Wednesday, July 06, 2011

Securtization, financial engineering and regulation

In my last post, I advocated for greater securitization in Islamic finance and I think it is a good way to expand the sukuk marketplace.  However, like all other things in finance, it should come with constraints and limitations because of the global capital standards under Bassel 2 and Basel 3.  However, those capital standards (applied to Islamic financial institutions by AAOIFI) still give the off-balance-sheet nature of those transactions preferential treatment and so it is especially important to make sure the Shari'ah standards can be applied to avoid Subprime (v.Islamic).

It is very clear to anyone watching the industry that it is mostly run by people with conventional financial experience a cadre of lawyers experienced in financial engineering to manipulate international capital standards to their own benefit.  The industry also operates to a large degree in emerging and frontier markets whose regulators may not be as well equipped as in developed markets (an admittedly low benchmark).

In "developed" markets, financial products engineered so that regulations become ineffective and the possibility for financial engineering to make regulation ineffective in emerging and frontier markets is even greater.  The only offsetting factor is Shari'ah scholars who should impose a degree of conservatism into the structuring process.  However, at this point, any challenge they raise to Shari'ah standards becomes an intellectual challenge to the lawyers and financiers to "overcome" much like they undid the prudential regulations in the developed world.

As cynical as this post is becoming, this is not meant as a diatribe against the possibility for Shari'ah-compliant securitizations.  It is more of a warning to watch out for the cynical manipulation of Islamic financial products to create a new "shadow banking" industry.  There is no widespread use of Islamic finance to evade the capital (or other) rules (sorry, conspiratorialists).

However, there are 'bad actors' in every industry and when one is exposed as Gulf Finance House was by Reuters, we know there are many more lurking in the shadows, either having evaded detection or those that are not yet big enough to merit attention.

All this gloom and doom should not obscure the efforts of thousands of people in the Islamic finance industry who are working hard with the best of intentions to create a financial system that is Shari'ah-compliant (even if there is continual debate about what that means).  It should serve, however, as a warning that not everyone in the industry has these pure motives and so regulations need to anticipate the next attempt to operate outside of bounds.

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