Three local banks in Malaysia are working with the International Islamic Trade Finance Corporation, part of the Islamic Development Bank Group, to provide trade financing for Malaysian companies working in emerging markets, including in the OIC. The realm of trade finance has been developing under the radar within the Islamic finance industry, but it should get more attention.
The idea of providing financing and insurance for intra-OIC country trade (and for trade with non-OIC emerging markets) is an excellent place for Islamic finance to operate since many of the contracts used in Islamic finance are based on trading contracts (the most prevalent being murabaha).
There are also many other reasons to develop trade within emerging markets in general and specifically within the OIC whose member countries represent diverse geographies spanning from Indonesia and Malaysia to Western Africa. Within the OIC, the countries with the largest total exports includes Malaysia (third behind Saudi Arabia and the UAE, whose economies are based on oil and gas exports, and behind Turkey, which is geographically near to the large import market of the European Union).
Encouraging trade between these countries financed by Islamic finance should develop connections that will help Islamic finance grow in the trade partners, but more importantly should lead to more pressure to open up bilateral trade flows so that countries with smaller economies can export their own products into other OIC countries in a way that helps their economy grow. Islamic finance should work to be at the forefront of encouraging these trade linkages for the countries' mutual benefit.
Tuesday, July 31, 2012
Monday, July 30, 2012
Should the Indonesian hajj funds invest in project-based sukuk or deposit the funds with Islamic banks?
The Indonesian hajj fund, which currently places its funds in bank deposits, is planning to invest at least some of the IDR44 trillion ($4.7 billion) into government project-based sukuk. There are some merits to this decision: it will generate Shari'ah-compliant returns for the hajj fund (as Mohammed Obaidullah held up as a model for handling waqf funds in India), and so long as the funds are guaranteed by the government no different from the funds being held currently, it should not be to the detriment of the depositors to the hajj fund.
However, it is not clear whether it would be the best use of these funds to encourage development (specifically of Islamic finance in the country). An alternative which could benefit the industry would be to deposit the funds in Islamic banks, rather than conventional banks to allow those banks to expand the asset side of their business. This would help the Islamic banking industry with an added boost to their growth.
This idea is not without pitfalls. For one, the funds would have to be protected for the depositors into the hajj fund, which could be lost if the bank failed, although Indonesia does have a deposit insurance fund. The fund covers Islamic banks as well as conventional banks but does so without distinction for the bank type, which could raise some Shari'ah issues (pdf). There are also risks that the funds would be allocated by political preference, rather than to the Islamic banks that perform the best.
Despite the challenges to implementing the deposits of hajj funds into Islamic banks to spur their growth (which is already growing rapidly), there are costs and benefits to investing them in project based sukuk and it would be worth taking a look at the relative costs and benefits of each.
However, it is not clear whether it would be the best use of these funds to encourage development (specifically of Islamic finance in the country). An alternative which could benefit the industry would be to deposit the funds in Islamic banks, rather than conventional banks to allow those banks to expand the asset side of their business. This would help the Islamic banking industry with an added boost to their growth.
This idea is not without pitfalls. For one, the funds would have to be protected for the depositors into the hajj fund, which could be lost if the bank failed, although Indonesia does have a deposit insurance fund. The fund covers Islamic banks as well as conventional banks but does so without distinction for the bank type, which could raise some Shari'ah issues (pdf). There are also risks that the funds would be allocated by political preference, rather than to the Islamic banks that perform the best.
Despite the challenges to implementing the deposits of hajj funds into Islamic banks to spur their growth (which is already growing rapidly), there are costs and benefits to investing them in project based sukuk and it would be worth taking a look at the relative costs and benefits of each.
Where is the Islamic ETF growth?
