An Islamic repo coming to market

The National Bank of Abu Dhabi announced that it will launch a murabaha-based Islamic repo (repurchase agreement) product in March. I believe this would be the first Islamic repo. The few details in the article suggest that it is similar to the structure proposed as most likely by the International Islamic Financial Market (IIFM) . That structure (and likely the NBAD structure) essentially create a secured commodity murabaha contract. The two parties engage in a commodity murabaha transaction (sale of a commodity with deferred repayment), but unlike a normal murabaha transaction, the borrower pledges a pool of sukuk to secure the repayment.

This transaction is not terribly innovative on its face. The main difference between this transaction and a commodity murabaha is the pledge of sukuk as collateral. There are other add-ons that could be part of the transaction. For example, the transaction could be structured so that the buyer (lender) can re-hypothecate the sukuk (i.e. use it for its own purposes, including by using it to engage in repos with other counterparties). This would differentiate the repo from commodity murabaha transactions because it ties up assets of the bank for the length of the transaction.

The downside of the repo transaction is that it further limits the potential for secondary market liquidity in sukuk because holders of sukuk will use the repo market as an alternative way to make their holdings liquid. Thus, they will be less likely to offer their sukuk holdings in the secondary markets that are already limited in the supply of sukuk being offered. The flip side of this is that it could benefit the primary markets for sukuk because investors (depending on the quality of the issuer) would be able to generate liquidity from longer-term sukuk than they can today. It could also reduce any illiquidity premium that is priced into current sukuk offerings, which would make sukuk more competitive with conventional bond offerings.

The one area of caution that the article raises is that repo transactions were used by Lehman Brothers to clean up (manipulate) its balance sheet at the end of each quarter (window dressing). By "selling" assets around the date when financial information is reported and using the proceeds of the loan (which was classified as a sale and thus not debt) to pay down debt, it was used by Lehman Brothers to reduce the level of indebtedness reported in its financial statements. This is certainly a possibility within Islamic finance, but the lending contracts are more cumbersome, raising the cost of repaying and reborrowing debt. However, the real lesson is that the practice (called Repo 105 and Repo 108 by Lehman Brothers) should be discouraged by regulatory bodies.

The details of the specific NBAD Islamic repo are not yet known, but can be guesstimated based on the IIFM paper on possible structures. Islamic repos--particularly if the pledged sukuk cannot be re-hypothecated--will not do much to reduce the reliance on commodity murabaha, but it can increase the liquidity management options available for Islamic banks, which should (given enough controls to prevent abuse) make Islamic banks more stable. One of the secondary effects could be a reduction in the spread between conventional bonds and sukuk, which could increase the appetite by issuers to choose sukuk. This on its own could help the secondary markets because investors might shed their hold-to-maturity outlook, at least those investors who maintain that attitude because of a shortage of replacement sukuk in either the primary or secondary markets.

What microtakaful needs to grow

Reuters reports that Tokio Marine Middle East is considering offering microtakaful in Egypt where it already owns 2 of the 8 takaful companies. The article specifically suggests that microtakaful could be offered for life, disability and accident insurance as well as livestock and crop insurance. Takaful is a Shari'ah-compliant form of insurance similar to mutual insurance where the takaful policy holders' premiums are invested separately than the firm's capital to cover the expected claims.

There is definitely a role for microtakaful to play alongside of Islamic microfinance because it will limit the chances that death, injury or a natural disaster (unpredictable events) could cause the MFI client to be unable to continue either their microbusiness or the payments on items or services financed by an Islamic microfinance instutiton. Even on the conventional microfinance side, there are many fewer institutions that offer microinsurance compared to the number offering microfinance (or more specifically microloans).

The CEO of takaful for Tokio Marine Middle East offered his case for microtakaful in an article from July 2010 in the Middle East Insurance Review (page 60-61, available as a pdf).

One issue that could become problematic for microtakaful firms is that in the absence of retakaful, the institutions could find it difficult to manage the claims when they are most likely to be made (and most likely to be needed by takaful members). Some of the risks that are insured against by microtakaful companies, specifically death, natural disaster and agriculture losses (including livestock) are likely to occur for many takaful members at the same time if the microtakaful firm is small and geographically undiversified.

For example, assume that 1,000 people in one region of a country form a takaful company that pays out $2,000 if a member dies, $500 in case of crop loss and $100 for each animal that dies. In exchange, each member pays $2 per month (these numbers are not based on any specific case). The takaful company estimates that it will have claims of 5 individuals who die, 10 cases of crop failure and 50 animal deaths. This would lead to the company collecting $24,000 per year in premiums and paying out $20,000. The surplus gets carried over to future years. In normal years, this works fine and the fund builds up assets.

