UAE central bank offering Islamic repo

The UAE central bank, which recently launched Islamic certificates of deposit to help Islamic banks manage their short-term excess liquidity needs is being expanded into a full repo (repurchase agreement) offering. I will discuss the structure in a little more depth (as much as I can based on the information now available), but the first point I find interesting is that it would be based on one model proposed in a paper by the International Isalmic Financial Market released last year, which I reviewed on my blog at the time it was released.

The structure that Reuters is reporting is being used is one based on murabaha. There is nothing new about commodity murabaha being used for liqudity management, but the repo product would use commodity murabaha with the central bank's Islamic CDs being offered by the bank as collateral for the loan. There are currently AED12 billion ($3.27 billion) in Islamic CDs held by Islamic banks in the UAE, giving a relatively large pool of assets for the repo transactions to use as collateral.

The need for a repo facility is clear for both central banks and Islamic banks, but the model that will be used is the most cynical possible outcome. When I read the IIFM report last year, I commented on the collateralized murabaha: "The addition of transfer of securities as collateral (without compensation) on top of the use of commodity murabaha would raise the most objections, I believe, on grounds that the product is cynical and does nothing to really help the industry develop new products." At that time, I saw the collateralized commodity murabaha as cynical because, although it tries to find a solution to a problem, it does so by further entrenching commodity murabaha into the Islamic financial industry.

The UAE repo facility goes one step further. Not only does it use the collateralized commodity murabaha between the Islamic banks and the central bank, it uses as collateral an Islamic CD which itself is based on commodity murabaha between the central bank and an Islamic bank. So, if an Islamic bank has surplus capital, it can loan it to the central bank by buying an Islamic CD, in which it buys a commodity and sells that commodity to the central bank and the central bank will repay the debt sometime within the next year (depending on the agreed upon maturity). However, if the Islamic bank needs liqudity before the CD matures, it can pledge that debt owed by the central bank to the central bank in exchange for a loan structured as a commodity murabaha.

If one takes this a step further and the central bank finds a way to have enable 'netting' of the commodity murabaha products, then it will have developed a way to trade debt (final payment for commodity murabaha represent a debt), which is mostly (outside of Malaysia at least) viewed as not permissible. As much as the short-term liquidity management tools are needed for Islamic banks (and for the central banks that want to engage in open market operations), creating a system where the central bank and Islamic banks are trading back and forth debts from commodity murabaha seems like the worst possible way to find a solution that has any lasting impact on the Islamic finance industry besides just solving the problem of the hour.

The UAE Central Bank has two PDFs describing:
-The Islamic CD; and,
-The collateralized commodity murabaha.

Shari'ah standardization: Inter- or Intra-regional

About a week ago, I called the idea of a GCC-wide Shari'ah board "largely unnecessary". John Foster, the Managing Editor of The Islamic Globe, a newspaper covering Islamic finance (for which I cover the Americas), offered a slightly different commentary in reaction to Dr. Hamad Hassan, the well known Shari'ah scholar, who supported the initiative. John wrote:

"No one doubts that there is a need for improved regulation and the streamlining of cross-border issuance of, for example, Sukuk. However, what the industry needs more is global standardization, not just standardization across the GCC, which is already very homogenized in its regulatory and Shari'ah regimes. The initiative - which does deserve some applause - does however run the danger of becoming a noisy sideshow, when the real challenge lies in finding a global language for Islamic finance - not creating another regional hub 300 miles away from one of the global centers for the industry. With emerging markets in Africa and Central Asia coming to the Islamic finance party, the industry needs one coherent voice - one leader - not three disparate voices calling from different directions."

I am mostly in agreement with his sentiment. The idea of Shari'ah standardization--while tricky--is necessary in some areas of Islamic finance. In the retail world, it is mostly unnecessary because retail banks are focused on their customer's demand and the prevailing Shari'ah standards in the countries where their customers are located. However, even in retail banking, using an interpretation of Shari'ah-compliance that differs in significant ways from the prevailing interpretation elsewhere could hamper the ability of the bank to raise capital needed to sustain and grow its business, unless this comes exclusively from regions that use the same Shari'ah standards.