One of the puzzles of Islamic finance is why Islamic ETFs have not seen a corresponding growth to the rest of the Islamic finance universe. A Reuters article tackles the subject and suggests that it is the incentive structure in how financial products are distributed in the GCC, the largest market for Islamic finance. Reuters describes:
However, one of the areas that Reuters only mentions in passing is:
The asset classes beyond equities represented by ETFs and ETNs have attracted controversy (ETFs, ETNs) because they are not doing what a normal fund would do--hold a diversified portfolio of investments directly in the fund. They would also be more difficult to create Islamic versions of, so it is neither clear whether there would be a demand for these products or if they would provide a valuable product for Islamic finance to endeavor.
In particular, many are leveraged products, and all are designed to be trading vehicles, since they tend to decay in their underlying values regardless of the performance of the underlying indices. Encouraging extra leverage and frequent trading is likely to not be something that will get favor from Shari'ah scholars approving these products.
As for plain-vanilla equity ETFs that actually own a portfolio of equities, they may have their day, but it is clearly not upon us yet.
That is, the distribution of financial products are run much more along a brokerage model, which is how financial products were overwhelmingly distributed in the the US, and still are to some degree. However, the rise of investment advisors, who are not reliant on commissions for determining investments, and a general growth in discount brokerages (which has made many investors more cost conscious) has made the relatively cheap, passively managed ETFs more popular. The investment advisor model is not as prevalent in the Gulf, but Tariq Al Rifai of Dow Jones Indexes says "At some point it will take off...Give it another three years."In the Gulf, institutional investors are usually catered to by placement agents and fund marketers, not financial planners. These agents, who charge commissions on their sales, prefer to sell private equity, hedge funds and real estate, where margins are higher for them - a hedge fund can charge a 2 percent management fee and a 20 percent performance fee.
However, one of the areas that Reuters only mentions in passing is:
"One attraction of ETFs is that they can provide investors with access to themes that have a low correlation with equities markets. But Islamic ETFs focused on asset classes other than equities have yet to appear, even though major index providers offer large families of sharia-compliant indexes."Many of the ETFs that provide investors with alternative investors, whether those are hedge funds, individual commodities, and a number of other asset classes (e.g. the VIX index) do not hold the underlying assets themselves, but instead use swaps and other derivatives to gain exposure, either as ETFs or Exchange-Traded Notes which expose the holders to the credit of the issuer and provides return based on the performance of an underlying index.
The asset classes beyond equities represented by ETFs and ETNs have attracted controversy (ETFs, ETNs) because they are not doing what a normal fund would do--hold a diversified portfolio of investments directly in the fund. They would also be more difficult to create Islamic versions of, so it is neither clear whether there would be a demand for these products or if they would provide a valuable product for Islamic finance to endeavor.
In particular, many are leveraged products, and all are designed to be trading vehicles, since they tend to decay in their underlying values regardless of the performance of the underlying indices. Encouraging extra leverage and frequent trading is likely to not be something that will get favor from Shari'ah scholars approving these products.
As for plain-vanilla equity ETFs that actually own a portfolio of equities, they may have their day, but it is clearly not upon us yet.
Are tax incentives good for Islamic finance?
A panel discussion in Malaysia included a discussion of whether tax incentives for Islamic finance should be continued (they were first introduced in 2004//05). Some of the tax incentives are provided to make Islamic finance competitive with conventional finance, and these should eventually be phased out, so that Islamic finance focuses on its competitiveness and offering customers with a valuable product (rather than developing sophisticated political power to entrench the tax incentives).
On the other hand, incentives that place Islamic and conventional finance on equal footing should be maintained. For example, eliminating double taxation where the structure of an Islamic financial product would lead to extra taxation compared to a similar conventional product that would be subject to lower taxes.
There is certainly a role for both placing Islamic finance on equal ground with conventional finance, as well as providing temporary incentives that allow Islamic financial institutions to grow to a scale that makes them more competitive, where they can spread costs across a larger institution and minimize the cost gap with conventional financial institutions. However, Islamic finance now makes up more than 20% of the banking industry in Malaysia, so it might be time to start phasing out the subsidies (tax incentives) that solely benefit Islamic finance without addressing some inequality (e.g. double taxation of Islamic products).