However, imagine that a drought hits the region and causes widespread crop failures and animal deaths with also more people dying than in a normal year. Assume, for example, that there are 100 crop failures, 25 deaths and 250 animal deaths. This would cause the claims to be $125,000, compared with only $24,000 in premiums. Based on the normal years before (with $4,000 in surplus every year), it would take over 25 years of "normal" years to cover the extra loses from the one bad year. If that bad year happened in year 4, the takaful company would be unable to fully pay claims and without the benefit of retakaful (or a larger parent company with operations across many regions and countries), it could fail to support its members when they need it the most. A few failures of microtakaful (or conventional microinsurance) companies could hurt the aacceptance of microinsurance because of their vulnerability to catastrophic events.

Unlike Islamic microfinance, which will be affected by catastrophic events because of widespread business failures, the failure of a microtakaful company because of a widespread event which causes the failure is directly connected to what the company is offering protection against (rather than being a casualty of an unrelated external event.

The point of this long tangent from the initial story about the prospects for microtakaful in Egypt is that there is much more infrastructure needed to set up microtakaful in one country or region within a country than just opening the microtakaful company. If the macrotakaful industry wanted to assist microtakaful institutions, perhaps the best way would be to provide retakaful to microtakaful providers. Even if they cannot fully diversify the retakaful coverage they offer, it could be a diversification tool for their overall risk profile because the likelihood of a catastrophic event happening in one part of the world is unlikely to affect claims by their customers in another part of the world.

'Profit for delayed period not Shariah-compliant' -Grand Mufti of Dubai

Emirates 24/7 is reporting that the Grand Mufti in Dubai has criticized a practice where purchasers of apartments in projects that have been delayed are being charged rent on the unfinished buildings. The Mufti, Dr. Ali Mashael, criticized this as being not Shari'ah-compliant. While the details of the contracts involved are not described, I went back to a paper by Dr. Abdul Sattar Abu Ghuddah on forward ijara (al-Ijara al-Mawsufah fi al-Dhimmah) [1] that I can no longer find a working link to. The usual warning applies that I am in no way qualified to offer any opinion on the Shari'ah aspects of the debate; I can only summarize what others have said.

The Emirates 24/7 article describes that "Some Islamic banks and mortgage companies have asked investors to pay advance installments (the rental profit or Ijara) even though an already delayed project is not yet completed or handed over." The contracts are further described as: "During the economic boom, many investors got in to agreement with Islamic banks and mortgage firms and the developers where the investor pays a down payment of about 5 per cent of the property price to the developer at the time of signing the contract. After that, the bank -- as owner -- pays the developers, and at the time of property handover, the investor pays the value of the property as rent-to-own installments to the banks over a period of time."

Dr. Abu Ghuddah focuses specifically on this type of transaction in his discussion of the forward ijara. The one aspect that is missing from his discussion is the down payment amount, which was paid to the developer, but this was outside of the financing aspect of the contract between the bank and customer (perhaps it is returned to the customer, who then uses it to make payments on the lease). After the customer agreed to buy the property (e.g. an apartment) from the developer, he has a debt that is due when the apartment was constructed. However, in order to finance that so it is not due up front, the customer went through an Islamic bank.

The bank approaches the developer and requests that the developer create an apartment meeting the customer's specifications, and agrees to an istisna'a contract with the developer. The bank then enters into a forward ijara contract with the customer to lease an apartment meeting the customer's specifications beginning on a set date in the future (when the apartment is expected to be completed) for a specified period with specified lease payments.

However, one key factor is that the apartment that is the subject of the lease is not specified in the forward ijara. Dr. Abu Ghuddah describes: "The suitability of this arrangement, or the solution to this circumstance by means of forward ijarah that ends in ownership, is that the subject of the contract is not a specific item". The permissibility of the forward ijara as Dr. Abu Ghuddah describes it that it follow the rules of a salam sale (with an exception to the requirement of spot payment) including that the item be precisely specified.

With regards to the banks requiring payment, Dr. Abu Ghuddah discusses what happens if the item described in the forward lease is destroyed: "A contract for forward ijarah is binding on the parties to the deal, and can remain valid even with the loss of the usufruct, since a replacement is to be provided in such a case." The binding nature of the forward ijara is probably what allows the banks to demand the rental payments beginning on the day specified in the contract; they couldn't have specified that lease payments begin at some date in the future when the project is completed, because that would have raised potential issues of gharar. However, in the same way that the bank would have been liable to provide a substitute if the one being constructed were destroyed, it is probable that they would be required to provide a substitute for the apartment that is delayed (i.e. that is not able to be occupied and used by the customer who is paying for the use of an apartment of certain specifications).

