German bond auction failure could not be 'cured' with sukuk

An Arab News article from Mushtak Parker begins:

"Sovereign Germany might be disappointed that its recent Eurobond offering was not fully subscribed. Perhaps in hindsight, had it instead opted to issue a debut Eurosukuk for the same amount, the story might well have been different.

Sukuk issuers, whether conventional entities such as HSBC Middle East or Goldman Sachs (both of which tapped the sukuk market in 2011, or Islamic banks, agree that market conditions in the sukuk space is more favorable than in the conventional space. And this confidence and appetite for Sukuk is backed by rising demand from big institutional investors in the Middle East and Asia.

Despite a difficult global financial climate and the continuing euro zone sovereign debt crisis, sukuk issuance has shown a remarkable resilience over the last year or so, with origination - both sovereign and corporate - gaining a second wind over the last few months if not weeks. Investors in sukuk in general are proving to be all-weather friends with their healthy appetite for such instruments, rather than their fair weather counterparts in the conventional bond market."

The story of Germany's 2 billion euro auction, where 35% of the issue was not subscribed would not have been  any different if it had been a euro-sukuk.  There is nothing special about Islamic finance or sukuk that make it more likely for investors to buy a sukuk from an issuer than they would a conventional bond because, when the economic structure of the transactions are examined, there is not much difference between sukuk and conventional bonds.  The only caveat to this statement is that some investors are constrained to only invest in Shari'ah-compliant instruments, but those buyers make up a relatively small portion of the total funds available to purchase in the primary markets.

The idea that Islamic finance can run to the rescue where conventional finance 'fails' is just as silly an idea as the idea that was all too common 3 or 4 years ago when people asserted without justification, that Islamic finance was 'immune' to the crisis.  This proved false, and it is equally as false to say that if Germany had gone with a sukuk instead of conventional debt it would have filled the full offering of its bonds.

Right now, Islamic finance does not offer a different product, it just is in a different form.  Sukuk are economically identical in most cases to conventional bonds, in order to re-structure the bond into a trade-based form.  This is not a value judgment on sukuk; they are in demand and are giving some companies new capital markets they can tap, but they do not change the underlying economics of the transaction.  In Germany's case, the bond issue failure was not a question of demand for German debt--if it were, the yields on bunds would have spiked (they haven't).  It was likely an isolated incident reflecting general debt market stress within the Eurozone.

Bringing a sukuk instead of a bond does not change the underlying situation in Europe and, if anything, would probably lead to lower demand for the bonds because of the difficulty of educating investors on how sukuk work.  Regardless of the issuer, however, it is unlikely that an issuer of any kind could bring a 10-year, 2 billion euro ($2.7 billion) sukuk to market.

The resilience of the sukuk markets during the eurozone crisis has more to do with the relative absence of direct exposure to Europe, where there are very few issuers, and is a reflection of the continued strengths of the GCC and other emerging and frontier markets where the economies are still (for the moment) strong.  In addition, a high oil price keeps the liquidity flowing in these regions giving investors the capital needed to invest in sukuk.  If the oil price slips because of the euro crisis and developed markets' economies (and/or China) slip, it is highly unlikely that the sukuk train will keep on rolling.

We have seen the connections in the global financial markets and how financial market disturbances in markets disconnected from Islamic finance can spill over into Islamic finance through slower economic growth.  This was the story in 2007/08 when the subprime mortgage crisis in the US led to financial markets freezing up and a widespread economic downturn leading to a near-collapse in the sukuk markets.  It is a waste of time to try and promote the idea that Islamic finance is somehow a panacea to all the financial market ills.

Islamic finance complexity (Part IIe)

After thinking a lot about how products are structured, I am moving onto some real-world breakdown in the actual balance sheet balances of some Islamic banks to translate the ideas of how they design their products into how they are actually represented in terms of the bank's liquidity profile.  To do so, I picked one country (the UAE) to limit the differences between banks caused by different countries, different regulatory environments, etc, and focused just on the "Liabilities" items in the balance sheet at one point in time (December 31, 2010 for all except for Ajman Bank, which only had annual financial statements through the end of 2009).

The liabilities section is, in rough form, broken into three categories of liabilities: deposits, inter-bank borrowings and other liabilities (e.g. longer term liabilities like sukuk).  In general, deposits made up the vast majority of the Islamic banks' liabilities that I looked at, ranging from 76% to 85%.  Within the deposits, there were a few main types (current accounts, savings accounts and investment accounts).  Most of the banks had just one type of investment account, which I am guessing is almost universally mudaraba-based profit-sharing accounts.  Two banks (Al Hilal Bank and Emirates Islamic Bank) which had another category of deposits, wakala.  The banks in general used "investment accounts" as their primary funding source, representing around 60% of total liabilities (three-quarters of the deposits), although this wasn't universal.

