Can Islamic finance return to the basics?

There was a very good opinion piece by Dhafer Alqatani that looked at the potential for standardization of the Islamic finance industry.  The key paragraph in the article was:

Shari’ah-compliant products and services have to be repositioned, where those products and services should be revisited, reviewed and consolidated as well as documented, thus establishing stronger foundations by going back to the basics which will pave the way to standardization and eventually the globalization of uniform structures and formats that are Shari’ah-compliant and acceptable to the critical mass, both Muslims and non-Muslims, without compromising the industry’s authenticity and integrity. 

The important point is that Islamic financial institutions should go "back to the basics".  Last week, I spoke at the Financial Management Association's Annual Meeting in Denver and one of my fellow panelists (from the World Bank) addressed the question of whether Islamic finance is more resilient and lower risk than conventional finance.  His conclusion was that it is not a foregone conclusion that the Islamic finance industry was lower risk because when you look at the structure of sukuk, for example (he showed the Nakheel sukuk), they are incredibly complicated financial instruments and that complexity is itself a risk (just as the complexity of the mortgage-based products that triggered the crisis posed a risk). 

The underlying reason I think that this complexity has arisen is because the Islamic finance industry has focused on creating financial products in a way that they are Shari'ah-compliant, rather than starting from 'first principles' of finance (i.e. what need are they addressing) and looking at how Islamic finance can meet these needs.  To some degree it was unavoidable that financial engineering to create "Islamized" versions of conventional financial products became the standard practice for Islamic finance because the institutions doing it operate in conventionally-dominated financial markets with regulations designed around the conventional finance industry.

However, it does not necessarily have to always be this way.  Where my views differ, however, is that I think a top-down approach will take too long and involve too many conflicted parties to be workable.  I think the better approach is more bottom-up.  It is much easier for one financial institution to change the way it thinks about offering Islamic financial services than to change the entire industry in one fell swoop.  After some controversy around the bai bithamin ajil (BBA) in Malaysia, there was a divide with some banks deciding to curtail their BBA activities, while others said they would continue to use BBA.  The difficulty in the bottom-up approach is about how it gets started, and I don't have a solution to that problem. Ultimately, it will be driven by market demands for alternatives to the products being offered today.

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

S&P disconnect on Islamic finance

One of the longstanding themes of coverage of Islamic finance is that it will grow rapidly once it starts to be tapped to fund infrastructure projects.  This may be the case--one could reasonably expect some of the money in the GCC looking for a long-term, relatively stable investment (not to mention something which is needed in many areas)--but when S&P takes this type of thesis one step further to suggest that Islamic finance (sukuk in particular) would be well suited for funding the $8 trillion in infrastructure projects needed in Asia over the next decade, it might be one step too far. 

What is this really saying?  Is there really demand enough among Asian investors for $8 trillion in new sukuk during the next decade.  That's $800 billion, more than 10 times the likely issuance this year.  S&P does not suggest that Islamic finance will play a "key role" in funding the infrastructure projects.  Perhaps the phrase "Islamic finance" might just be a way of saying "oil money from the Middle East". 

Ok, perhaps I'm too cynical about S&P's analysis.  But they finish the press release: "In our view, Islamic finance would be a good match for financing Asia's infrastructure funding gap, especially sukuk bonds. The Sharia principles governing Islamic finance ban speculation and specify that income must come from shared business risk. What's more, Islamic finance is based on the concept of asset-backing." 


S&P, a company that has standards for rating different types of sukuk--asset-based, asset-backed and other--yet it falls into the same old "Islamic finance is based on the concept of asset-backing".  When I see simplistic (and incorrect) descriptions of Islamic finance used by people or organizations who should know better, it makes it more likely in my opinion that the article found an area where there is a funding gap, noticed that there are large flows of capital into the GCC and used Islamic finance as the link between that supply of and demand for that money.