If that analysis is right and I am not misunderstanding (or misapplying) the description of the financing contract used by the Islamic banks or Dr. Abu Ghuddah's description of the forward ijara contract, then the Grand Mufti in Dubai is directing his criticism at the forward ijara that was used widely in the pre-crisis period (widely enough to merit an in depth paper from Dr. Abu Ghuddah), not necessarily the Islamic banks themselves. However, the banks don't get a clear pass either; if they are collecting rent for the use of an apartment under the forward ijara contract from 2009 until today without the specified apartment being inhabitable, then it would seem to me that they would be required to provide a substitute apartment to the customers from whom they are demanding lease payments.

I don't expect this article to be the last we hear about these types of contract and it would be good to see how the bank's Shari'ah boards (and other scholars) weigh in on the bank's responsibility to provide a substitute for the delayed apartments.

[1] Dr. Abdul Sattar Abu Ghuddah. 2009. Practical Application of al-Ijara al-Mawsufah fi al-Dhimmah (Forward Ijara). Paper presented at the 30th Albaraka Symposium. You can find a download link on Google (search for the title).

Qatar Central Bank directive and monetary policy

The other part of the Qatar's central bank I wanted to comment on (refer to my last post for the bulk of my comments) was its discussion of the monetary policy implications of the closure of Islamic windows:

"In view of the evident difference between the bases and the methodologies pertaining to the conventional and the Islamic banking activities, since for instance, the impact of each type differs from the other in the ability to create money and increase money supply, the use of monetary policy instruments available to Qatar Central Bank faces significant challenges due to the current overlap between non- Islamic and Islamic activities of conventional banks operating within the State. This overlap hinders the optimal use of those tools, negatively impacting on the monetary policy performance and efficiency, and impeding the creation of new tools, which enhance the monetary policy effectiveness. At the same time, the segregation of the conventional and Islamic banking activities will enable Qatar Central Bank to have a systematic framework of liquidity management and improve the efficiency of open market operations. On the other hand, this will also open new prospects for the monetary policy to develop new instruments targeted at these two types of banking activities according to the size and relative weight in the market, in addition to the degree of influence thereof on money supply. The monetary policy instruments will then have a faster and more efficient impact on the operational, intermediate and ultimate objectives."

The main takeaway from this part is that the central bank plans (or is planning to) engage in monetary policy differently for Islamic and conventional banks. It also plans to address the liquidity management issues facing Islamic banks (which I neglected to mention in my earlier post on a hypothetical Islamic window). This is important, but it is a long-term plan implemented with a short-term, almost hasty decision to separate Islamic and conventional banks completely within the regulatory framework.

The most basic form of policy mentioned in the press release is the potential for additional liquidity management tools that Islamic banks need and are substituting with inter-bank commodity murabaha or wakala agreements. As I have discussed earlier, this is an unstable solution should their be another crisis where banks lose access to loans based on fears of insolvency that are widespread across the global financial sector. These could be in the form of securities issued by the central bank akin to the Central Bank of Bahrain's sukuk al-salam and sukuk al-ijara, which have met with substantial demand in that country. However, this would not require that Islamic banks be completely separate from conventional banks. Bahrain has both wholly Islamic banks as well as Islamic windows at conventional banks and doesn't plan on changing that.

The press release hints at further moves, including separate monetary policy for conventional and Islamic banks. That would be unique in the world if it were accomplished. From what I understand, the change would allow the central bank to set different benchmark rates for Islamic banks and conventional banks through separate open market operations and they do not want there to be any overlap between the two sectors (which of course leads to arbitrage that would make the two policies identical if the market became efficient). It would also lead to a more feasible outcome of the central bank being able to support the Islamic banks without providing stimulus to conventional banks at the same time. If the banking sector were a greater size relative to the economy (like in Bahrain), this could make sense, but it is still would be difficult to accomplish in practice.

In the end, the section on "monetary policy" in the press release does not leave me with much additional explanation for the directive and its sudden and non-transparent release. It is far more likely that the main reason for the new complete separation is the difficulty of the regulators in overseeing Islamic windows at conventional banks within the current regulatory framework. The potential black-eye for the regulators if an Islamic window were operationally separate and saw its capital depleted without the regulators being aware and involved is a much better explanation. The methodology of the directive--requiring the units be closed or sold--is likely a reflection of the central bank wanting to strengthen the domestic Islamic banks, even at the expense of some conventional domestic banks.