The real difference between the banks (only two banks offered this detailed breakdown, unfortunately) came with the maturity of the deposits.  Dubai Islamic Bank had more (about two-thirds) of deposits in short-maturity or demand deposits, while Al Hilal Bank had more mid-range (3-6 month) deposits (about one-half) compared with the remainder split between longer-term (>1 year) and short-term funding (<3 months).  The split between short- and longer-term deposits is more of a business decision, than it is something that goes to the heart of how Islamic banking differentiates itself .

However, with the limitations on Islamic deposit insurance, the maturity of deposits can be a factor in how resilient an Islamic bank is to future banking system problems (longer maturity giving more protection against runs on the bank becoming destabilizing). The offsetting factor (for the bank) is that longer-term deposits are more expensive than short-term deposits, and that will be true whether the bank is Islamic or not because in practice, deposit accounts are not entirely pass-through, and also must offer rates of return that are competitive with conventional banks.

The other two areas of liabilities on Islamic banks' balance sheets varied bank to bank to fill the remaining 15-25% of the liabilities with some having more in inter-bank financing while others had longer-term liabilities like sukuk or the Central Bank wakala financing that was provided to banks during the Dubai debt crisis.  However, in general, the larger the bank the less reliant on inter-bank financing, although the three largest banks (DIB, ADIB and Emirates Islamic Bank) all had wakala financing from the UAE Central Bank, which skews the relative shares.

Removing the wakala financing from the Central Bank (assuming it was replaced with inter-bank financing) removes the previous relationship between longer- and shorter-term other (non-deposit) liabilities between larger and smaller banks (the smaller banks being Sharjah Islamic Bank, Al Hilal Bank and Ajman Bank; Noor Islamic Bank does not put financial statements on its website).  The ratio of short term to the sum of short- and long-term non-deposit liabilities is the metric I looked at (moving wakala financing from long- to short-term) ranged from a low of 29% to a high of 87%.

The sample I chose was purposefully non-representative to try and limit the fluctuations due to country-specific factors, but a few trends emerge.  First, most banks have deposits as the largest source of their funding, which is probably good because it is lower cost than sukuk and less volatile than inter-bank financing.  The one exception to the stability of bank deposits is in a banking crisis and the UAE Central Bank did what central banks are supposed to do in a crisis: they lent freely on more costly terms than they normally would (the wakala is convertible into equity).

In the non-deposit liabilities, the wide range of splits between inter-bank financing (short-term) and longer-term financing like sukuk was mostly explained by the difference between banks that had sukuk outstanding and those that didn't.  The banks with sukuk outstanding had lower reliance on inter-bank financing than banks that did not issue sukuk.  This suggests that one way to mitigate the reliance of banks on short-term inter-bank financing is to further develop the sukuk market, especially finding structures that don't require physical assets, but can fund longer-term assets on the balance sheet with longer-term funding.

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

Islamic finance complexity (Part IId)

From my newsletter (subscribe on the left side of my blog):

I was just reflecting on the types of deposit products available from Islamic banks and there are generally four: qard, mudaraba, wakala and murabaha.  There are costs and benefits associated with each, both from a theoretical perspective as well as in practice.  

In much of the theory of Islamic banking, the mudaraba deposit product is widely viewed as being superior because it is a profit-and-loss deposit.  On similar lines a wakala deposit also requires the deposit to bear losses on the investments for which their deposits are used to fund.  A qard deposit is also in theory perfectly acceptable because no return is provided on the funds in exchange for the safety of the principal amount.  A murabaha deposit would be viewed in this light as being inferior because it replicates a conventional time deposit where principal is guaranteed (at least as far as the bank stays in business) and a return is provided to the deposit.
However, the way Islamic banks operate change the equation.  The qard product is not affected; it works the same way with no return and safety of principal, and is not too different from how many demand deposit accounts function today with the global zero or near zero interest rate environment.  In a more normal situation, the qard deposit product would probably be viewed as less competitive because of its zero return and would not provide a sustainable funding base for Islamic banks because it would be hard to gather qard deposits except from people who want to have a safe place to keep their money and don't want to engage with a conventional bank (it is a great deal for the banks who receive a free source of funding, apart from the potential liquidity management issues that it creates).  

