Sukuk not dented by MENA region unrest

I have seen several articles, but one recently from The Asset magazine, that attempt to contrast the protests across the Middle East and North Africa with the resurgence of the sukuk market.  I think this misses one very significant point about the sukuk market that makes the analysis somewhat flawed: there is not a "sukuk market", but instead there are many "sukuk markets". 

The geographical spread of sukuk is not terribly great but it is growing by the day.  However, the most imporant thing to remember is that despite the convergence to some degree in Shari'ah standards between the Gulf Cooperation Council (GCC) and Malaysia, the two markets are driven by different factors and are at very different stages of development. 

Returning to the article, it begins by stating that "So far, the market is riding out the political storm in the Middle East and parts of North Africa.  This is likely because, with the exception of Bahrain, the crisis is playing out in countries with virtually no Islamic finance activities - Syria, Yemen, Egypt and Libya".  I would say that this statement on its own is misleading because of Bahrain as a hub for Islamic finance, particularly for the international financial institutions involved in the industry.  Bahrain is also home to the standards setting bodies like AAOIFI and IIFM.  So, noting Bahrain as an exception misses the significant impact of disruptions in that country would have to GCC sukuk markets.  Finance, both conventional and Islamic, accounts for more than a quarter of Bahrain's GDP. 

Then there is the hangover effects of the financial crisis which are being resolved, but which still account for a drag on the Islamic finance industry in the region.  Dubai's debt crisis is well known, but other countries had problems like Kuwait and Bahrain, whose Islamic investment banks suffered greatly due to the crisis even before any hints of protests arose.

The reason the sukuk market has continued to do well is because of the resurgence mostly of Malaysian sukuk markets.  Malaysia was initially hit harder by the financial crisis, but also recovered more quickly than the GCC.  The Zawya quarterly sukuk bulletin is a good source of data on sukuk, and using data from 2010 and 2011, the GCC sukuk markets were not hurt by the protests in the first half of 2011, but neither did they lead the recovery--in fact, they were weaker in 2010 (GCC sukuk accounted for 13% of the $52.5 billion in sukuk issued), while in 2011 the GCC accounted for 29% of the $43.3 billion issued year to date. 

In December 2010, I wrote a piece on my blog titled "What is wrong with the GCC sukuk market?".  In that post, I compared the depth of the Malaysian sukuk market (using sukuk issuance as a percentage of GDP) to the GCC market and found a significant difference.  If GCC sovereigns and corporates issued sukuk representing as large a share of GDP as in Malaysia, the total issuance should have been $184 billion ($6.9 billion were issued in 2010).  That is a big gap that should wipe away any methodological mistakes I made in the estimates. 

The reason the sukuk market globally has been resilient in the face of unrest in the Middle East has something to do with the geographical breakdown of Islamic finance in the region, but much more to do with the sukuk market 3,400 miles to its east in Malaysia.  The Malaysian market has grown stronger on the back of a rising Ringgit and government support for the industry.  It has even attracted issuers from the GCC who are now choosing to issue sukuk in Malaysia instead of their home markets.  As I concluded my blog post in December 2010--something which remains true today--"until the GCC markets are "fixed" (or an alternative market like the Luxembourg Stock Exchange becomes the go-to location for sukuk issuers), there will continue to be a large gap [between the GCC and Malaysia for sukuk issuance]".

Int'l Islamic Liquidity Management Corp to issue $200 to $300 million product this year

Bernama released an article based on an interview with CEO Mahmoud AbuShamma of the International Islamic Liquidity Management Corporation (IILM), which was established in October 2010 (and launched at the beginning of 2011). The IILM was established to provide short-term sukuk to global Islamic financial institutions for use in their liquidity management. Currently most Islamic financial institutions hold excesses of cash and use inter-bank murabaha (mostly) to manage their liquidity needs. Some countries (e.g. Malaysia, Bahrain and the UAE) have set up their own local currency denominated short-term instruments and all have seen strong uptake. However, there has not been any short-term sukuk issued by any institutions that are denominated in the global reserve currencies like the US dollar and are backed by supranational institutions.

The IILM has been quite mum about its own product and it remains largely unspoken now, but there were a few new pieces included in the article. The IILM now is hoping ("if all the systems have been put in place and the infrastructure is ready and the market conditions are suitable for the issuance"--a lot of 'ifs') to issue the first short-term sukuk denominated in US dollars for $200-$300 million by year end 2011. After the inaugural issuance, further sukuk will be issued "when needed by the market" and the IILM will consider issuance in other (local) currencies "depending on the requirements of the market" according to Bernama. The local currencies would presumably be those currencies that are used in the countries whose central banks are members of the IILM: Indonesia, Iran, Kuwait, Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Saudi Arabia, Sudan, Turkey and the UAE.