However, the problem becomes much more significant when cross-border products are developed. These cross-border products will be limited significantly if large regions--for example the GCC--operate with a different understanding of Shari'ah-compliance. This was in part the case in the oft-mentioned difference in Shari'ah standards between the GCC and Malaysia. Many contracts used widely in Malaysia are not permissible under the standards used in the GCC and so the Islamic finance industry in Malaysia developed with a much stronger domestic focus than the GCC. This may have been fine when Islamic finance began to grow during the 1980s and 1990s, but as Islamic finance becomes more globalized, Malaysia has begun to reduce the use of contracts which are problematic. The best known effort to bridge the gap was the sukuk ALIM, developed jointly by Cagamas, the national housing agency, and Al Rajhi Bank, the Saudi Islamic bank which is one of the largest Islamic banks in the world.

I think this is a good example of the types of Shari'ah convergence which is beneficial--not just GCC/Malaysia convergence, but globally. Institutions and their respective Shari'ah boards working together to develop products that are globally accepted. This--rather than an intra-GCC Shari'ah board--should be the focus. It can, as I suggested in my earlier post, be moved under the banner of a standards setting body like AAOIFI or the IFSB or within the Islamic Development Bank, but the inter-regional differences are likely to be greater than intra-regional differences. These differences will also pose the greatest risk to the continued globalization of Islamic finance.

Whether you believe Shari'ah standardization is a fruitful exercise or not, the focus should be on bringing in regions that are diverse, not focusing on the regions where Shari'ah standards are already mostly the same.

Islamic finance education

Last week's newsletter (signup on the left side of the screen) was about Islamic finance education--specifically an article by Mohammed Khnifer about the challenges facing the recent graduates of Islamic finance education programs. 

Mohammed Khnifer wrote an article (the second in a series) that paints a disturbing picture of the job market for graduates, even as the speakers at conferences say there is a huge talent shortage in the industry as a whole. It suggests that either there is a disconnect between the skills that Islamic financial institutions want and what these programs provide, or there is not actually a shortage in the less experienced jobs available from Islamic financial institutions, and the shortage is at higher levels in management.

Neither is promising for Islamic finance graduates, but the former is more easily fixable than the latter. However, if the Islamic finance programs are in fact not offering training in the skills in demand (for which they are charging significant tuition), then a cynic would conclude that they only are involved to capture a 'hot' area of education in demand and do not have their student's best interests at heart.

I don't which one is the case, but it is in some ways a reflection of how the industry works. Most of the students or aspiring students I have talked to or received emails from are younger, less experienced people--many who recently finished their undergraduate studies--who want to work in the Islamic finance industry, but don't know how to get a foot in the door and view specialized Islamic finance training as a way to do that. However, the way the industry works, with a focus on replication of conventional financial products, this is not likely to be an easy way to break into the industry.

A far easier track is there for people with conventional financial experience who want to move horizontally within a firm or from one firm to another. Their familiarity with how financial institutions work from first hand experience makes them more appealing than someone with less experience but more training. This presents a dilemma for some people who don't want to work for conventional financial institutions because there is no substitute for the experience it provides. By recruiting people largely from within the conventional financial industry, at all levels, there will also be more likelihood that Islamic finance continues to operate in the same way it has for the past several decades and make significant changes to the mix between different products, and business models.
 
This is the innovation that, if done gradually to avoid disruptions and with enough care to avoid adding too much risk to the industry, will make Islamic finance evolve in a different way than conventional finance. It will strengthen the industry while at the same time providing a clearer distinction between Islamic and conventional finance. However, without providing an opportunity for younger financial professionals who are not already traveling down the well worn ruts of conventional finance, this innovation will be slowed.

Hawkamah/IIFM sukuk template

Speaking at a conference in Dubai, Nasser Saidi, the CEO of the Hawkamah Institute of Corporate Governance, said that they would issue a template for ijara sukuk (with the International Islamic Financial Market) this year. In contrast to my last post on the prospects for a GCC-wide Shari'ah council, I think this is a fantastic idea.

Ijara sukuk are based on selling an asset to an SPV and leasing it back with the SPV raising funds by issuing sukuk to fund the purchase price. They are the staple of the sukuk market today and are easily understandable to investors, even those without expertise in the workings of Islamic finance. They are usually designed to create an unsecured obligation of the issuer (the company, not the SPV). In situations where the issuer has conventional secured debt, it is often required to fit within the negative covenants on their secured debt (from what I am told; I am not a lawyer).