As things work, a mudaraba and wakala account does not function in the way it was envisaged because depositors are unwilling in general to bear risk of loss of their deposits.  Islamic banks have therefore used reserve accounts to even out the profit payments and protect the depositors from loss.  There is also an informal (as far as I know it is informal) promise by shareholders of the bank to subordinate their claims over profits to the depositors, so that any shortfall in profits would come out of the profits accruing to the bank to keep the deposit rates competitive in comparison with conventional banks.  There is, therefore a deposit product that is designed to be profit-and-loss sharing but in practice works more like a conventional deposit account where principal is protected and returns are stable over time.  

In contrast, a murabaha deposit account is not viewed as theoretically preferable, but in practice may be superior to mudaraba or wakala because the theoretical idea of murabaha (at least of a commodity murabaha) bears more similarity to how the murabaha deposit account works in practice.  Depositors lend money to the bank through a purchase and re-sale of commodities with repayment on a future date (which could be daily, weekly, monthly or any other frequency to meet the depositors' desire for liquidity).  However, the position of the depositors as creditors and the bank as debtor is much more similar to how Islamic deposit accounts actually operate than the more appealing (to many) wakala and mudaraba deposit.  However the same problems arise with murabaha in deposit accounts as in the rest of Islamic finance because it becomes more and more a replication of conventional banking products rather than a new way of thinking of the banking relationship.  

The picture is slightly different when there is an Islamic deposit insurance system, which I described in a blog post earlier today, where the deposit insurance can take away the tail risk of large losses for mudaraba or wakala depositors and make these more appealing than murabaha deposit products.  

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

Islamic finance complexity (Part IIc)

Wakala and murabaha deposits

Reading through the previous posts, I realized that I focused on only two of the four types of Islamic deposit products (qard and mudarba).  The other two--wakala and murabaha--should also receive a quick discussion. The wakala deposit product is very similar to the mudaraba, except that the profit accruing to the bank is determined differently.  In mudaraba, the bank receives a share of profit as mudarib, while in a wakala, the bank charges a fee for serving as the wakil (agent).  In both cases, the losses are supposed to be borne exclusively by the provider of funds (rabb ul-maal under mudaraba and muwakkil under wakala) but in most Islamic banks, there are reserve funds to preserve depositors principal to remain competitive with conventional banks and also to limit the likelihood of a run on the bank.

The other product, murabaha, is a more recent development and is often a commodity murabaha.  On the one hand, a murabaha is a useful product because it is not ambiguous like a mudaraba or wakala, in that the deposit is directly exposed only to the credit risk of being a creditor of the bank, rather than existing in a middle ground of being exposed to the risk of the investments made by the bank, but in practice, relying on the bank prudently creating a reserve fund to protect depositors funds.  On the other hand, the use of murabaha in deposit accounts further entrenches the product which is seen by many as less than desirable because it further enforces the idea that Islamic banks develop products that replicate conventional bank products.

Islamic Deposit Insurance

However, the main issue I have not yet addressed is Islamic deposit insurance.  The idea of deposit insurance is at first glance anathema to an Islamic banking system that is based (at least in rhetoric) on profit-and-loss sharing.  There are benefits to making rewards related to the risks, but in a bank, putting risks on depositors shoulders when those banks are competing with conventional banks is likely to hurt their competitiveness when there are no protections to depositors like deposit insurance (or to a lesser degree reserve accounts).

Depositors are generally focused on safety of their deposits and immediate access to their funds on demand, with returns (to keep pace with inflation) being secondary for most depositors with current (demand) deposit accounts.  Time depositors sacrifice immediate access to their deposits for some return to offset inflation, but  generally are not focused on high returns, especially if those returns put their principal at risk.  For both demand and time depositors, the safety of their principal is important and without some form of Islamic deposit insurance, a proportion of these depositors would move to conventional banks that can offer deposit insurance.

Without deposit insurance, the security of depositors' money is reliant on their faith in the solvency of the bank and its ability to properly accumulate enough reserves to offset the losses of funds that are invested on behalf of the depositors.  However, the confidence in the bank and its reserve accounts are likely to be highly correlated with depositors' faith in the solvency of the bank and if one is put at risk, there is a possibility for a bank run to start, which will turn doubts of confidence into a self-fulfilling prophecy (in some, but not all, cases).  Thus the need for deposit insurance.

There is limited experience with Islamic deposit insurance.  Most of the Islamic deposit insurance programs (detailed in a survey by the International Association of Deposit Insurer's (IADI) Islamic Deposit Insurance Group (IDIG) conducted in 2009) are either part of a conventional deposit insurance program entirely or are done with small changes to be Shari'ah-compliant.  The only fully Islamic deposit insurance program is Sudan because the banking system is (or was at the time) fully Islamic.