On the other hand, incentives that place Islamic and conventional finance on equal footing should be maintained. For example, eliminating double taxation where the structure of an Islamic financial product would lead to extra taxation compared to a similar conventional product that would be subject to lower taxes.
There is certainly a role for both placing Islamic finance on equal ground with conventional finance, as well as providing temporary incentives that allow Islamic financial institutions to grow to a scale that makes them more competitive, where they can spread costs across a larger institution and minimize the cost gap with conventional financial institutions. However, Islamic finance now makes up more than 20% of the banking industry in Malaysia, so it might be time to start phasing out the subsidies (tax incentives) that solely benefit Islamic finance without addressing some inequality (e.g. double taxation of Islamic products).
Monday, July 23, 2012
Kazakhstan's first sukuk and the potential public benefit from government sukuk issuance
The Development Bank of Kazakhstan (DBK) issued its first sukuk, the first for the country. The sukuk, for MYR240 million ($76.6 million) was issued in Malaysia (where 82% of subscribers were pension funds who are facing a shortage in sukuk). For a market new to Islamic finance, the issuance by a development bank may provide a good starting point for opening the market for other sukuk issuers because of the development bank's connection to the government.
The DBK is part of the government, but will still have to navigate the country's rules for fixed income offerings, and the associated challenges (but likely not any difficulties with taxation). This should focus the government's attention on making changes to its laws that would otherwise block sukuk, which will benefit private issuers, who would otherwise have to find ways to convince the government to change on their behalf, which is likely a challenging proposition in any country.
In addition, there are few forms of intellectual property protection for financial instruments, so the sukuk structures used by the government should be able to be adopted by private issuers, benefiting from the extra cost the development bank will have to commit to issuing its own sukuk. There is also likely to be additional information available for pricing a corporate sukuk if a government entity has already issued a sukuk: investors can use both the corporate issuer's conventional debt, the government's conventional debt and the government's sukuk pricing as guides and the more sources for this pricing are available, the greater the potential for corporate issuers to lower the additional spread it will have to pay for sukuk versus conventional debt.
This does create additional costs for the government when it issues its sukuk, but if the government is committed to increasing the opportunities for sukuk issuance in the country, as Kazakhstan's is based on its public statements, having the additional cost be borne by the government could be a boon for the development of both a sukuk market, as well as Islamic banks who are otherwise going to have to look abroad for government-issued assets to use to fill a portion of their balance sheet.
The DBK is part of the government, but will still have to navigate the country's rules for fixed income offerings, and the associated challenges (but likely not any difficulties with taxation). This should focus the government's attention on making changes to its laws that would otherwise block sukuk, which will benefit private issuers, who would otherwise have to find ways to convince the government to change on their behalf, which is likely a challenging proposition in any country.
In addition, there are few forms of intellectual property protection for financial instruments, so the sukuk structures used by the government should be able to be adopted by private issuers, benefiting from the extra cost the development bank will have to commit to issuing its own sukuk. There is also likely to be additional information available for pricing a corporate sukuk if a government entity has already issued a sukuk: investors can use both the corporate issuer's conventional debt, the government's conventional debt and the government's sukuk pricing as guides and the more sources for this pricing are available, the greater the potential for corporate issuers to lower the additional spread it will have to pay for sukuk versus conventional debt.
This does create additional costs for the government when it issues its sukuk, but if the government is committed to increasing the opportunities for sukuk issuance in the country, as Kazakhstan's is based on its public statements, having the additional cost be borne by the government could be a boon for the development of both a sukuk market, as well as Islamic banks who are otherwise going to have to look abroad for government-issued assets to use to fill a portion of their balance sheet.