The importance of a template to the sukuk market is that it would dramatically lower the cost of issuing new sukuk when compared with the expensive process of re-creating relatively standardized documents for each sukuk issued. This matters because it puts an ijara sukuk on a level playing field with conventional debt from a cost perspective to the issuer and could attract new issuers who have avoided issuing sukuk because of the additional costs.

For the Islamic finance industry as a whole, this could have the beneficial effect of increasing the supply of new issuers, which provide more opportunities for sukuk funds to develop. It could also help the secondary market liquidity of sukuk through the increased supply because holders of sukuk would have more opportunities to replace sukuk they sell with new sukuk or other sukuk trading in the secondary market.

There will never be a full "plug and play" template because different issuers have different needs and their investors have different demands as well. There are also differences due to diverse legal and tax environments that sukuk issuers operate within. However, removing one major factor that adds cost (drafting new legal documents for the ijara part each time) should lower costs and have a beneficial impact on the sukuk market.

A GCC Shari'ah council

Plans are underway to create a Shari'ah council for the GCC (a "Shari'ah council for banks" according to the Gulf News headline). I think this is largely unnecessary. There should of course still be Shari'ah standards but whether those standards are national, supranational or regional doesn't matter in the big picture.

The key to Shari'ah standards is that the people determining them are credible in the market among people who are concerned with Shari'ah-compliance. In general the Shari'ah-compliance aspect of financial products matters less than the financial outcome of the products to most investors. This does not discount the impact of Shari'ah-compliance (and the auditing function that Shari'ah scholars provide). Yet, this does not seem to be a function that requires regulatory attention (which is and should be focused on maintaining trust in the financial system and protecting investors).

There are different interpretations of what is and is not Shari'ah-compliant, although most scholars agree on most of the key points in Islamic finance. For investors, it is important to have a fatwa attached to the product and AAOIFI provides standards already on the board composition and may also provide more input on the Shari'ah standards themselves.

The national regulators are concerned with the financial activities occurring within their borders and if Islamic finance is a significant part of this mix, then the regulators can take steps to set minimum standards (whether that is through a national Shari'ah body or by setting minimum standards of qualification for Shari'ah scholars. A regional body to develop consistent standards about what is and what is not Shari'ah-compliant is unnecessary.

It would create another set of different standards in a region which is already fairly unified on what is and what is not Shari'ah-compliant. If common standards are to be beneficial, they should proceed through already established organizations like AAOIFI, which despite their poor record on making their decisions available to the general public, are already established and credible. They have become more involved with the Shari'ah standards, in addition to their primary roles setting standards of accounting and auditing.

Shari'ah-compliance should not be minimized in terms of its importance to the Islamic financial industry, however, it should not be institutionalized yet. There are still too many areas where new ideas can benefit, either by developing solutions to problems like liquidity management or by finding suitable alternatives to the oft-criticized reliance on murabaha and tawarruq. This is best left to individual institutions and their Shari'ah boards. There may be a time well down the road (the reports are that this Shari'ah board would not be operational for at least 5 years), but we are far away from that point now and there are more pressing issues to deal with now.

Experimental evidence on Islamic microfinance in Egypt

From this week's newsletter (sign up on the left side of the page):

Continuing on the microfinance theme from last week, I came across a paper by Mahmoud El-Gamal, Mohamed El-Komi, Dean Karlan and Adam Osman which developed and tested a Grameen model and a "bank-insured RoSCA" in Egypt to see whether one was superior to the other in attracting clients and ensuring repayment.  The bank-insured RoSCA (rotating savings and credit association) is a slightly modified form of the traditional RoSCA where each participation contributes regularly and each period, one member receives the contribution.  In the modified form, the bank will collect a premium from the participants and if one of them does not pay the contribution, the bank will step in and make the payment and that participant will owe the bank.  It is viewed by the authors as a simplified credit union.  

Their test was focused on determining whether the RoSCA would lead to better, worse or the same take-up by participants, as well as whether it would lead to more frequent repayment.  To do so, they used real money in an experimental setting with participants who shared the same demographics as a typical microfinance client (in a country with a large enough Muslim population that a portion would be expected to turn down the Grameen loan because it required interest payments).  However, they did not include any factors that would affect the return on the investment that participants theoretically made (the investment was predetermined to have a certain return).