Two deposit insurance programs which I looked at were Bahrain's (run by the Central Bank of Bahrain) and Malaysia's (run by the country's deposit insurance agency PIDM).  The deposit insurance systems are different.  Bahrain's covers deposits, not including mudaraba deposits or other deposits not involving safekeeping or custodianship where the depositor would be entitled to share in profits and losses.  It is post-funded (i.e. deposit insurance assessments are only collected from banks when there is a failure) so there are no issues with how the deposit insurance premiums are invested (although the CBB website does indicate that a new deposit insurance program is under construction that would shift it to being pre-funded raising the issue of investing the premiums collected by the Central Bank).

PIDM, in contrast, does both collect premiums (it is pre-funded) and does cover mudaraba depositors in addition to deposit contracts based on custodianship or safekeeping (e.g. wadiah).  The deposit assessments are calculated in a similar way to conventional banks, but the premiums are held in a separate fund from those collected from conventional banks and are invested only in Shari'ah-compliant government investments (e.g. bonds, notes, bills issued by the Government or Bank Negara Malaysia, the central bank).

Since PIDM's deposit insurance program does cover mudaraba, it would be natural to assume that it limits the profit-and-loss nature of mudaraba deposits, but the deposit insurance program does not cover regular losses that would accrue to mudaraba depositors.  It only comes into play when a bank that is a member of the deposit insurance fund fails.  In order to not place return-generating accounts above those that do not generate a return for depositors, the wadiah and qard depositors are placed ahead of mudaraba depositors in the seniority of creditors of a failed bank.

The deposit insurance issue should be more aggressively developed now that the Islamic finance industry has the experience of surviving a global financial crisis.  It is probably luck more than just about anything that there were no bank runs on Islamic banks during the crisis, and in part also due to the ad hoc interventions by governments.  A deposit insurance program (operating under kafala bil ujr, a guarantee provided for a fee, like Malaysia's) is essential if Islamic banks want to compete with conventional banks while also avoiding being covered by conventional deposit insurance programs (which may lessen perception of their Shari'ah-compliance).

As the Malaysian program shows, deposit insurance programs do not offset any profit-and-loss sharing of mudaraba deposit accounts, except if the bank fails.  This is probably prudent because while depositors are likely willing to risk small fluctuations of their deposits in rare occasions (where the reserve accounts are not large enough), they are unlikely to accept the total loss of their deposits, and will move to conventional banks if that possibility is shown to be real by the failure of an Islamic bank somewhere in the world.

The existence of Shari'ah-compliant deposit insurance (deposit takaful?) will, I think, increase, rather than decrease, the profit-sharing nature of Islamic banks by taking the 'tail risk' away from mudaraba depositors. They will still have to have faith in the bank adequately maintaining a reserve account (something that the bank regulators should focus on), but it will make the returns generated from a mudaraba account seem worthwhile, even if small, because the unlikely event that they suffer a large loss has been removed.  For proponents of a profit-and-loss sharing bank system, this should be a priority, especially before murabaha deposits become the norm rather than qard, wakala or mudaraba that prevail today.

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

IILM delays first sukuk issue

The International Islamic Liquidity Management Corporation (IILM) has delayed its first sukuk issuance according to Zeti Akhtar Aziz, the chairwoman of the IILM and head of Malaysia's central bank.  She said that the first issuance would come in the next six months, while previous statements had said issuance would occur before the end of 2011.  However, progress is being made with a rating forthcoming.  The first issuance would be small, with follow-on issuance in the range of $2-$3 billion per issue in several currencies to meet demand, although in the past the IILM has stated that issuance would begin in US dollars and be followed by Euro issues with other currencies added as they were demanded by Islamic financial institutions. 

The key function that the IILM provides is short-term sukuk, issued by a body with a high credit rating to meet the liquidity needs of Islamic banks.  Banks generally take in short-term deposits and use those funds to lend long-term.  To remain in business, they need to have sufficient liquidity (i.e. cash) on hand to meet withdrawals by depositors.  The rating on the short-term assets they hold is important for meeting their minimum capital requirements under Basel and local regulations.  The short-term sukuk provide an investment option that will generate some yield without exposing the banks to the counterparty risk that would emerge from inter-bank murabaha, for example. 

