The "Immunity" Myth, debunked by the IFSB

"At the IFSB, we share in the general assessment that Islamic finance has been resilient to the global crisis, but Islamic finance has not escaped the crisis and it is certainly not immune to it." - IFSB Secretary General Jaseem Ahmed

The IFSB held its 9th summit in Istanbul and Secretary General Ahmed laid out a few goals in his speech, but I think most critically for the industry gave the above quote that effectively renounces the widely parroted view that Islamic finance is somehow immune from crisis.  This is important because the view that Islamic finance is immune from crisis (or even from the most recent financial crisis) is one of the damaging viewpoints for the industry's development.  It is critical that the Islamic finance industry recognize that it is connected intimately with the global economy (including the conventional financial industry). 

Islamic finance must learn from the failures of the conventional finance industry lest it repeat the failures, especially since it already has been swept into the crisis with the massive real estate boom in Dubai that became speculative and led to its own crisis.  It is true that the Dubai property boom was fueled in large part by conventional financial institutions, but Islamic finance was not immune from the greed-fueled run-up. 

One need only to remember that the trigger for the entire Dubai debt crisis was the likely inability of Nakheel to repay a massive sukuk that came due in December 2009.  I wrote about the prospects for the holders of that sukuk at the time and noted that, although it was guaranteed by Dubai World (unlike the other Nakheel sukuk) there was no direct sovereign recourse, making repayment unlikely without a bailout. 

That bailout of course did come, from Abu Dhabi, which loaned Dubai $10 billion to repay, in part, the $3.52 billion Nakheel sukuk. The important point in rehashing the Nakheel sukuk bailout is to remember what the sukuk was financing (or at least the asset underlying the sukuk).  It was a strip of desert that was envisaged to become a huge development (and the value of its appraisal was based on these plans).  After the near-default, Nakheel struggled to craft a resolution for its creditors, a high point in the crisis in my mind since most of the claims were adjudicated by a tribunal made up of foreign judges under the laws of the DIFC (which are based on English law). 

However, for trade creditors, the situation was not quite as predictable since they were paid partly in cash but partly with a sukuk backed by land under the Persian Gulf.  Essentially they were given a back-door version of a (now) common 'extend-and-pretend' refinancing which gives some remedy (you might get some repayment, just not now), but also avoids the type of public restructuring that Arcapita is now engaged in (I personally favor the route forced on Arcapita since it gives more transparency).

Circling back from a rather long digression, the next step from the admission by the Secretary General of IFSB that Islamic finance is not immune from crisis is to develop a reaction to the next crisis, whether that crisis hits just one institution or the global economy.  The first order of business is to consider the idea of how bankruptcy or other resolution for failed institutions could work (a primer on the implications of bankruptcy of a Shari'ah-compliant financial institution are described in a paper by Michael McMillen). 

The next is to continue the focus of developing tools for Islamic finance institutions to avoid reaching a Lehman moment, since bankruptcy for financial institutions outside of a formal resolution process can turn messy and lead to contagion.  The keys for avoiding cascading failures is to have short-term liquidity management tools that are not tied up in the perceptions of solvency of a counterparty that doomed Lehman when times turned bad. 

The best solution for Islamic financial institutions would be to have a robust liquidity management system that offered both nearly risk-free assets like those that will eventually be issued by the International Islamic Liquidity Management Corporation (backed by many counties' central banks) and repurchase (repo) facilities in each country that will allow Islamic financial institutions to borrow against the IILM-issued assets.  Let's all thank the IFSB Secretary General for stating a point which is clear to all of us who paid attention to the financial crisis, but which was ignored by people who continued to describe Islamic finance as 'immune' from crisis, and get to work on making Islamic finance as robust as possible against future crises.