Qatar's central bank weighs in

The Qatar Central Bank has provided some background to the decision to issue a directive to conventional banks with Islamic windows that require them to shut the Islamic units by the end of 2011. However, while the Central Bank provided some greater clarity on the problems it sees with Islamic windows, this does not clarify the situation going forward much, and still leaves great uncertainty about whether there is any way for conventional banks to retain Islamic subsidiaries without violating the directive.

Gulf Times published portions of a note that the Central Bank issued (available as a pdf from the Central Bank):

"Islamic finance is characterised by certain risks of more diversified and complex nature than conventional financing, particularly with regard to the return, liquidity, credit and market risks relating to Mudaraba, Musharaka, Istisnaa and Ijara finance methodologies."
[...]
The issue becomes more complex when a large part of these activities receive their funding from customers’ conventional fixed-income deposits, which are not based on profit distribution as in Islamic deposits. Moreover, these two types of risks are getting reflected in the same financial statement of the bank. As a result, applying oversight instruments and prudential ratios and indexes used for risk management and preserving the two types of depositors’ rights are becoming more complex."
[...]
It seems there is a conflict of interest with conventional banks having the two side by side. These affect the stability and growth of Islamic banks."

The main issue for the Central Bank on the regulatory front is the co-mingling of funds between the conventional and Islamic units within each bank that has both types of businesses. This objection is perfectly understandable. If this were the case, there would (or should) probably be objections from the bank's Shari'ah board.

The article I linked to earlier written by Sheikh Taqi Usmani in 2002 about Islamic windows described the permissible method for conventional banks to fund Islamic windows:

"a portion of the initial capital of the bank is earmarked to be employed in the proposed window. In the absence of a proof to the contrary, the initial capital of the bank may be presumed to be pure.
[but]
Accounts of the Islamic window must be separate from the conventional side of the bank. The deposits received by the window must not be mixed up with the deposits taken on conventional side. Similarly, the finances offered by the window must be independent."

This is consistent with descriptions from conventional financial institutions like HSBC Amanah, which use funds from their conventional bank to seed the Islamic windows (although the HSBC Amanah FAQ linked to is vague on the shifting of assets between conventional and Islamic units).

The difficulty of the division of funds between conventional and Islamic segments of a mainly conventional bank is that money is fungible, that is, one dollar can not really be distinguished from another and when the financial statements combine both units, as they would be in a consolidated balance sheet and income statement, it requires no more than an accounting entry to designate the funds flowing from conventional to Islamic segments of the bank as coming from the bank's capital rather than its interest income or conventional deposits.

The only way for the bank to really keep the units funds separated with consolidated financial statements is to keep the segments operationally independent from one another. Specifically, a conventional bank opens an Islamic unit as a subsidiary and funds it with $10 million in capital which are put into a segregated account. The Islamic unit starts up and begins opening branches, taking in deposits and extending financing. The income from the assets are used to cover operating expenses and make profit-sharing payments to depositors (with whatever reserve accounts are used to smooth those payments over time, as most Islamic banks do).

However, the difficulty comes from a regulatory perspective because there is a contradiction between the financial statements the bank provides to the regulators (as one company) with a consolidated financial statement showing assets, liabilities and capital, as well as the total risk weighted assets (the denominator in the capital adequacy ratios). However, from an operational perspective, the two segments (Islamic and conventional) must remain separate. That is, there is little way for the regulator to assess whether the Islamic unit is healthy on its own, whether it has adequate capital to support its assets (with their respective risk weightings that are often higher than conventional banks' assets).

At this point, there is a dilemma for the regulators who face potential embarrassment if an Islamic window ran into trouble (for example, by lending lots of its money to dubious real estate projects that subsequently lose value). If this happens, the bank would have two options. First, it could just fold up its Islamic window and force the depositors (apart from the non-profit-returning deposits) to share in the loss. This would be untenable for any bank that wants to reassure its conventional depositors of its solvency. The other solution would be to recapitalize the Islamic unit. However, these funds would not necessarily be Shari'ah-compliant and it would be a public relations disaster for a conventional bank to try and move capital from the conventional side to the Islamic units after the Islamic windows had been operating for a while. And that would embarrass the regulators who were supposed to be overseeing both conventional and Islamic banks.

So, on these grounds the directive makes some sense (if I have not made any serious errors in my analysis). However, this does not make the directive or the method in which it was handed down any better handled in terms of minimizing disruption within the Islamic finance industry. At least there is not a week-long holiday involved like there was when Dubai World declared a standstill agreement back in 2009.

