Tawarruq

There are almost as many opinions on tawarruq as there are people who know what the term means. With questions being raised about whether a recently launched Goldman Sachs murabaha sukuk was a tawarruq or not, the issue has been thrust into the forefront of discussions within Islamic finance*. A discussion of some of these issues are available from Camille Paldi (posted as a PDF).

This article had a link to a page from ISRA, which listed a number of different fatawa from different Shari'ah boards about the permissibility of, and structure of, tawarruq transactions. I, of course, cannot say whether a tawarruq is permissible or not. However, reading Paldi's article, and the Shari'ah opinions about tawarruq, there are some points which I find noteworthy about tawarruq.

The basic structure of a tawarruq (as used in the financial industry) is that the bank will buy a commodity (e.g. nickel from the London Metal Exchange). Once ownership transfers to the bank, it will resell the metal the the customer for the price paid, plus a profit, with repayment either in installments or as a lump sum. In either case, repayment will occur in the future. The customer then takes ownership of the metal and sells it to a metal broker to get cash.

In terms of economic outcome, neither party owns the metal, but the customer has X dollars in cash, with an obligation to repay the bank X + p dollars (p is the profit). In this example, the bank and the client can be switched for a tawarruq-based deposit product. During the entire transaction, the only time the metal involved makes an appearance is in the initial purchases and sales. One fatwa said: "It is compulsory to base this practice on the purchase of assets, which are then sold to the party who desires financing, i.e. the customer. The customer will then sell it to another party at a price that is agreeable to both parties. The delivery and payment is concluded on the spot".

When the final sale is completed, another fatwa reads: "One of the conditions of a legitimate tawarruq contract is that the bank must not guarantee the customer a specified price in the market but sell the goods at the best price, in accordance with the forces of supply and demand at the time of sale." One of the issues raised by multiple fatawa was avoiding instances where the bank (or its broker) is both selling to the bank and buying back. 




These Shari'ah issues are interesting--I cannot offer an opinion about what they mean for the Shari'ah-compliance of any individual product--but they do raise a few issues on the financial side (e.g. if one were looking at the way transactions were actually carried out).  First, the basis of the organized tawarruq product relies to some degree on ensuring that the price paid for the commodity is equal to the price at which it can be sold.  The commodity markets on which these tawarruq transactions are based can be volatile, even on an intra-day basis, so an Islamic bank acting on its own behalf to buy the metals and later as agent for the customer to sell them, is exposed to the risk that the price of the commodity rises or falls.

Theoretically, I assume that the bank is supposed to pass that price risk on to the customer, who owns the metals between the initial purchase and the final sale.  However, many customers, particularly retail customers, will not want to assume the price risk of the underlying commodity.  There may even be regulations that limit the ability of the bank to change the effective profit rate after the contract is signed (the effective rate would change if the markup is fixed and the price realized is different than the original cost of the metals; if the price fell, the rate would increase while if the price rises, the rate would decrease).  Yet, the bank cannot guarantee the price realized on the sale of the commodities lest it become both the seller and the buyer (as an intermediary). 

Besides the operational issues with tawarruq, there are more theoretical arguments about its use.  Initially, tawarruq was used for short-term inter-bank financing, where there was no other alternative available (there still are only a few, which was the rationale for forming the International Islamic Liquidity Management Corp.).  Then the product became a consumer financing product.   Now it is being used to structure deposits.  The theoretical question is whether tawarruq ties the hands of Islamic banks to structures that (at slightly higher cost) replicate conventional banks. 

I am generally in favor of Islamic banks using products that meet a banking need from Muslims who would not otherwise engage in the financial system.  I think that makes sense.  However, I also believe that creating an exact replication of the conventional financial system, or even the banking system, albeit with more transaction costs, is not the best goal for Islamic banking.  There is a middle ground between making products available to meet consumer need and turning the entire exercise into a problem-solving exercise for clever bankers and lawyers. 