There is also the potential, particularly if the IILM extends the maturities of sukuk it sells, for these sukuk to form the backbone for repurchase agreements (repos).  A repo is a secured short-term (often overnight) loan between banks and in the conventional world operates using high quality bonds as collateral like US Treasuries.  In the Islamic form of repos in use today in the UAE, the collateral is commodity murabaha-based certificates of deposit issued to banks by the UAE central bank, of which I have been critical.  The International Islamic Financial Market (IIFM) has laid out other alternatives, none of which are optimal, for Islamic repos, which I described in an earlier post.

The next piece of information that will be interesting will be the assets that are used to back the issuance, and Zeti said they are working to "get the allocation of high-quality underlying assets".  The most likely structure will be istithmaar or ijara, both of which would probably be done using an asset-based structure.  The assets would likely be contributed by IILM members, most of which are central banks from OIC countries, although the Central Bank of Luxembourg is a member.  The central banks are not likely to risk that their assets could be taken by sukuk holders should the IILM default or otherwise fall apart. 

It is good to see the IILM move towards beginning operations, however late its development is.  The biggest need it can fill is to provide a source of short-term assets for Islamic banks that do not have the risks associated with lending their surplus funds to other Islamic banks.  When an Islamic bank lends its funds to another bank--even for a short period--it subjects itself to the risk that the funds would be lost or tied up if that bank failed.  For the Islamic banking system as a whole, this provides a powerful mechanism for contagion, where the fears about an Islamic bank's solvency could be transmitted to other institutions which have lent money to it. 

Islamic finance complexity (Part IIb)

After my summary of the ideas behind the deposit accounts of Islamic banks, I went and did a very unscientific survey looking at two Islamic bank's deposit accounts (Dubai Islamic Bank and Meezan Bank) to see how they actually operate in practice.  As I expected, the deposit products are similar to what one would find in conventional banking.  There are a mix of demand deposit and savings products offered by each bank.

In the case of Meezan bank, the deposit accounts offer a mix of demand deposit accounts based on qard, where "the Bank is liable to pay your money back on demand".  One interesting point is that, in contrast to the mudaraba deposit accounts, the qard accounts does not discuss the conditions in which the depositor could lose his or her money, even though there is no one would expect depositors placing their money under qard to be below those placing them under wadiah to be in a lower position in the bank's capital structure.

The Meezan savings accounts were all based on mudaraba, which one would expect from an Islamic banks and all stipulated that the deposits would be invested in Shari'ah-compliant contracts like murabaha, ijara, istisna'a and musharaka to generate a return, although "in case of a loss, as per the rules of Mudarabah, the Rab-ul-Maal shall bear the loss in the ratio of their investment".

When I looked at the Dubai Islamic Bank's products, the descriptions looked much more like conventional bank accounts.  Some accounts had profit-sharing features, while others did not.  The contracts under which the accounts operated were not specified, so one can reasonably assume that the ones providing profit-sharing were based on mudaraba while the ones which did not were based on wadiah or qard.

One troubling feature of the DIB accounts was that in neither case of the mudaraba or wadiah/qard was the prospect of loss presented.  When I searched the DIB website for 'loss' or 'lose', the only page that I found was an FAQ page describing in general terms how Islamic finance works without  presenting any risk statement that one would expect from a bank (especially one of the oldest Islamic banks in the world). 

My survey was not representative in any way, but it did find a troubling lack of disclosure of the risks associated with Islamic deposits from one of the banks I surveyed.  When a consumer looks to place funds with a bank, as I discussed in an earlier post, there are three key things he or she expects: safety of the deposits, a return on deposits to offset the costs of inflation, and access to the money deposited.

Both banks provided good access to funds for their depositors, with the note that some products offer limited access by design (similar to conventional Certificates of Deposit).  In terms of a return in excess of inflation, it is unclear.  Not all of the products offered concrete terms or histories of the accounts in terms of whether the deposits were paid returns in excess of inflation, but this is to be expected in Islamic banking.

However, with regards to the safety of the deposits, one bank offered clear disclosure that the account holders could lose their deposits if the investments made with those funds were money-losing.  The other bank did not make any reference to the potential for losses.  Perhaps this lack of disclosure is due to a leniency of regulations in one country versus another, but if Islamic banking is to use mudaraba as a means for raising deposits, there is a clear moral imperative that the costs and benefits of the product be clearly disclosed.

This is especially the case for a bank like DIB where the financial statements for 2010 report a provision against the depositors, albeit one that is outweighed by a far larger transfer from the profit equalization reserve account.  The fact that a bank pays returns based (somewhat loosely) on the returns from its own assets funded by the deposits and shares the risks from those investments with depositors should be clearly stated.  This should be even more pressing an issue for a bank like DIB which still holds a wakala liability to the UAE Ministry of Finance from the recent bank bailouts in Dubai.