The reason for the higher frequency of repayment in the RoSCA model is that the loans between participants is interest-free. It will not benefit the participant to renege when the social cost of default is more than the amount of the loan (in the Grameen model, that tipping point is higher, at the amount of the loan plus interest).  In addition, when the social cost of default (which applies to the single defaulter alone) is lower than the loan amount, the bank (which guarantees the RoSCA, and to whom the defaulter becomes a debtor) can raise the cost of the penalty (which applies to both participants) to a level where default by a participant no longer becomes attractive.  

In practice, this was borne out in their field experiments.  The RoSCA attracted greater levels of participation and also had lower probability of default, which is what the game theoretic model predicted.  It creates one data point, albeit under simplified assumptions, for how a RoSCA could be used as an alternative to the Grameen model of microfinance, and perhaps even expanded in the future into larger, more formal financial institutions similar to credit unions.  It will be interesting to see what research develops out of this paper--either from the co-authors or from other researchers.  

Link: http://www.uh.edu/%7Eachin/workshop/EMF-04-11.pdf

What will replace the property bubble in the GCC?

One of the trends in Islamic finance outside of the GCC (and excluding Malaysia, which has a thriving local Islamic finance industry) is that countries, fund managers and companies are eager to tap the financial resources of the GCC countries, particularly when oil prices are high and funds are entering the GCC seemingly faster than they can be deployed. Another factor in the flow of funds from the GCC to the rest of the world is the need to diversify (both geographically, but also the relative scarcity of investment opportunities locally. There is also some movement of funds internationally to take advantage of non-real estate based private equity and venture capital (look for an article in this coming week's Islamic Globe on a development in the U.S.).

This theme of funds flowing out from the GCC and being sought out by countries, companies and fund managers internationally is not solely the domain for Shari'ah-compliant investments; it is probably larger on the conventional side. On the Islamic side, two recent countries vying for a piece of the GCC investment pie were Indonesia, which is trying to attract both money and expertise in Islamic finance, and Russia, whose region Tatarstan is considering issuing a sukuk focused on attracting foreign capital from the GCC.

With the sheer amount of capital flowing into the GCC (and mostly into the hands of a few wealthy individuals and sovereign wealth funds), there are probably good reasons why international investments are likely to be able to attract this capital (and benefits for the GCC from this occuring). However, the more that international investment opportunities are able to attract GCC capital, the slower the region will be to developing a domestic financial sector as well as capturing the spillover in other areas from regionally-focused investment firms.

The main impediment to the deployment of capital in the region is that there is still too much dependence on oil for a big chunk of the GDP in many of the GCC countries. Because of the large oil wealth (and relatively under-developed public goods like a proven legal system), there has not been as much progress on creating a private sector outside of the energy sector. Even within the energy industry, there has been a significant reliance on expatriate workers, which is fine on its own, but when combined with the underdeveloped private sector outside of energy, you see the levels of unemployment (particularly youth unemployment) which hurts future prospects for non-energy-related sectors.

Some countries have found industries in which they can grow; Bahrain (at least until the recent protests and martial law) had developed a large financial sector while Dubai developed itself as a real estate/tourism capital with a significant role in international trade through ifs port. However, each has its own limitations and does not on its own create a sustainable, diverse economy that would generate a diverse enough set of investment opportunities to keep more of the money generated from natural resources locally.

Then there is the financial sector locally, which does not have a stellar track record post-crisis (not alone in that regard in the financial industry). Too much of the money invested locally went into real estate, which created a bubble at least as significant as the subprime-fuelled bubble in the US (all real estate is local, so there were some exceptions). The key point for Islamic finance with this is that the real estate bubble did not have nearly the same conventional focus as it did in the U.S. The blow up in real estate (e.g. in Dubai) was due much more to sky high prices than it was to derivative products magnifying the extent of the growth in prices.
For this reason, Islamic banks--particularly investment banks--had a much greater exposure to this real estate bubble than they did to the U.S. bubble. Like conventional banks, they had extended credit to real estate developments (either directly or through "private equity" transactions) with the expectation that prices could keep risisng. When they stopped rising and began their precipitous fall, the investment banks shrivelled. With the real estate bubble gone, many of these investment banks and particularly the ones with a focus mostly on real-estate driven "private equity" have struggled to find a way to generate revenue.

