaps. This could come from global investors, in particular from investors in the GCC looking for diversification. It could also come from non-bank sources within Indonesia.
The most logical non-bank source would be takaful funds (and also some pension funds). There has been an acute shortage of longer-dated sukuk for takaful funds to invest in. Infrastructure-based sukuk with government involvement (and the other government-issued debt from its directly financed infrastructure projects) would provide an investment for takaful funds. This would be particularly beneficial for the local industry because most sukuk from Indonesia are denominated in rupiah and domestic investors don't have to be worried about currency risks like international investors do (accentuated by an appreciating rupiah).
These infrastructure projects coupled with the short-term liquidity management tools forthcoming from the government could help international investors some, but most likely they would benefit the domestic Islamic finance industry. This would be a positive for Indonesia, where the domestic industry got a late start, particularly compared with neighboring Malaysia. With such a large population compared to Malaysia (not to mention a GDP of about 2-1/2 times as large), the Islamic finance industry in Indonesia has the potential to be equally as significant in Indonesia as it is now in Malaysia. It may just take a decade to develop.
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