Leaving aside the institutional differences between the banks surveyed above, I see a few lessons.  First, Islamic banks should disclose the full risks of their products, including the position in the capital structure based on the type of deposit.  Second, Islamic banks should provide full disclosure that the profit paid on their deposits are totally based on the return on those investments and that they are liable to bear the loss on those investments unless there are funds available in the profit equalization reserve to cover the losses.

It is commendable for Islamic banks to smooth the returns on mudaraba deposits to essentially store up reserves so that depositors can not worry that they will lose their deposits.  However, it is essential that they be fully aware that the reserves put aside to safeguard their deposits may run out and they could lose their deposits.

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

Islamic finance complexity

The issue of Islamic finance complexity is a common theme of criticism of Islamic finance from people who view the industry as creating nothing of value beyond what the conventional industry can provide.  After proposing a "back to basics" approach, I have been working through how the industry is designed or imagined to work and the products that are actually offered to try and ascertain where the industry is satisfying legitimate financial needs of consumers and where it is developing products that suit its own profitability.  I will update this post as an index to the other posts where I look at specific items (in chronological order, with the most recent posts at the bottom of the list).

Can Islamic finance return to the basics?
Overview of the thought experiment (Part I)
How should Islamic financial institutions develop products (Part Ia)
Islamic financial product disclosure (Part Ib)
Islamic banks - depositors (Part IIa)
Islamic banks - deposit accounts (Part IIb)
Islamic banks - deposit insurance (Part IIc)
Islamic banks - deposit products (Part IId)
Islamic banks - composition of banks' liabilities (Part IIe)
Islamic banks - empirical evidence on deposit rates (Part IIf)
Islamic banks - cash holdings (Part IIg)
Islamic banks - profit-sharing investment accounts (PSIA) and capital requirements (Part IIh)

Islamic finance complexity (Part IIa)

The goal of this thought exercise is to understand whether Islamic banks meet the financial needs of their customers and structures products that are both readily understandable to customers and competitive in price to conventional alternatives (where they exist).  The first, and most basic, need among consumers is to have access to a safe place to put their money that can earn a return, as well as a place they can turn to for a loan (whether a consumer or a business).  This is a bank.

On the most basic level, a bank is an institution that collects savers' money and invests these funds into loans that earn a return sufficient both to pay a competitive return for depositors and at the same time keeping the depositors' funds safe.  The function of the bank is to turn short-term deposits into long-term loans--to manage the maturity mismatch between the liquidity needs of depositors and the need for long-term funding for borrowers.  In addition to the depositors' money and the loans provided, the bank holds some degree of equity, that for regulatory purposes is separated by how much it is able to absorb losses so they do not need to be passed onto depositors.

Depositors

For depositors, the underlying need is for a safe place to store money with the requirement that they be able to access their money when they need it, that they can earn a return sufficient to offset the effects of inflation and to provide depositors a way to use their money.

The theoretical idea of an Islamic bank where depositors place their deposits under mudaraba conflicts with the idea of safety of the deposits from loss, which (among many reasons) is probably why a pure mudaraba is not used in Islamic banking today.  However, the alternative--wadiah--does not succeed in generating a return sufficient to offset the costs of inflation of deposits by reducing the purchasing power of the deposits held at banks.  Abstracting from the mechanics of how a debit card works, which may not fully comply with the current standards of Shari'ah-compliance, the issue of accessing the funds is not any different between an Islamic bank and a conventional one. 

The solution to two needs (protecting depositors from losses and still providing a return necessary to offset the costs from inflation) that Islamic banks have adopted is that the mudaraba accounts are made liable for losses of the bank, but the profits accruing to equity (who would in theory be on par with depositors) are voluntarily made subordinate to the return of depositors' principal.  In addition, through reserve accounts, the depositors' profit is 'smoothed' by setting up reserve accounts where excess profits are stored to maintain profit payments when the profits generated fall below the market interest rate on deposit accounts.

The arrangement is not optimal because the equity investors are basically making their investment as a mudaraba (they provide the capital and the bank provides the management expertise to generate a return on that equity).  Therefore they should not have to 'voluntarily' sacrifice their return in order to prevent losses on other mudaraba capital, although when the they can capture additional upside from higher profits than depositors can, where excess profits beyond the deposit rate are stashed away in reserve accounts, there is at least the potential for equity investors' return to be higher than depositors, in compensation for the additional risk they are taking.