Money as a store of value in Islamic economics
Islamic economics has developed much under the radar of Islamic finance (despite having preceded the development of the modern Islamic financial industry), but occasionally a few items from Islamic economics enter into the discussion of Islamic finance, and one of the most common is the idea of reintroducing the Gold Standard (i.e. bringing back the Islamic Dinar as a backing for currency), whose prime advocate is former Malaysian prime minister Mahathir. I view the adherents of this idea no differently than I do any other calls for the return of the gold standard: I am dismissive of the idea as a solution in search of a problem.
However, I saw an argument that ties into the idea of a return to the gold standard, brought about through Islamic finance, that approaches the problem from another angle where the return of the gold standard would be the natural outcome. An excerpt from Iraj Toutounchian's book Islamic Money & Banking: Integrating Money in Capital Theory (note: I am basing the post just on the excerpt) includes the proposition that:
The economic situation would then be reduced to finding another store of value, which would likely mean precious metals like gold and silver. However, if the whole point of Islamic finance (and presumably Islamic economics as well) is to encourage a risk-sharing alternative where money has value only because it can be invested in economic activity to make a profit, or used to avoid the costly need for the 'double coincidence of wants' that plagues a barter economy, then money has to serve as a store of value. Whether that is in the form of gold, or in the form of paper currency, there cannot be a system in which money ceases to exist as a store of value or its use as anything more than an accounting mechanism (as the ruble was in Soviet Russia when it was not freely convertible into any other currencies). It would not be money as money is currently defined. This applies both to paper currency and precious metals. Precious metals fall under the same rules in Islamic finance as does paper currency with respects to riba.
There can be arguments about how money can function in the economic system in order to generate profits, and Islamic finance doesn't allow what would be thought of as a "money market", but that is an entirely different thing than saying it cannot be a store of value.
However, I saw an argument that ties into the idea of a return to the gold standard, brought about through Islamic finance, that approaches the problem from another angle where the return of the gold standard would be the natural outcome. An excerpt from Iraj Toutounchian's book Islamic Money & Banking: Integrating Money in Capital Theory (note: I am basing the post just on the excerpt) includes the proposition that:
There is probably little doubt that from a definitional perspective there would be no Islamic money market, since the very idea is based on exchange of money for money with profit, something which no doubt falls into the prohibited areas. However, the idea that money cannot serve as a store of value is peculiar. If you are talking about paper money, and asserting that it cannot be a store of value, than it is reduced to being an accounting mechanism only, and really doesn't serve as a very good as a medium of exchange."The money market, which plays such a major role in the capitalist system, is the result of speculation with money. It is only logical, then, that the abolition of interest would lead to the total disappearance of this market. Therefore, any changes in the level of investment in an Islamic economy should be directly attributed to the marginal efficiency of capital (or, equivalently, the rate of profit).To summarize then:Money has just two functions to perform: as a medium of exchange and a unit of account. It can no longer be a store of value."
The economic situation would then be reduced to finding another store of value, which would likely mean precious metals like gold and silver. However, if the whole point of Islamic finance (and presumably Islamic economics as well) is to encourage a risk-sharing alternative where money has value only because it can be invested in economic activity to make a profit, or used to avoid the costly need for the 'double coincidence of wants' that plagues a barter economy, then money has to serve as a store of value. Whether that is in the form of gold, or in the form of paper currency, there cannot be a system in which money ceases to exist as a store of value or its use as anything more than an accounting mechanism (as the ruble was in Soviet Russia when it was not freely convertible into any other currencies). It would not be money as money is currently defined. This applies both to paper currency and precious metals. Precious metals fall under the same rules in Islamic finance as does paper currency with respects to riba.
There can be arguments about how money can function in the economic system in order to generate profits, and Islamic finance doesn't allow what would be thought of as a "money market", but that is an entirely different thing than saying it cannot be a store of value.