In addition to the handling of the announcement, there is a more substantive argument that the directive is needlessly damaging to banks by forcing them to shut down overnight. The Central Bank's statement says the directive told Islamic windows to "stop opening new Islamic branches, accepting Islamic deposits and dispensing new Islamic finance operations". There are reports (as yet unconfirmed) that the Central Bank is considering merging the Islamic units into one Islamic bank. This could be one solution if the banks contributing their business units were given equity in proportion to the size of their Islamic units, but it's probably not the best solution, in terms of reducing disruption and keeping the possibility open for other conventional banks to open Islamic windows in the future.

The alternative would be to require the conventional banks to spin off the Islamic windows into wholly-owned subsidiaries that are required to hold separate Islamic banking licenses, be regulated along with the Islamic banks in the country and maintain enough capital on their own to satisfy the regulatory requirements. This would provide the regulators with the authority they need to maintain the soundness and stability of the financial system, but would also provide the banks who now have Islamic windows with the opportunity to profit from the growth in Islamic finance, which was the reason they opened these windows in the first place.

I think I'll take this opportunity to end this post, even though there were a couple other points in the Central Bank's press release that I wanted to discuss, but those can be left to a later post.

Broadening the appeal of Islamic finance

I was reading an article on Indonesia providing advice on Islamic banking regulations and I was struck by one quote from Grace Stuart Ndyareeba, the deputy director of commercial banking at Bank of Uganda, the country's central bank. He said, "We in Uganda know that Islamic banking is not only for Muslims. It is another financial product. [And conventional banks charge] very high interest rates expensive for consumers".

Although Uganda has a significant Muslim population--12% or 4 million people--it still is better viewed as an example of a non-Muslim majority country creating opportunities for Islamic banks to provide their services. It is unlikely to develop a large Islamic banking industry that a country like Indonesia might based on its larger population and higher proportion of the population that are Muslim.

In this context, Islamic banks are best suited to focusing on the Muslim population, particularly in the early stages of development. It will thrive in the end if it is able to serve these people's needs well and will attract non-Muslims if it is able to provide quality efficient banking services. What it will not do is replace the very high interest rate products with products that are cheaper, at least not at first.

It is likely based on the small population of Muslim consumers and probability that there will remain additional costs and inefficiencies to Islamic banks in the country that the Islamic banking products will be more expensive than conventional alternatives. An analogy that should provide some forewarning about the benefits from a cost perspective alone in non-Muslim majority countries is the difference between the US and Canada, which both have Islamic finance companies offering products. Reports I have seen suggest that the Islamic financial products in Canada are more expensive than in the US. Canada is at an earlier stage in the development of its Islamic finance industry than the US and has a smaller population as well (both in total population and Muslim population, about 1/10th for total population and 1/7th for Muslim population).

This doesn't mean that Islamic banking cannot work in Uganda (or Canada), but it seems preferable that it be targeted first to Muslims and then, once it has matured and been able to better compete with conventional banks, the products should be marketed on their own merits to non-Muslims. They will not have any natural preference towards Islamic banking products unless they are cost-competitive and offer a tangible benefit compared with conventional products. A good example of a market where non-Muslims participate broadly in Islamic finance based on the cost of the product is Malaysia.

The cost aspect is easy to understand; if a product offers a better value for consumers (lower cost for equal or higher quality service), then consumers will be inclined to choose it. The "merits" of the Islamic banking products is a little more complicated.

There may be some consumers who, for whatever reason, want to avoid explicit interest in their financial dealings. There are others who want to ensure that their deposits are not being used for socially detrimental activities like selling alcohol or tobacco, producing weapons, or gambling and pornography. These consumers may be indifferent between Islamic and conventional products or even be willing to pay a premium for the more 'ethical' product.

However, many consumers will look at an Islamic banking product and see additional cost, limited 'ethical' screening (compared to socially responsible investments which use a broader set of screens) for a similar product to conventional financial products. This is particularly true for murabaha and ijara. Each are analogous to conventional financial products (loans and leases) and the benefits may not be apparent. They are often not apparent to many Muslims based on this similarity.

There are no easy answers for how to make Islamic banking products more appealing to consumers, Muslim or not. It is not even clear that the products abstracted from the benefit of Shari'ah-compliance, are better than conventional financial products. This is the largest challenge to making Islamic financial products more acceptable to non-Muslims absent a cost reduction (which is often not present because the products are benchmarked to interest rates and they are generally more costly to create). It also highlights the challenge to Islamic finance to attract a new set of Muslim consumers. How can Islamic banks operate in a way that differentiates their products from conventional financial products without confusing consumers, running into regulatory issues, raising costs further or creating stability concerns for the Islamic financial institution.

What should Qatar do with Islamic windows?

The Qatar central bank's directive to conventional banks to close their Islamic windows is still the top news story in Islamic finance. Malaysia has come out and said it does not plan to institute a similar move, while commentators see a likelihood that other GCC countries will introduce similar rules.