There is, I think, a valid place for tawarruq in the development of Islamic banking.  It is a useful tool where other tools are not yet designed.  For example, there are few products available for education financing from Islamic banks and the benefit from providing this type of financing to people who will not use interest-based financing is high, both for the individuals and for society as a whole.  This is the proper role of organized tawarruq (in my opinion) within Islamic banking.  It is a fine tool, but Islamic bankers should not let tawarruq be the only tool (as the expression goes, when all you have is a hammer, everything looks like a nail).




* I wrote an article on the sukuk for The Islamic Globe, which was followed by a critical article about the sukuk program, which was followed by another critical article with a rebuttal by the firm which provided Shari'ah consulting services to GS.

Bank Indonesia reverse repo

Bank Indonesia (BI) extended its reverse repo operations to government sukuk on December 1st.  The structure of the transactions are not clear, but based on another article and a BI regulatory document (which is not available in English, so I had to rely on GoogleTranslate) it looks like a wa'd-based repo transaction.  In the past, the sukuk issued by BI were based on ijara (mitigating concerns about the Shari'ah-compliant of trading at prices different from par if it were repo on sukuk based on commodity murabaha). 

However, the repo concept has been tricky to synthesize in a Shari'ah-compliant way, so the BI reverse repo would be a novel transaction.  It appears that the structure is based on wa'd, a unilateral undertaking to purchase or sell.  In the repo transaction (which the article said would be with a 1 month maturity, although that may only be used as an example), BI would sell a sukuk to a bank for the market value (assume for simplicity this is par, 100).  The bank would make a unilateral undertaking to sell the sukuk bank to BI in one month for 100 plus a spread based on a repo rate of 4.6% annualized. 

I think, although I am not familiar enough with the Shari'ah-compliance rules on wa'd to say for certain, that because it is only a unilateral promise, it is permissible to specify a price for the transaction in the future.  If there were two unilateral promises (one by the bank to sell and one by BI to purchase), it would not be permissible.  Presumably since BI is originating the transaction and is the central bank, it is virtually assured that it would purchase the securities without needing to give a binding promise. 

One area where difficulty would arise is if the sukuk rose in price during the repo, for example to 120.  The rules for the reverse repo transaction stipulate that if the bank decides not to honor its unilateral promise to sell, BI will charge the bank a penalty of the difference between the market price (i.e. 120) and the amount that the the bank bought the sukuk (i.e. 20).  This appears to me to be a sticky point for Shari'ah-compliance, although it could be mitigated if the penalty were stipulated to be donated to charity.  Anyway, with the penalty being stipulated as being the profit the bank would realize by not honoring its unilateral promise (removing the financial incentive for the bank to default), it is unlikely that this would ever occur in practice. 

I think this is an interesting idea and I would like to see more documentation about how it works and also the logic by which it was approved by the Shari'ah board advising BI.  I would appreciate any reader comments on the structure, since I am trying to piece together the structure from limited information, some of which I had to base on imperfect translations.

Islamic finance media

Back in January, when I took the offer to cover the Americas for The Islamic Globe, I agreed not to write for other publications, which at that point, was primarily the magazine Business Islamica, where I wrote the "Expert Opinion" column for a couple of years.  I told them of my intentions, and thanked them for the opportunity. 

However, recently someone sent me an "Expert Opinion" column from the magazine that was posted on their website that had me listed as the author.  I didn't remember writing that particular article for Business Islamica, so I did a search for some of the article's text only to realize that it was content I published on my blog in June, well after I stopped writing for Business Islamica. 

I contacted the magazine, and they promptly removed the article from their website and I moved on.  However, when speaking with other bloggers in the Islamic finance industry, I now realize that they do this with other people's work.  They will find content on a blog and reproduce it in their magazine as if it were written for inclusion in their magazine.  This does not seem right to me in the context of Islamic finance, which is focused on operating ethically.  It also troubles me as a blogger. 