The wadiah account holders are essentially sacrificing one goal (protection from returns against inflation) to promote the other goals (safety of principal and ability to use their money when they need it).  Their principal is guaranteed, even if inflation erodes the purchasing power of the deposits, and through checks, debit cards or wire transfer, is able to use their deposits as they see fit. 

On a basic (and grossly oversimplified) analysis of the depositors position, the basic Islamic banking model does make sense, although there are trade-offs, which could arguably be used as evidence that Islamic banking both does not suit the needs of both depositors and equity investors in the banks.  However, there are always trade-offs between risk and return and linking risk and return is often described as a key feature of Islamic finance.  While it is not optimal to have mudaraba depositors implicitly subsidized by (mudaraba) equity holders, the potential higher returns for equity investors should assuage some criticism that they are forced to bear greater risk than depositors than they would in a theoretical mudaraba-based Islamic bank.

This analysis does not necessarily cover the actual products offered by Islamic banks for depositors, but that will have to wait for a later post.

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

Islamic finance complexity (Part Ib)

Another link I posted earlier on Twitter took a lesson from microfinance.  The article describes studies about transparency and disclosure in microfinance, particularly relating to disclosures on interest rates, costs and the outcome if things go wrong (i.e. default).  Any issue on disclosure and transparency (with regards to consumer disclosure) is common across any financial products targeted towards the broad consumer market because so many disclosures are essentially pointless for consumers because they are written in legalese and are usually too long for consumers to bother reading through in their entirety.  One example of overcoming this legalese is the efforts in the US by the Securities & Exchange Comssion to bring "plain English" into disclosure statements for companies and financial institutions (which is accompanied by an 83-page handbook on writing in plain English (pdf)).


However, there is more to the issue of disclosure and transparency than just the disclosures presented.  The CGAP article mentions specifically that consumers understand much more clearly fees when presented as dollar amounts, rather than in effective interest rates.  Consumers also are not familiar with "recourse" impacts of financial products (i.e. what happens when the s*** hits the fan).

The analogy to the Islamic finance industry is two-fold: cost and complexity.  On cost, the Islamic financial products are generally more expensive than conventional financial products.  Most Islamic financial institutions would prefer not to convert their fees into an annual percentage rate (APR) because of its roots in conventional finance referring to interest rates.  However, in most regulatory regimes, disclosures are required to include an APR.  As the CGAP study found, this may not be the most useful number to have included in the disclosures and so Islamic banks that want to embrace transparency should add additional disclosures that detail the fees of their products in a separate schedule.  It will both inform consumers better and also give an alternative to the (mandatory) disclosures of APR, as long as it is not deceptive in terms of the actual costs of the product.

The complexity issue is more interesting to me and has fewer requirements imposed in terms of disclosure from a regulatory perspective.  How many consumers can explain how the Islamic financial product they choose actually works?  In some Islamic financial products it takes hours for even people who read prospectuses for a living to understand exactly how an Islamic financial product works, even if the goal of the whole process is relatively simple.  This has attracted the interest of regulators like the Dubai Financial Services Authority, who criticized excessive complexity, citing the Nakheel sukuk.  Unfortunately, the article is subscription only so I can't read it all, but the Nakheel sukuk is a perfect (if extreme) example of an excessively complex sukuk. 

If Islamic financial products are complex, can consumers understand them?  Do consumers of the Islamic financial products know what happens in a default on the products they use and how they differ (or even if they do differ) from conventional products?  I would suspect that few people do.  Part of that is an education issue.  Consumers should learn how these products work, but financial institutions have a responsibility as well to not use overly complex structures.  The key should be meeting a financial need, but if the financial need requires elaborate structuring to re-create a conventional financial product, then perhaps Islamic banks should just take a 'pass'.

All in all, the Islamic financial industry should ensure that its products are understandable and understood by consumers of the product (I hold out little doubt that they will produce any clearer disclosures to consumers than conventional financial institutions) and that the fees are both comparable, fair and understandable.

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

Islamic finance complexity (Part Ia)

Earlier tonight, I posted an article on Twitter from CGAP about microfinance product development that I think has lessons for the Islamic finance industry as a whole.

The article discusses the way that microfinance institutions use daily journals from a sample of their customers or potential customers to determine how people actually use their money and how they engage with financial institutions to develop what financial needs are not being met currently by financial institutions (i.e. what are they using cash for that a financial intermediary could help them get a better outcome).  While I don't believe that Islamic financial institutions are flying blind in regards to their clients needs, it does appear that in some cases they are developing products that they can make money selling and then taking them to market and hoping that the supply will create a demand.  In other cases, they see a need (e.g. a financial product not being offered by Islamic banks and developing their own Shari'ah-compliant version and bringing it to market).