Reuters reports that the central bank has clarified the reason for the directive being "based on issues related to the supervision and monitoring as well as monetary policy", as well as potential problems in financial reporting. The central bank may create separate capital adequacy rules for Islamic banks.

Not being an expert on financial reporting, I can't comment on that aspect, but other articles report that the directive was based on difficulties with ensuring the segregation of assets between the conventional and Islamic units of banks offering both services. This may even be the key issue behind the ruling with the central bank wanting to create new capital adequacy rules for Islamic banks. There have been complaints before that the capital weighting of Islamic finance products is problematic, although they are generally more conservative (i.e. Islamic banks have to hold more capital for Islamic products than conventional products).

I linked to an article by Sheikh Usmani about Islamic windows (from 2002, ht Islamic Finance Resources) that provides a good commentary on the role of Islamic windows. Sheikh Usmani begins by referencing the critics of Islamic windows of conventional banks:

"It is argued that such windows are established purely for commercial objectives which aim at capturing the Islamic market. The main business of these conventional banks is still based on interest and is intended to remain operative for good, but only a small part of their activities is claimed to be run on Islamic principles. This attitude, according to these critics, is neither sincere nor reliable, and the Muslims should not therefore cooperate with it."

He counters that:

"The criticism is not wholly justified. If a conventional bank opens an Islamic window and it is ensured that all the requisites for a true Islamic window are fulfilled in letter [and] spirit, this step cannot be criticized merely on the ground that the whole bank is not converted. In non-Muslim countries, in particular we find numerous commercial institutions that offer Islamic and non-Islamic products simultaneously. For example, all the hotels and restaurants in non-Muslim countries sell liquor and soft drinks. Nobody can reasonably argue that so long as they deal in liquor, they should not sell soft drinks. On the same analogy, if a conventional bank offers real Islamic products through a separate window, it will not be justified to raise objection against it."

This summarizes the two sides of the debate between allowing conventional banks to offer Islamic financial products through their Islamic windows. The funds are segregated so that there is not impermissible income generated using funds from the Islamic window. However, they are often seeded with funds from the conventional bank. Sheikh Usmani dealt with this issue as well:

"The initial capital employed in the Islamic window must not be a part of interest or any other impermissible income earned by the bank. The ideal method for that purpose would be to raise new capital meant exclusively for the Islamic window. If this is not possible for any reason, a portion of the initial capital of the bank is earmarked to be employed in the proposed window. In the absence of a proof to the contrary, the initial capital of the bank may be presumed to be pure."

This is still an issue that is raised because money is fungible and there is no distinction between the money generated through a conventional bank's interest-based business and its capital except different line items on the balance sheet.

There is no way to undo the past to separate the bank's capital from the original source of the funds, so the in part the move could be viewed as an admission that the capital for the Islamic window was impermissible from the start and therefore the window was non-Shari'ah-compliant and, thus, should be closed. Even if this was the case (and I am going out on a limb here in terms of the rationale for the move by the central bank[1]), however, the closing of Islamic banking windows isn't the best solution to the problem.

If the issue is the capital backing the Islamic banking operations, then there are three alternatives:

• Shut the units down: this is tack taken in the directive as far as it has been reported, but will likely harm the customers of these bank's Islamic windows.
  
• Force the conventional banks to sell the units to wholly Islamic banks: this outcome would be amenable to consumers because it would cause less disruption and would treat the conventional banks fairly by giving them at least some compensation for losing access to a growing market. However, given the short timeline and regulatory requirement for the sales, they would not necessarily get fairly compensated in the sale.
  
• Allow the conventional banks to apply for Islamic banking licenses, transfer their Islamic units to wholly- or majority-owned subsidiaries.

The final option would be the most just option for the banks, would also minimize disruption for customers and also ensure that there remains the same level of competition in the Islamic banking industry in Qatar. It would also clear up any issues with the capital backing the Islamic units if the central bank forced a recapitalization of the subsidiaries with new funds from investors. This would force the banks to share some of the profitability with the investors, or issue new shares with the funds being directed to the subsidiaries without being "tainted" by being part of the conventional bank.

It would be positive if the uncertainty were cleared up and the final rules were released publicly so that bankers as well as the other industry participants (perhaps worried about similar rules in other countries) could have clarity on the final rules. However, for now, there are only bits and pieces coming out. This will do no good for bankers in the GCC at conventional banks trying to sleep or consumers who are now unclear about the status of their deposits or loans from Islamic windows in Qatar or the rest of the GCC.

[1] There is a non-trivial possibility that the move was based on developing the domestic Islamic banking industry and removing competition from the multinational banking companies that have entered Islamic banking to reach a new market.