I write things posts for my blog without editing them as carefully as I would if I were writing a formal article, so if my blog posts are appearing without my knowledge in a magazine, I am both being associated with that magazine without my knowledge or consent, but if I make a mistake or write unclearly do not make my point clearly enough, my reputation could be harmed because readers will assume the article was written for a magazine, not for a blog (where I could return to clarify or correct mistakes).  When I do make mistakes on my blog and return to clarify or correct them, I like to add as a note, and not change the original text.

I hope that other magazines in the Islamic finance industry are not also engaging in this misappropriations of people's writings, whether they originally appear on a blog or in another publication.  It is unethical and reflects poorly on the magazines doing it, while potentially also being damaging to the writers whose writings are being taken.  While most writers do want to get additional eyes on their work, it has to be on their own terms, and with their consent, to ensure we have control over the content we produce. 

Are sukuk cheaper than conventional bonds?

I was thinking about sukuk tonight and it occurred to me that sukuk might not have an advantage compared to conventional bonds in a way that I had not thought.  The basis for this idea is how sukuk work in practice, not how they work in theory.  I am also thinking more about mudaraba or musharaka sukuk than ijara sukuk, since the former cannot have clauses stipulating repurchase of the underlying assets at par like the latter can (according to the AAOIFI guidance issued in 2008).

In a mudaraba or musharaka sukuk (I will focus on an unsecured mudaraba sukuk because the analysis is simpler), the issuer becomes the mudarib and will manage the funds provided by the investors, to fund a particular business.  These types of sukuk are often used by banks to fund their lending, for example, to fund ijara contracts under which funding is provided to acquire a real estate asset.

The sukuk are structured so that the bank sets up an SPV to issue the sukuk and the SPV funds the bank, which issues the financing, secured by the real estate.  The bank finances the ijara contracts to receive a higher rental income than the required coupon on the sukuk.  The mudaraba stipulates that the rental income is split 99% to the investors and 1% to the mudarib, with the income used to pay a coupon to the investors anticipated at 5%, while the rent is set to generate a 7% return.

The excess return (2% in the example) generated is placed in a reserve account, to cover shortfalls in the future from non-payment or late payments of rents, which will be paid out to the mudarib as an incentive fee if left at the maturity of the sukuk.  However, if there is a shortfall at the redemption date, the investors are required to bear the loss.  In this case, where the mudaraba is based on these specific assets, the investor would be worse off for a given coupon on the sukuk compared to if it were an unsecured corporate bond, backed by all the assets of the company, except for those used to issue secured debt.  As a result, they would demand a higher coupon to compensate for the risk compared to a conventional bond issue.

Of course, this is not how these sukuk work in practice.  In one that I was reviewing recently, the bank that issued the sukuk (and managed the mudaraba assets), non-performing assets could be swapped out for performing assets of the same type.  The sukuk is also set up to be pari passu with the bank's other creditors, and so the assets backing the sukuk are not the only ones whose performance will determine ultimate repayment of the sukuk.  In this case, the investors would likely demand a similar coupon to conventional bond investors for the same issuer and maturity of bonds.

In neither case would the issuer find a sukuk to be a cheaper alternative than a conventional bond.  There are of course market considerations, like relative demand for conventional bonds versus sukuk, that could make the issue of a sukuk cheaper than a conventional bond.  Yet, the sukuk is not on the basis of its structure, cheaper than a conventional bond because, even where the risks are limited to put them on par with a conventional bond, the upside is returned to the issuer as an incentive payment, while the downside is limited to the same downside as for conventional bond investors.

If the goal of Islamic finance is to create financial products that Muslims (or companies run to be Shari'ah-compliant) who avoid conventional finance are willing to avail themselves of, then this is not problematic.  If, however, the goal is to design a product that is different in its risk and return profile from a conventional bond (as the rhetoric suggests, especially relating to mudaraba and musharaka), then all the mudaraba sukuk described above has done is to create a mudaraba that functions like an ijara, without any ownership of the underlying asset and cloaked in the mudaraba structure.  It has essentially been stripped of its risk and return sharing that is supposed to make mudaraba an 'optimal' structure for Islamic finance.