Now, without a property bubble to generate investment activity locally and with the spigots opening anew with rising oil and natural gas prices, the capital is accumulating and it needs a home. The Islamic financial institutions (like conventional banks) are returning to growth slower than the flow of funds, so there is a greater and greater share that will need to be invested internationally. Thus, the countries, companies and fund managers internationally have returned to make a 'pitch' to the GCC to invest the funds in banks in Indonesia, regional governments in Russia and private equity funds in the United States (among others).

The downside to the GCC if this persists and nothing more sustainable is developed post-real estate bubble is that the funds will not benefit the local economies as much as they could if found a home developing non-energy-related industries locally. So, while much of the capital from the energy resources is being invested internationally, there should be a continued focus on greating local industries--particularly new small businesses--that will be able to absorb some of the capital and create a relatively larger impact in terms of employment than large, capital-intensive businesses like downstream energy business or financial services.

Introducing AAOIFI to the YouTube generation

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), a standards setting body for the Islamic finance industry held its annual conference in Bahrain recently. In an article describing the conference, there was as much focus on the topics covered as the number of attendees, which did not decline from last year despite "worries by the recent unrest in the kingdom, according to AAOIFI deputy general secretary Khairul Nizam".

What has not been mentioned, but is striking for an industry body that is very influential in shaping the standards under which the Islamic finance industry operates, is the lack of availability of details of the conference discussions, beyond the list of topics covered. Even here, the topics were listed in English, but the bullet points were all in Arabic. This is understandable for a conference taking place in an Arabic-speaking country; however, it is not understandable for an organization which has influence over an industry with a global scope whose working language is English.

Even less understandable is why the standards issued by AAOIFI have not been made publicly available on the organization's website (in contrast, the Islamic Financial Services Board (IFSB), does make its standards freely downloadable on their website). The explanation I have heard for why AAOIFI does not put its standards on its website is that selling the books containing the standards is a key revenue source for the organization. This is unacceptable in a globalized world where internet access is ubiquitous and transparency is lauded.

Without making the standards publicly available except to those who purchase the hard copy, there will be far less public scrutiny and understanding about what AAOIFI standards cover and what they do not, and in particular, public discussion (even within the industry) about how they can be improved. AAOIFI was initially an accounting and auditing standards body, so most of its standards would not have been significant to those not directly involved within the industry. However, AAOIFI has expanded its remit into areas of corporate governance, codes of ethics and Shari'ah standards, which are areas of concern to people who are not Islamic finance practitioners.

For example, how is an investor in a publicly-traded Islamic bank supposed to compare different institutions based on their public reporting of governance, ethics and Shari'ah standards if they cannot look at the source document for the standards those institutions are supposed be following? The Shari'ah board is a natural (but not flawless) check for the Shari'ah standards, but in other areas there are gaps where the standards themselves are not well known and AAOIFI does not have enforcement powers over its members.

This is untenable when Islamic finance expands across borders. AAOIFI members are in many countries and the local regulators are responsible for most of the regulation, but there are global standards being developed that are not publicly available for investors in these institutions to have easy access to. The investors are likely to provide some form of supervision if the regulators fall short, which has been the case in many developed countries in finance recently. There may be some capable regulators in some emerging and frontier markets, but when there are such serious lapses in developed countries regulatory systems, it makes no sense to reduce the ability of investors to police Islamic financial institutions by making it more difficult to see the standards under which they are supposed to be operating.

It may be an uphill battle to convince AAOIFI to put its standards on its website in PDF format (they can still sell hard copies and it is likely that many Islamic financial institutions will buy them). However, it would be a start for AAOIFI to put much more detail about the recent conference on its website, whether that is the presentations made, transcripts of speeches or video of the conference in its entirety for the YouTube generation of Islamic financial market participants.

UPDATE (6/2): When contacted by email, Khairul Nizam, the Deputy Secretary General of AAOIFI said they are working on putting the slides and papers from the conference on their website and they would be up "in the next week or so".