Wednesday, July 18, 2012
The vulnerability of sukuk markets
The resurgence in sukuk issuance since the twin shock of the global financial crisis and the Dubai debt crisis has been nothing short of remarkable. One of the most surprising indicators of how much demand for sukuk has rebounded is that the Dubai sovereign sukuk--issued by the very sovereign that was at the center of a storm in December 2009--has seen its yield drop from 6.396% when it was issued to just 3.2% yesterday. There have been a few hiccups in the 'year of the refinance' (notably with Arcapita's $1.1 billion syndicated murabaha), but many new sukuk have been issued, including the largest sukuk in history, the $4 billion Qatari sovereign sukuk which priced to yield 2.1% which reportedly left enough buyers out that they flooded the secondary markets, bidding prices up.
The development of the Islamic repo market (as nascent as it may be) has likely also encouraged a few extra buyers for sukuk, since they can realize some liquidity from their sukuk holdings through Islamic repo that allows them to hold onto that sukuk. This is true in particular for investment-grade sukuk like Qatar's sovereign sukuk. At the same time, reports suggest Western investors are becoming interested again with sukuk, through both primary and secondary markets.
This is a good thing. More demand and better secondary market liquidity will help bring new issuers into the market to provide more supply to meet the demand, which is clearly growing. However, the rapidity with which the market has boomed should be a cause for some concern. There will undoubtedly be a break in trading activity once Ramadan begins, but after the Eid, will there continue to be the same confluence of financial market conditions to support the prices for sukuk?
Will Western investors return to Europe if there is a pathway to a solution of the Eurozone debt crisis? Will there be geopolitical tensions in the GCC that affect local investment demand in sukuk versus 'safe' assets like US Treasuries (since not all investments from that region are dedicated entirely to Shari'ah-compliant investment strategies)? These are always concerns for the market, but when it has risen as quickly as it has recently, the risk of something happening that spooks an already relatively illiquid market rise.
In the long-run, sukuk markets are likely to continue to grow as Islamic finance increases its share of the financial markets in the GCC, but that does not mean the growth will occur along a straight line. There will be rough patches (hopefully not as challenging as the last five years), but the demand for sukuk is robust and the more mature that market becomes, the more it is likely to attract new potential investors and issuers.
The development of the Islamic repo market (as nascent as it may be) has likely also encouraged a few extra buyers for sukuk, since they can realize some liquidity from their sukuk holdings through Islamic repo that allows them to hold onto that sukuk. This is true in particular for investment-grade sukuk like Qatar's sovereign sukuk. At the same time, reports suggest Western investors are becoming interested again with sukuk, through both primary and secondary markets.
This is a good thing. More demand and better secondary market liquidity will help bring new issuers into the market to provide more supply to meet the demand, which is clearly growing. However, the rapidity with which the market has boomed should be a cause for some concern. There will undoubtedly be a break in trading activity once Ramadan begins, but after the Eid, will there continue to be the same confluence of financial market conditions to support the prices for sukuk?
Will Western investors return to Europe if there is a pathway to a solution of the Eurozone debt crisis? Will there be geopolitical tensions in the GCC that affect local investment demand in sukuk versus 'safe' assets like US Treasuries (since not all investments from that region are dedicated entirely to Shari'ah-compliant investment strategies)? These are always concerns for the market, but when it has risen as quickly as it has recently, the risk of something happening that spooks an already relatively illiquid market rise.
In the long-run, sukuk markets are likely to continue to grow as Islamic finance increases its share of the financial markets in the GCC, but that does not mean the growth will occur along a straight line. There will be rough patches (hopefully not as challenging as the last five years), but the demand for sukuk is robust and the more mature that market becomes, the more it is likely to attract new potential investors and issuers.
Sustainable Islamic finance
A fund was announced recently that will invest in forestry and agricultural projects, and which will be Shari'ah-compliant. One of the interesting points raised by the fund manager is that "Sustainability has been a challenging conversation in the Gulf, as it was regarded as a competing asset class. But energy security cannot be built on one source alone".