Islamic finance complexity (Part IIg)

I have covered the structure of the liabilities section of the Islamic bank's balance sheet in earlier posts, and I plan to return to the liabilities in the context of its interaction with the income statement and the maturity mismatch that is a function of banking.  However, that is best done with reference to the asset side of a bank's balance sheet because the income statement deals both with the income earned on assets and the costs of funding the assets.  Therefore, I am going to move onto the asset side to describe the 'stocks' of the asset (the maturity mismatch and the income/expense are included in the 'flows' arising from the 'stocks' of assets and liabilities).

Before going into the asset side of the balance sheet, I want to reiterate that this whole Islamic finance complexity series (maybe I should have come up with a better title for the series) of blog posts is a thought exercise to come up with interesting areas of how Islamic finacne works that are not always part of the day-to-day discussion of how Islamic finance works in practice.  Most of what is out there is either new products offered by Islamic finance institutions, the financial results of their activities or theoretical discussions of how Islamic finance should operate, or why it is 'superior' to conventional finance.  There is definitely a place for new developments and discussions of how the industry should operate, but I have found that the latter is done in generalities (including within a lot of my own writing).

Apologies in advance if my in depth discussion becomes dull or is too simplistic, but I think that if a discussion of the Islamic finance industry (and an analysis of how it has diverged from what it is 'supposed to be') is to be undertaken in a comprehensive way, it has to be a bit dull at points and include a simplistic analysis of the data that is put out about Islamic banks, which are largely contained in financial statements.  However, I hope that there is some value in the insights that come out of this analysis.  As always, I welcome comments on the blog posts or by email at blake@sharingrisk.org.

Moving into the balance sheet, there are a number of categories of assets held by Islamic banks and for a sampling, I delved into the balance sheet of a large UAE-based Islamic bank to provide a set of assets to go through.  It's not important which Islamic bank was selected, because the focus should be on the types of the assets on the balance sheet.

The assets can be divided into a few categories:

• Cash
• Inter-bank lending
• Islamic financing and investment
• Investments
• Receivables
• Property, plant & equipment
• Goodwill

Cash

Islamic banks, like all other financial institutions want to have a liquid supply of cash available to meet depositor withdrawals, payments to their vendors, money held with their central bank to meet reserve accounts, and any other needs that arise in the course of their business.  One thing that I have seen repeated widely (including in my blog) is that banks hold higher cash balances than conventional banks.  As a rough test of this idea, I compared the Islamic bank with one in the US that has similar total assets (I picked the US bank because it was easier for me to find a bank with comparable assets in the US).  

The US bank had 2.7% of its assets in cash (either in non-interest-bearing or interest-bearing instruments) while the Islamic bank held 6.4% of its assets in cash.  I accept that this is a highly unscientific analysis, but with a cash-to-assets ratio of the Islamic bank more than twice the conventional US bank, it seems probably that Islamic banks do hold more cash than conventional banks. 

The problem for Islamic banks when dealing with their cash balances is that it is harder for them to make a return on the balances sufficient to offset the cost associated with their funding and so higher cash balances should all other things equal lower the return on the bank's assets.  A mitigating factor is that the Islamic bank was able to place a large proportion of its cash balances in profit-paying instruments with the central bank (the UAE has an Islamic CD available starting in 2010 for Islamic banks in the country).  However, the remainder is either cash on hand, held in a current account at the central bank or held against the bank's reserve requirement with the central bank.  

The Islamic CD offered by the UAE Central Bank was significant for the bank I looked at.  Between the end of 2009 and the end of 2010 (i.e. before and after the Islamic CDs were offered), almost all of the drop in cash on hand and current account deposits with the Central Bank were offset by deposits in the Islamic CD (representing about 30% of the total cash balances of the bank).  Banks are responding to the opportunity to place funds with the central bank and generate a return on these assets, even if it is low.