Qatar central bank tells banks to shut their Islamic windows

The announcement by the Central bank of Qatar that conventional banks with Islamic windows must close these units by the end of the year is creating a lot of uncertainty. There are few details about what will be permitted and what will not for banks to either spin off these units into stand-alone subsidiaries or as independent banks operating under their own Islamic banking license. Here are a few bits of commentary, after a few points from my latest newsletter where I took a stab at offering my own thoughts.

From my newsletter (to subscribe, enter your email address on the left side of the blog):

"I think this is somewhat short-sighted for Islamic banking because it reduces the competitive pressures from conventional bank's Islamic windows which force all Islamic banks to adopt best practices that multinational financial institutions use to efficiently offer their banking products.
[...]
On the other hand, there could be some benefit to the Islamic banking industry if the wholly Islamic banks are able to increase their market share and thus also increase their size. Many Islamic banks have been less efficient because of their relatively small size compared to conventional banks. This means that there are fewer customers across which they can spread their fixed expenses.
[...]
It will be interesting to watch how conventional banks in Qatar push back against rules that force their divestiture or closure of their Islamic windows and whether any decide to either spin off their Islamic units into stand-alone Islamic banks or sell them to wholly Islamic banks. If they choose to do the latter, it could speed up the growth in the size of the acquiring Islamic banks and, if the acquisitions can be integrated in quickly, could speed up the growth in Islamic banks.

Reuters reports:

"But it was still unclear whether the central bank will allow conventional banks to spin off their Islamic businesses into standalone units.

Seeking an Islamic banking licence would be an option, said a banker at a major Qatar-based lender, if it was clear one would be granted. Without that certainty, "the bank is in limbo," he said.

A licence to open a standalone Islamic bank would allow the banks to retain their customers and appease critics within the Islamic finance industry who say there is not enough governance in the current structure to ensure sharia compliance.

The National reports

"HSBC is in talks with Qatar's central bank as fears emerge that a recent order to close some Islamic banking operations in the country will hit lenders' revenues."
[...]
"'We are communicating with the Qatar central bank to seek clarification on this issue,' said a spokesman for HSBC Amanah, the Islamic division of Europe's largest bank."

The Peninsula reports

"Conventional banks, in keeping with Qatar Central Bank’s directive, have stopped opening new accounts and dispensing loans at their Islamic banking units ahead of closing down these operations by the year-end."

"But customers of these units, whose numbers run into thousands, are worried, wondering what would happen to their accounts and debt-servicing. The possibility of the affected units being converted into commercial bank branches is not ruled out, reliable sources point out."

The Business Times in Malaysia offers a quote:

"The central bank’s directives will help separate Islamic from non-Syariah resources in the banking sector,” Manoj Kulkarni, the head of credit research at brokerage SJS Markets Ltd in Hong Kong, said in a telephone interview yesterday. “It will also attract more Islamic banks to the industry. However, it’s not good news for conventional banks, which stand to lose revenue.”

UPDATE (2/8): There is a supportive article from 2002 by Sheikh Taqi Usmani (ht Islamic Finance Resources) on the development of Islamic windows at conventional banks that is interesting in light of the new Qatar central bank rule.

Thoughts on Islamic microfinance

PBS, the American public broadcasting network, had a segment on Islamic microfiance in Pakistan and there were a couple points that I thought were worthy of a further understanding.

"There’s a lot of compatibility between the notion of Islamic finance and microfinance. That’s how I see it, very simply. The first is you only do productive lending. In Islamic finance you cannot do consumer lending, for example. Similarly, in microfinance we are not really in the business of consumer lending. The second thing is you support the business itself, so you have to do a very detailed analysis of returns from the business."

This is not necessarily true. Islamic finance is easily adaptable to consumer finance, whether through tawarruq or through murabaha for consumer purchases. In microfinance, that is not necessarily a problem; there is no reason why low-income borrowers should not have access to consumer finance. Indeed, excluding consumer finance from Islamic microfinance won't reduce the debt burden on the clients. They will just find it elsewhere, often at higher cost.

However, the story does make a good point that the ability of borrowers to access finance from multiple microfinance institutions (MFIs) can lead to crisis for borrowers (and lenders) like it did in India recently. Without any way to gauge the client's other indebtedness other than just asking the client, there is a possibility that over-agressive lenders can give clients the opportunity to overextend themselves. Initially, this is to the benefit of the MFI, but when the debt load becomes unsustainable, the MFI will lose as well.