The problem with these approach is that they take as their premise either that the products that they develop to be profitable (for the bank) have a natural market or that conventional banks are offering products that always suit the needs of consumers.  My idea of "going back to the basics" for Islamic finance is based on the premise that financial institutions creating products to suit their own needs (in terms of generating high profits) or by replicating conventional products (which creates added complexity) do not do the best job in fulfilling the financial needs of the consumers who look to Islamic banks for Shari'ah-compliant alternatives to conventional banks (mostly Muslims, but non-Muslims should be the market as well if Islamic banks have a change of growing across the world).

One aspect of the article that I think makes it useful for Islamic banks is that it is developed from the perspective of microfinance institutions that have a small market share in terms of the customer's business that they want to see grow.  Islamic banks start by trying to attract customers who either do not use banks or are with conventional banks.  Similarly, microfinance institutions are trying to get the business of people who rely on cash for most of their transactions because they don't have access to banks.

The analogy is not perfect, but an Islamic bank that is developing new products would be well served asking Muslims who don't use banks (or who have non-interest-bearing deposit accounts only) what aspects of their financial life are most inconvenienced by their lack of access to banks.  With that need in mind, they can develop financial products that fulfill that need, whether or not it ends up being a product identical to a conventional offering.  Instead, it seems that banks are assuming that people need a credit card (for example) and are structuring a complex series of murabaha transactions to create a payment/credit system that extends credit to the customer without formally being structured as a loan from the bank to the customer that is repaid with interest.

If Islamic banks want to cater specifically to the portion of the Muslim population that wants a credit card, but don't want to pay interest, then creating Islamicized versions of credit cards etc. will work fine, but why would a non-Muslim get an Islamic credit card that has all the metal trading behind that adds cost when a regular credit card will charge far less?  Even if the underlying goal is to include Muslims into the financial system, there will be plenty of Islamic banks offering complex structured versions of credit cards.  Working from a bottoms-up perspective (starting with the institution rather than trying to effect top-down change on the Islamic finance industry), an Islamic bank can choose not to offer every conventional product as an Islamic finance product without having to be concerned with overall access to finance among devout Muslims who don't work with conventional banks.

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

Islamic finance complexity (Part I)

I have been pulled away from blogging, mostly because I was finishing a chapter I am contributing (for a book which is coming out next year) on Islamic microfinance.  Hopefully, I'll be able to address some of the topics I was researching for the chapter in future blog posts (and newsletters).  However, first I thought it would be useful to revisit one conclusion from my last blog post on whether Islamic finance can "return to basics".  I wrote:

"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."

Given that the Islamic finance industry has branched into so many different areas, it is difficult to succinctly define the "financial needs" that Islamic finance is supposed to serve.  In some ways, the financial needs are not any different from the "financial needs" that conventional finance, which can lead to (somewhat deserved) cynicism about how the industry works now and whether there is anything that can usefully be accomplished within the Islamic finance industry as it is constructed now. 

But to start the thought process (this blog post and future ones on the topic are almost as much exercises for me to think through the issues as it is intended to share the thoughts with readers) every financial institution should serve two sides as an intermediary, matching the excess funds on the one side with the need for funds on the other.

• Islamic (retail) banks: 
• Hold Excess Funds: Depositors, Investors
• Need Funds: Individuals, Companies

• Islamic (investment banks) banks: 
• Hold Excess Funds: Investors
• Need Funds: Companies, Governments

• Islamic investments: 
• Hold Excess Funds: Investors
• Need Funds: Companies

• Takaful: 
• Hold Excess Funds: Individuals, Companies
• Need Funds: Individuals, Companies (when need arises in the future)

In some ways these different functions (drop any general categories I have missed in the comments) are all inter-linked.  Investment companies will invest in equity (and debt) of the Islamic banks and takaful companies.  Takaful companies will invest the premiums (donations) from policyholders in the Islamic investments.  Islamic banks will provide financing to companies that also receive investments from other Islamic financial institutions. 

These financial needs are not unique to Muslims, and the institutions should not be viewed as specifically targeted towards Muslims, nor should they necessarily be viewed as mirror images of conventional financial institutions.  My goal (if time permits) is to go through the different institutional types and look at how they are set up today both conventionally and as Islamic financial institutions and critique areas where the Islamic financial institutions have moved too far towards excess complexity at the expense of simply providing a service to meet a basic financial need. 

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