This led Bernardo Vizcaino, the reporter writing the article for Reuters to explain: "One reason for the lack of close ties between the Islamic and ethical investor communities is geographical: Islamic investors have strong roots in the Middle East and southeast Asia, while the ethical investment industry has its strongholds in North America and Europe."
Because of the limited offering of sustainability-related investment opportunities, a fund focusing on this area, that is Shari'ah-compliant as well, should have a natural home, but Islamic finance has so far gravitated more towards other alternative investments like capital-protected notes, and investments in real estate.
Back in May, I wrote in my newsletter that Islamic finance should incorporate 'positive screens' focusing on the environment and poverty alleviation, not because they are good in and of themselves, but because they have strong basis within Islam on their own. In that newsletter, I quoted Olav Kjorven, the Assistant Secretary General for the UN Development Program who, after the launch of the Muslim 7 Year Action Plan on Climate Change: "The role of Islam could be one of the decisive factors tipping the planet towards a sustainable future."
The point of that Action Plan was not that Muslims should embrace environmentalism or work to avert climate change for its own sake, but because it was an important part of the Islamic view that people do not own the earth, but are allowed to use for their benefit, acting as caretakers of the world. The environmental movement has become influential over the past century and Islamic finance can benefit from this pool of knowledge, while adapting it to have the best combination of authenticity and impact within the Islamic finance industry (and not just as a cut and paste from how it operates in North America and Europe).
This would provide a new area where Islamic finance can offer both a Shari'ah-compliant financial product (based on avoiding what is prohibited), but also a positive vision for economic development in harmony with the environment, based on the Islamic ethical conception of the relationship between mankind and the earth.
Monday, July 16, 2012
Whither Islamic finance dispute resolution?
The issue of how to resolve disputes in Islamic finance is complicated. Currently, the most common way is to make most large Islamic finance products subject to English law (or more rarely New York law) to capitalize on those regions' long history in finance and strong legal systems. The legal systems in many countries where Islamic finance is prevalent are not viewed as sufficiently predictable should a dispute, insolvency or restructuring happen. I addressed the issue in my last newsletter (sign up on the right side of my blog) with respects to new laws being considered in the UAE to develop a new insolvency and restructuring regime that will be Shari'ah-compliant.
The issue of Shari'ah-compliance particularly in insolvency and restructurings, but also in commercial dispute is important for Islamic finance. When using English and New York law, the need for certainty outweighs Shari'ah considerations (and those can be considered, but only consensually; these courts will not consider Shari'ah in their decisions, nor should they be expected to being a part of secular legal systems). However, for Islamic financial institutions, there will come a day when the consensual system of finding solutions that are Shari'ah-compliant will not be sufficient and there will be disputes that involve important issues of Islamic jurisprudence at the heart of the contracts, and a secular legal system will not be able to handle it.
The UAE route of changing their laws to put in place a system that is both based on well established legal systems but also tailored to the needs of that country (including incorporating Shari'ah). An alternative is being considered in Qatar through the Qatar International Court and Dispute Resolution Centre (QICDRC), which would operate within Qatar but with a more global focus. Both systems would be a welcome change from the situation today where Shari'ah disputes that are part of conflicts between parties or are involved within insolvency and restructuring situations cannot be directly addressed. It will undoubtedly be a long time before any new system through either the QICDRC or the new UAE laws will develop the credibility and predictability required to challenge London or New York as the legal homes for cross-border products, but to get to that point requires a first step, which the UAE and Qatar appear to be taking.
The issue of Shari'ah-compliance particularly in insolvency and restructurings, but also in commercial dispute is important for Islamic finance. When using English and New York law, the need for certainty outweighs Shari'ah considerations (and those can be considered, but only consensually; these courts will not consider Shari'ah in their decisions, nor should they be expected to being a part of secular legal systems). However, for Islamic financial institutions, there will come a day when the consensual system of finding solutions that are Shari'ah-compliant will not be sufficient and there will be disputes that involve important issues of Islamic jurisprudence at the heart of the contracts, and a secular legal system will not be able to handle it.