Derivatives trading in Islamic banks

I was reading through an article from a few weeks ago from Reuters about Kuwaiti banks involvement in derivatives trade in a way that might put depositors' money at risk and which lies (as I read it) outside of the central bank's regulatory oversight.  The banks concerned are the National Bank of Kuwait and Kuwait Finance House. The former is a conventional bank that has an Islamic window, while the latter is an Islamic bank with a long track record in Islamic banking.  The statements from the banks were:

Bank 1: "[The bank] does not engage in any derivative trading at all and has no exposure whatsoever to these instruments"
Bank 2: "[The bank] is fully committed to the laws and regulations of the supervisory authorities and all the procedures governing banks, and has no dealings that violate or circumvent the supervision of the Central Bank of Kuwait"

Can you guess which bank is which?  I would imagine that most readers would pick Bank 1 as KFH because derivatives (in their conventional form) are not permissible, but most readers (and me to be perfectly honest) would be wrong.  Bank 1 is NBK.  The bank providing an evasively unspecific response was KFH. 

The Islamic finance industry has developed Shari'ah-compliant versions of derivative products, as they should, to deal with interest rate (profit rate) risk, currency fluctuations, commodity fluctuations, but the idea often given for why Islamic banks are better than conventional banks is that by the nature of the Shari'ah standards they adopt, they should be more transparent, and should adopt simpler products to perform their role as financial intermediaries. 

Regardless of whether KFH uses derivatives (they probably should be since they have operations in Kuwait, Turkey, Malaysia and elsewhere), statements like what KFH provided do nothing to provide outside observers such as this blog with any confidence that they are transparent in how they operate.  That more than anything is increasingly important when competing with a conventional financial industry that has lost the public's trust due to hidden liabilities. 

The well known financial commentator from the UK in the mid 1800s Walter Bagehot pointed out that when a bank is arguing over its solvency, it has already proven to the public that it is not solvent (and in the days before deposit insurance) this usually led to a run on the bank.  Today, while bank runs do happen, they are much less of a risk.  The issue at the heart of Bagehot's argument was that once a bank loses confidence of the market or its customers, it is impossible for it to convince people to restore that confidence.

In today's world of Islamic banking, the issue of confidence is much more concerned with the bank's reputation as an "ethical" institution.  There have been many examples of that confidence abused and punished (Gulf Finance House comes to mind).  KFH should not tread down the path where it cannot come out unequivocably and state that it either does not use derivatives (like NBK) or that, while it does use (Shari'ah-compliant) derivatives, these are done for the purpose of risk management and in full compliance with its regulatory requirements.  KFH took the third way of not acknowledging whether or not it uses derivatives but stating without clarification that it acts in compliance with regulatory requirements. 

This is the "trust us" path that asks for confidence without refuting the allegations against it.  In a climate where banks are suspect and Islamic banks try to keep above the fray by deferring to their "ethical" underpinnings, this is a risky strategy.  Evasion does not often win friends or confidence. 

Sukuk markets not resilient in the middle of the financial crisis

I was a bit surprised to read the statements of the NCB's Chief Economist about the sukuk market and the financial crisis:

"Sukuk market proved resilient in the face of the crisis, with funds raised through sukuk issues grew from $2.8 billion in 2001 to $53.2 billion in 2010 and even during the tumultuous period of 2008-2009 funds raised from sukuk increased significantly, NCB Chief Economist Dr. Jarmo Kotilaine said at the 7th World Islamic Funds Conference held recently in Bahrain"

 I thought that the denial that the financial crisis impacted Islamic finance had died out amidst the vast evidence that the statement was just not true.  Yes, it is true that sukuk issuance grew significantly from 2001 to 2010, but it is false to claim that it grew uniformly through that period and even more false to claim that sukuk issuance "increased significantly" in 2008-2009.  The first thing I had on hand was Zawya Sukuk Report for data on sukuk issuance.

In 2006, $19.5 billion in sukuk were issued.  In 2007, it rose to $34.3 billion.  However, it then fell to $15.5 billion in 2008 and through the date of the report, $16.2 billion were issued in 2009 (the report was released in the fourth quarter of 2009).  How is it possible for anyone to claim that the 2008-09 performance represents a significant increase.

The period of 2008-2009 included in the report (which is likely to include most of the period) was $31.7 billion, which is lower than the 2007 total (and remember that the sukuk market did not really begin to falter until the second half of 2008).  To hear such statements being reported (unless the reporting is inaccurate) is disheartening.