Sunday, May 13, 2012

Shari'ah risks are not the only risks to Islamic repo

Repurchase agreements, also called repos, are a common way for conventional banks to manage liquidity needs or to lend out surplus liquidity.  By doing so, the banking industry is able to manage its liquidity in a way that, at least in theory, does not create systemic risks.  This is because a repo transaction is a form of secured lending so that even if the counterparty in the repo transaction goes out of business, the lender can recover the amount lent by liquidating the securities provided as collateral.

The International Islamic Financial Market released a paper exploring the different options for a Shari'ah-compliant version of the repo transaction used by conventional banks.  The paper, which I discussed in a newsletter and in a blog post, had several possible methods for an Islamic repo, but the most likely to be used in practice is likely the collateralized murabaha structure.  A few using the collateralized murabaha have been executed in the market, but there is still not nearly enough agreement on the structure for it to become as commonplace as repos are in the conventional banking industry. 

The National Bank of Abu Dhabi seems to be leading the charge into using the collateralized murabaha structure, since it first executed a one-week $20 million Islamic repo with Abu Dhabi Islamic Bank.  However, moving forward in $20 million or even $100 million increments will not put the Islamic repo into common usage anywhere close to the levels of conventional repos (even when viewed in terms of relative size compared with total assets  in the Islamic banking system). 

Part of that is that it is new, and any new product will start out being used by one institution and other banks will only adopt it gradually.  However, based on the Reuters article describing the discussions at the AAOIFI conference, the entire structure is still facing an uphill climb to gain industry-wide approval from various Shari'ah boards regarding some of the issues associated with the transactions (for example, margin interest and netting exposures by setting off positions against other transactions in similar amounts in the opposite directions).

These are thorny issues, but as the idea of an Islamic repo gains market acceptance, there will be other weightier issues around the systemic risks from repos that will arise outside of the current discussion over Shari'ah issues with repos.  Specifically, if you return to remembering why a collateralized murabaha repo would be an improvement for the industry, it is because the collateralization protects the lenders in the transactions from default by the counterparty since in the case of default they can always sell off the collateral to recover the amount lent. 

The collateralized murabaha repo would presumably give the lender the same right, which would improve on the current commodity murabaha inter-bank lending (which is unsecured).  In the current state, lenders are likely to be more attuned to the risks that their counterparties default since their loans are backed only by the full faith and credit of the counterparty to repay the principal plus profit.  There is no asset they could take ownership of and liquidate so Islamic banks would or should be more hesitant to engage in inter-bank lending with institutions at risk of failing. 

They will be much faster at denying interbank credit to the very banks that need the funding the most to stay solvent and avoid a liquidation of their assets in a fire sale, which could turn a liquidity crunch into insolvency for the bank (which is where the systemic issues begin if the panic spreads to the banks who had been lending to the troubled one).  A secured inter-bank financing market based on collateralized murabaha repos will make Islamic banks more likely to continue to lending to one another even if one becomes troubled since the lender will have the collateral to protect its financing interest in the counterparty. 

The point where a risk remains is "what is the collateral?".  Most conventional repos are backed by government or quasi-government debt and so in most times banks can be assured that there will be a stable market with a ready bid if it ever needed to seize and liquidate the collateral.  The same cannot be said for most sukuk.  There is, in the best of times, a thin market for sukuk and any troubles for the issuers of sukuk lead to sharp sell-offs. 

When sukuk are used as collateral, the lending bank will require a haircut based on the strength of the sukuk issuer and the liquidity of the market for that sukuk, which introduces an inefficiency that, by requiring a higher degree of overcollateralization, will limit the potential for Islamic repos to replace unsecured commodity murabaha inter-bank lending.  Or else, participants in the Islamic repo market will ignore the risks that the collateral itself can play in the repo transaction as a whole, which is perhaps a worse outcome.

The Shari'ah issues probably will be resolved to provide an Islamic repo structure that is accepted widely, mostly out of the need for such a product.  However, the systemic issues underlying the growth in Islamic repo that uses risky collateral will not be addressed as easily.  However, it is incumbent on the industry to recognize these risks, and while the adoption of international financial and accounting standards like the Basel standards should force this issue to the forefront for each institution, it should be another reminder of the importance of ensuring a large supply of high-grade sukuk with a liquid secondary market behind it.


steve said...

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