This is a problem that Islamic finance cannot solve on its own and I think the solution to the problem can be used by both Islamic and conventional MFIs, to the benefit of the institutions and the clients. There should be an organization that collects information on all the microfinance loans extended by all MFIs, organized by client. There will need to be significant effort and expense incurred to create and maintain this database, and make sure it maintains the client's privacy (just as consumers trust that the information reported to credit agencies in the West expect that their information will be protected).

However, unless each MFI is able to accurately assess the amount of debt each client has and is required to consider this in the lending decision, there will be problems in the future of MFIs unwittingly contributing to overindebtedness of clients, with predictable results. The problem is significant; avoiding measures that allow and require MFIs to consider the ability of clients to repay the financing they are provided will lead to more crises in MFI that will harm the reputation of microfinance.

The other issue is more relevant to Islamic microfinance. The reporter notes that:

[Clients] must share the high administrative costs. Borrowers pay an effective interest rate of about 35 percent. Zafar says it’s the only way to sustain the model, because Kashf has to pay between 14 and 16 percent on the money it borrows to make loans.

On this issue, there are ways that Islamic microfinance can create a unique model to reduce the cost of microfinance to clients and, in doing so, can increase the involvement of Islamic banks and financial institutions in microfinance (enhancing their corporate social responsibility in the process).

Islamic banks that receive impermissible (haram) income, either from aspect of their financing activities that their Shari'ah boards determine are non-compliant or from charging late fees to clients to encourage on-time repayment. On the latter issue, they are permitted to charge late fees, but generally are not allowed to recognize them as income and are required to donate this income to charity.

One possibility is that Islamic financial institutions could donate this non-permissible income to a cash waqf. To avoid conflicts of interest, the waqf would be independent of the institution and to increase efficiency in its charitable use, the waqf would pool donations from many Islamic financial institutions. These funds could then be used to provide qard hasan financing to Islamic MFIs, which would lower their cost of funds from 14-16% as the article describes to 0%.

Another alternative would be for the waqf to invest directly in Islamic MFIs to provide capital on a mudaraba basis (an equity investment), which would provide funds to expand the very limited Islamic microfinance industry. Most likely, both alternatives would be used. The continuing cash flow from Islamic finance institutions' non-permissible would serve to increase the size of the waqf, as well as to replace any funds lost from qard investments.

This source of funds from Islamic finance institutions, on which no return is expected or likely even permitted, would provide a source of finance for Islamic microfinance institutions that could lower the costs to the end-client, expand them as well as make them more competitive with conventional MFIs. It would also serve as a way to distinguish Islamic (macro-)financial institutions from conventional financial institutions which must bolt-on the corporate social responsibility and for whom CSR is competing for funds internally; this model funds the CSR with income that the bank is not permitted to recognize and must donate to charity.

The Islamic microfinance industry is underdeveloped and under-recognized in the broader Islamic finance industry. Yet, it plays an important role in poverty reduction and social justice that are important parts of the underlying reasons for the rules governing Islamic finance derived from the Shari'ah. Finding a way that Islamic banks and other financial institutions can help this segment of the industry without sacrificing their own competitiveness with conventional banks should be an important focus as the global economy returns to growth.

A step forward for Islamic finance in India

Recently I wrote a post on the potential benefit for Islamic finance in the US (and potentially also the possibility of US municipal sukuk) caused by a courts dismissal of a lawsuit filed against the US government. In that case, the court found that the US government's bailout of AIG which left it with majority ownership of the company, which offers takaful, did not represent the government's encouragement of religion. That would be prohibited under the First Amendment's Establishment Clause.

It appears that a similar court ruling could have the same effect in India. Today, the high court in Kerala dismissed a petition that would have prohibited the state government from participating in promoting an Islamic bank. The court found that "although the institution was based on the principals of a religion, its motive was not to propagate the religion and the state's participation in it was purely based on commercial prospects" according to the Times of India.

This could open up the Indian market somewhat for Islamic finance, which has been slow to develop. There are differences between the US and India. The largest difference is that in the US, the government has been open to allowing Islamic financial institutions to operate under existing financial laws, which are broad enough to accommodate Islamic finance. In India, in contrast, the regulatory climate is much less certain and the Reserve Bank of India, the country's central bank, determined that Islamic banking is not possible under India's existing regulation in an unpublished report.

There are still many things that will need to be worked out before India's Islamic finance industry can really begin to grow to serve the large Muslim population (and hopefully non-Muslims as well), but this is a step in the right direction. There have been many setbacks in non-Muslim-majority countries, from the failure of sukuk legislation in South Korea to the decision by the UK government not to issue a sukuk, so it is encouraging to see signs of progress. This is particularly true in countries that have for many years been viewed as being hostile towards Islamic finance.