Saturday, January 28, 2012

Is Islamic finance a failure?

Oliver Agha of Agha & Co, a Shari'ah-compliant law firm, wrote an opinion piece for Reuters, which I highly recommend as a good summary of where Islamic finance is now and what it needs to focus on to continue growing.  There is a lot in the article, so I'm only going to discuss one section (though the whole piece is worth reading).
"More often than not, people have said to me, "Islamic finance is a sham." They don't see the difference between Islamic banking and conventional banking and cannot differentiate between conventional and Islamic products. Some of this criticism is unfair and due to a lack of understanding of the difference in the actual risk profiles between the two (e.g. in an Islamic ijara project/property finance transaction, the financier assumes the risk of loss of the asset, which is markedly different than a conventional mortgage situation where the mortgagee (bank), as lender rather than owner, does not assume such risk of loss). However, in other products such criticism is warranted. A case in point is the term "Islamic bond" -- this oxymoron, used so commonly by practitioners and the media, suggests Islamic finance can offer a debt instrument that generates an interest-based return -- a complete absurdity."
I agree to some degree with the differentiation of Islamic finance products.  However, I think that the transfer of risk in an ijara compared to a conventional lease is perhaps overstated.  In a conventional mortgage, the lender will require insurance on the home being financed through the loan in order to protect their collateral.  The risk in a mortgage that the house gets destroyed does remain with the homebuyer, but the insurance that the lender requires the homeowner carry offsets this risk.  In the same way, the financier of an ijara can limit the risk that the home is destroyed by taking out takaful on the home (since it owns the home).

The cost of the insurance or takaful will fall on different parties in an ijara or a conventional mortgage, but the additional cost to the bank for having to assume the risk of loss (or the cost of it buying takaful cover on the home) will be built into the financing cost for the homebuyer, and the bank will not be any more liable for losses from the destruction of the home than under a conventional mortgage.  This should not make Islamic mortgages any less useful (or any more costly on net), since they are just putting a different structure in place for the same goal (for the home buyer to buy a home).

There may be differences in Islamic mortgages in other ways.  For example, an Islamic mortgage based on musharaka may limit the liability of the homeowner to the value of the home.  That is, the loan may be non-recourse (the lender cannot make the borrower pay amounts greater than the sale price of the home if there is a default) and in many US states (I don't know about internationally), mortgages are not always set up this way.

On the issue of sukuk (which are commonly referred to as Islamic bonds), I disagree that "Islamic finance cannot offer a debt instrument that offers an interest-based return".  They can and do and many of the structures are non-controversial (e.g. an ijara sukuk which works just the way it was described in home finance).  The cost of financing is linked to an interest rate (through the calculation of the rental rate), but the returns are rental payments...payments in exchange for use of the asset being used for financing.

There are a lot of areas of the sukuk markets that are worthy of criticism, particularly those areas where the sukuk become so complicated that they make the mind spin (read the Nakheel 1 sukuk offering documents and if you can explain all of the intricacies of how it works--and you did not work on its construction--you will have my respect).  However, the plain vanilla sukuk use an interest-rate as a benchmark.

Islamic finance does not involve the paying or receiving of interest, but that does not mean that there is no time value of money in Islamic finance.  To take a simple example, look at the murabaha.  In a murabaha, you buy something now and pay a lump sum (principal plus markup) at a point in the future.  That is relatively uncontroversial in Islamic finance, excluding some of the creative ways lawyers have used it to structure debt financing, Islamic CDs and repos.

Take an example of a car costing $1,000.  If you had the cash to buy that car now, you wouldn't use a murabaha, you would just buy the car.  If you don't have $1,000, you go to an Islamic bank and say, "I want to buy this particular car that is priced at $1,000". The bank will say, "Ok, if you pay us $1,200 in equal payments of $100 per month, we will buy the car and sell it to you with delivery today".  Instead of spending $1,000 today, you pay $1,000 plus the $200 markup the bank charges in profit.  In return, you get to use the car for a year and you don't have to pay for the car all at once today.  That benefit is the time value of money.  You could find any determinant for that value that you want, but prevailing interest rates serve as a pretty neutral benchmark.  It doesn't change the fact that you are not paying the bank interest, but are paying for the time value of money that you would have spent today on a car, but instead can spread over a year, while still using the car, which has its own value.

An ijara sukuk also uses interest rates as a benchmark, but the payments being made are for rents on a particular asset.  You have a building that you are using and own, but need to raise money.  In an ijara sukuk you sell the building to investors who lease the building back to you (at a rental rate that is benchmarked to an interest rate).  At the end of the lease you buy the building back.

The idea that I think is being critiqued here are the more complicated sukuk that serve no real purpose except to generate the equivalent of an interest-based loan and I think that has merit.  Most sukuk offering documents transfer only the beneficial ownership in the underlying assets.  These asset-based sukuk do create quasi-debt instruments (unsecured debt, in particular).  However, I am not sure whether the sukuk market could function if all of the sukuk being issued had to be asset-backed (i.e. full recourse for investors to the assets underlying the sukuk).

Many issuers would balk at having assets (like their headquarters building or manufacturing plant) being subject to seizure by their creditors.  There may also be legal impediments for international companies like GE Capital that want to issue sukuk if they had to be asset-backed.  These companies also use conventional debt and much of this debt has covenants on attaching new debt to assets of the companies. 

To close this post, I want to reiterate that I thought the article was very thought provoking and while I picked one part of the article that I had a few disagreements with, I agree with most of the article.  I also think that the sentiment of the article--that Islamic finance has a lot of self-examination to do to to keep thriving--is right on target.  By starting a Shari'ah-compliant law firm (they do not advise clients on non-Shari'ah-compliant contracts, as I understand it), Oliver Agha is going a step beyond many other law firms working in Islamic finance.

The more knowledgeable and well constructed discourse there is about Islamic finance among people working in the field the better!

UPDATED 2/9/12: Corrected quote from Agha's article regarding sukuk in paragraph 5.

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