While I describe the issuance as a "sukuk", the term is not used once in the entire article, instead describing it as "short-term liquidity products", which could mean the instruments will not be a tradable sukuk, but will instead be structured along the lines of other short-term products; Bahrain issues sukuk al-salam and sukuk al-ijara while the UAE Central Bank uses a commodity murabaha (as well as offering Islamic repo transactions using a commodity murabaha collateralized by the Islamic CDs that are themselves based on commodity murabaha).

There is still much work to be done and no certainty of issuance in 2011 given the careful hedging of the launch date by the IILM CEO (see the list of 'ifs' above). However, it is a step forward for the industry that this institution has come to form so quickly from its establishment (how long has an Islamic 'mega bank' been just over the horizon?) and the fact that the original idea for an institution similar to the IILM was "mooted by the Islamic Financial Services Board High Level Task Force" in the fall of 2008.

Sukuk have record first half

Zawya and KFH Research separately have announced that the first half of 2011 had the highest level of sukuk issuance compared to comparable periods (Zaywa reported $43.8 billion, KFH reported $47 billion).  For comparison sake, $34.3 billion was issued for the entire year of 2007, the pre-crisis peak (according to an Ernst & Young Trend Analysis in the Zawya Sukuk Report released in 2009).  The return to growth in sukuk markets is a good development, but there is still some concern about the sustainability of this growth.  For one thing, most of the growth has occurred in Malaysia; the GCC has not participated nearly as much.  Of the GCC issuers, most have been sovereign or government-related entities and many issuers have tapped Malaysia's more liquid sukuk market for financing rather than issue in their local markets. 

This is good news for Malaysia, which had been largely domestically focused in Islamic finance, in part because of differences in Shari'ah standards. However, the standards, which are viewed as more permissive in Malaysia, have allowed for more cost-competitive products, which have led to much deeper secondary markets (aided by government involvement in promoting the industry).  Now that sukuk that conform to GCC standards are being issued in Malaysia, they can maintain the Shari'ah standards prevailing in the GCC while also tapping the greater liquidity that has developed over the past 20-30 years. 

The growth of Malaysian sukuk markets for local issuers as well as foreign issuers is even more important with the UK seemingly stalled on legislation to facilitate government sukuk, the US non-existent and other developed countries either moving slowly or not at all (e.g. South Korea for religious reasons, Japan for economic reasons and Europe because of the focus on resolving sovereign debt crises).  For now, sukuk remain largely an emerging market phenomenon and this doesn't seem likely to change any time soon (it may even be further off on the horizon than it was a year or two ago). 

Islamic investing 2.0

Writing in Gulf News, Rusdhi Siddiqui runs through the equity screening criteria for Islamic stock indices and concludes that there is nothing exclusively "Islamic" about the process of "doing good by avoiding the bad". He concludes: "Islamic investing does not have a monopoly on doing good, by avoiding the bad, its common shared values with all investors of conscience".

I would go one step further and say that for equity investing in public companies--which as he notes includes companies like ExxonMobil, Nestle, Microsoft, Johnson & Johnson and Novartis--Islamic investing is far behind the curve in terms of ethical investing.

For example, consider the Calvert Funds, a well known socially responsible investing fund. Their screening criteria is similar in terms of what is excluded: firms engaged in tobacco, weapons, alcohol, gambling, human rights issues and nuclear. These have significant overlap with the Islamic screens used across the industry (with the additional exclusion of companies with poor human rights track records and those engaged in the nuclear industry). From this "doing good by avoiding the bad" strategy, Calvert adds another set of criteria: governance and ethics, environment, workplace safety, product safety, human rights, indigenous peoples' rights and community relations.

These criteria add another level of screening. Calvert not only avoids the companies engaged in socially detrimental industries, it also screens the companies that pass its 'negative' screens to ensure their businesses are conducted in an ethical way. This is something missing today in Islamic finance. All the focus is placed on avoiding companies that generate significant revenue from 'bad' industries, but doesn't ask how the companies generate revenue from the acceptable industries to determine whether they conduct business in an ethical way.

This should be an area where Islamic investing focuses because of the often-stated idea that Islamic finance supports a more ethical economy. How is this verifiable if there is no screening of companies in acceptable industries to see whether they make products that harm people, whether they deal fairly in their employment practices, have adequate corporate governance to ensure shareholders' rights are protected and there are no 'ticking timebombs' of unethical behavior (e.g. the failures of management at News Corp to stop the hacking of individuals' voicemails and bribery of police).