I will return to the Islamic bank's assets in a future post.  See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

Islamic finance complexity (Part IIf)

One of the ideas of Islamic banking that is most often repeated is that the Islamic banking system is based on profit-and-loss sharing products.  However, the theory and practice diverge significantly on this at least on the asset side of the balance sheet.  The liability side (e.g. deposits and equity) are done more along the lines of the theoretical model of mudaraba.  However, a recent working paper published by the IMF (pdf) found that the profit-and-loss sharing of Islamic banks did not translate into a significant difference in the profit rates paid on deposits.  

The study examined Malaysia and Turkey from 1997 to 2010, which included 2 crises (1997/98 for Malaysia, 2000/01 for Turkey, and 2008/09 for both).  This should provide some evidence that Islamic banks operate differently from conventional banks by not focusing exclusively on a smoother period, or a crisis period.  However, the results of the econometric tests showed that the deposit rates on Islamic and conventional deposits moved together and tests for causality showed a significant causality from conventional deposit rates to Islamic deposit rates, but did not find evidence of causality in the other direction.  The data used in the study were for 1-year deposits, although the authors indicate that tests using 1-month and 3-month deposit rates gave similar results. 

The authors of the study do not test to see why this relationship exists, but they do hypothesize on a few possible explanations.  One is that Islamic banks have to compete for deposits with conventional banks and therefore have to pay depositors competitive returns on their money in order to attract deposits.  This is accomplished in most Islamic banks by using Profit Equalization Reserve accounts that allow the bank to save up excess profits to cover shortfalls from the market rate of deposit interest/profits. 

Another explanation is that the profitability of an Islamic bank is determined, in large part, by the assets on its balance sheets.  Given that the products used by most Islamic banks are debt-based products like murabaha, ijara, and istisna’a, which generate returns that are benchmarked to LIBOR or another conventional interest rate benchmark, the profitability of the bank will be in large part based on interest rate movements.  

This explanation does make sense, but is less obvious an explanation because, while deposit rates do move in line with other interest rates, like LIBOR, there is not necessarily an automatic relationship between one and the other.  If the changes in Islamic bank deposit rates were driven by changes in rates on assets (e.g. LIBOR), the causality flowing from conventional  bank deposit interest rates to Islamic bank deposit profit rates would probably not be there.  Islamic banks as they work today should not have significant differences in the breakdown of their assets compared with conventional banks, so the transmission of changes in LIBOR to changes in deposit profit rates should not occur with a lag compared with conventional banks (there should not be causality from conventional rates to Islamic rates on deposits).  

The evidence, at least from this one study looking at just two countries, suggests that the more probable explanation is that Islamic banks manage their deposit profit rates using Profit Equalization Reserve accounts to follow conventional deposit interest rates.  The reason for this is relatively simple: if they offer lower rates, they will have trouble attracting deposits.  Alternatively, if the rates are highly variable, with some period where Islamic deposit account returns are significantly higher than conventional deposit rates, but also periods of significant underperformance, it will also discourage depositors from moving to Islamic banks because depositors are not likely concerned with the average deposit rate over a period of time alone, but want this return to be of lower variability.  

What are the lessons from this?  First, Islamic banks are not independent of conventional banks and (based on the data in this study) compete directly with conventional banks.  Second, Islamic banks do not operate based solely on the theoretical construct of profit-and-loss sharing, even on their liability side.  As long as this relationship continues to hold--and there are valid consumer demands that Islamic banks must meet, and regulatory environments which make Islamic banks look like "banks"--the idea that Islamic banks are more resilient or even somehow unique in their response to economic changes should be dismissed.  There may be areas where they could be, but even on the side of the balance sheet where profit-and-loss sharing is at least theoretically entrenched, the data shows a strong relationship between Islamic banks and their conventional competitors.  

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html