That leads to the final area where firms like Calvert go beyond the Islamic investing standards. When there are problems at firms in the additional criteria, investors' voices should be used to force changes through shareholder advocacy. As far as I know, most Islamic investing companies take passive positions where they could be more active and try to advocate for changes that make the companies they invest in make positive changes like avoiding certain areas of business, avoiding taking on additional debt, improving corporate governance and disclosures.

Yet, they do not. Most Islamic investors are concerned with 'avoiding the bad' but do not widen their screens to favor companies that are leaders in their industry in corporate governance, human rights, or more generally in conducting an ethical business. If Islamic investing does not adopt the 'best practices' for sustainable investing, then it is unlikely that the companies in which they invest will adopt 'best practices' in terms of sustainability.

Securtization, financial engineering and regulation

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

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

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

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

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

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

The rise of istithmar sukuk

From my newsletter:

On June 20, 2011, the Malaysian central bank, Bank Negara, unveiled its newest liquidity management product, although few details were offered. In the first auction on the following day, Bank Negara sold RM500 million.($165 million) of the 1- to 3-year sukuk. The product itself is based on the istithmar structure, which combines other receivables from murabaha as well as ijara transactions. In general, under AAOIFI rules, the portfolio must have at least 33% ijara sukuk in order to be tradable, although in many cases, a more conservative interpretation is used where 51% of the portfolio must be ijara.

It is always interesting to see new Shari'ah-compliant liquidity management products come out with different structures (istithmar, commodity murabaha, salam and ijara are the ones I have run across). However, beyond the liquidity management space, the istithmar structure is becoming more widely used with institutions like the Islamic Development Bank. The International Finance Corporation used a similar wakala (agency structure) which securitized a portfolio of other contracts.

The thing that I find about this interest in istithmar sukuk is that it (and/or wakala) have potential to replace mudaraba and musharaka sukuk, which were used (and misused) extensively before the financial crisis and the AAOIFI ruling clarifying the rules around the buyback clauses used at maturity of those sukuk. There may be less concern about misusing structures (or misapplying their rules) in an istithmar sukuk (compared with a mudaraba or musharaka) because the former type is designed to be specifically an investment portfolio, where latter is commonly associated with venture financing (either providing financing from one party in mudaraba or through a joint-venture financing in a musharaka).

It will remain to be seen how much uptake their is in the istithmar sukuk structure but they are likely holding many ijara and murabaha assets on their balance sheets that could be securitized. It will likely depend on whether they have sufficient ijara assets to match up with murabaha to get to the threshold to make their sukuk tradable.

As I re-read the newsletter, it occurs to me that the entire area of securitization has largely passed Islamic finance by, although it would be a natural source of new sukuk were Islamic banks to pass on their risk and return to investors. However, the likely reasons for the absence of securitization (with a few exceptions) is the absence of standardization of the contracts for securitization, as well as the collapse in the securitization market that occurred just as the sukuk market was reminded of the rules around mudaraba and musharaka sukuk, which had been widely used (and as I mentioned, misused).

Now that the securitization market is coming back to life in the conventional market, it would be a good time to look towards pure securitization. It has the "ideal" structure (in the eyes of many) of making investors participate in both the risk and reward, would allow for the relatively quick creation of a lot of new sukuk in a market that has been coming back strongly from the credit crisis and the istithmar and wakala structures are much better vehicles, at least on a high-level view view, than mudaraba and musharaka, which were somewhat co-opted for creating sukuk based on a pool of financial assets.

There are, of course, some caveats. The first would be to find and address the reason why Islamic banks are reluctant to securitize their assets. Perhaps they believe that they will be more highly rewarded by holding the assets themselves, although that creates additional risk within the system as a whole. Or, perhaps, the infrastructure for creating cheap securitizations does not exist. Compared to the first possibility, this would be the best case. The International Islamic Financial Market (IIFM) is already reported to be working with Hawkamah on a standardized contract for ijara sukuk.

There is also the ever-present risk to investors that Islamic banks will securitize their bad assets and keep the ones they believe will perform the best. Given the ability of some Islamic banks (Gulf Finance House is the best known name) to use questionably ethical business models, the potential for Islamic banks to dump risky assets into securitized sukuk risks creating Subprime (v.Islamic). Perhaps the Western Islamic banks could take the lead in developing the infrastructure for Islamic securitizations.