The UAE route of changing their laws to put in place a system that is both based on well established legal systems but also tailored to the needs of that country (including incorporating Shari'ah). An alternative is being considered in Qatar through the Qatar International Court and Dispute Resolution Centre (QICDRC), which would operate within Qatar but with a more global focus. Both systems would be a welcome change from the situation today where Shari'ah disputes that are part of conflicts between parties or are involved within insolvency and restructuring situations cannot be directly addressed. It will undoubtedly be a long time before any new system through either the QICDRC or the new UAE laws will develop the credibility and predictability required to challenge London or New York as the legal homes for cross-border products, but to get to that point requires a first step, which the UAE and Qatar appear to be taking.
Saturday, July 14, 2012
Islamic cooperatives in Indonesia look for apex organization
Several Baitul Maal wa Tamwils (BMTs), small, lightly regulated Islamic microfinance cooperatives in Indonesia, asked the government to set up an apex institution for BMTs in the country. In a paper from 2007, Hans Deiter Seibel described (in a paper presented at a microfinance seminar organized by the Harvard Islamic Finance Project) the BMT in existence as:
Very small microfinance institutions--both conventional and Islamic--that operate outside of a suitable regulatory structure, as well as not having an apex organization, are likely to be less beneficial to their cooperative members because there is a greater potential for the organizations to fail, as well as for money to be stolen by unsavory people being allowed to work within them. As Seibel concluded after on-the-ground research: "Unsupervised Islamic, like conventional, cooperatives are an outright menace to their member-shareholders and depositors, who risk loosing [sic] their money".
There are also several advantages for the cooperatives and their members from having an apex organization: mostly dealing with lowering costs. If MFIs (conventional or Islamic) are responsible for collecting, managing and safeguarding deposits, as well as providing financing, and administering the collection of the repayments from clients, they will have difficulty without a system for tracking information internally, which will be costly. This cost will eventually be borne by the cooperative members of the BMT.
A lot of these functions can be more cheaply provided through an apex institution that will spread many of the costs across a larger number of institutions, as well as making it easier for effective regulation of the BMTs, something which was--at least at the time when Dr. Seibel was doing research on the BMTs--much needed.
Islamic financial cooperatives suffer from the same regulatory and supervisory neglect as the rest of the sector. There is not much difference between Islamic and conventional cooperatives. At most one-fifth of Islamic cooperatives are in reasonably good health. The majority are dormant or non-performing; most of the remaining ones exist for the purpose of receiving funds from the government. The Ministry of Cooperatives does not register cooperatives as Islamic or conventional and provides no information on, or special assistance to, Islamic cooperatives.The BMTs petitioning the government for an apex organization seem to be focusing on the important issues described above. According to a rough translation: "With the apex, more scalable performance and BMT may be more developed. Absence of functioning as an apex institution to make our activities, such as financing and distribution of the velocity of money that we manage, unrecorded and unsupervised".
Very small microfinance institutions--both conventional and Islamic--that operate outside of a suitable regulatory structure, as well as not having an apex organization, are likely to be less beneficial to their cooperative members because there is a greater potential for the organizations to fail, as well as for money to be stolen by unsavory people being allowed to work within them. As Seibel concluded after on-the-ground research: "Unsupervised Islamic, like conventional, cooperatives are an outright menace to their member-shareholders and depositors, who risk loosing [sic] their money".
There are also several advantages for the cooperatives and their members from having an apex organization: mostly dealing with lowering costs. If MFIs (conventional or Islamic) are responsible for collecting, managing and safeguarding deposits, as well as providing financing, and administering the collection of the repayments from clients, they will have difficulty without a system for tracking information internally, which will be costly. This cost will eventually be borne by the cooperative members of the BMT.
A lot of these functions can be more cheaply provided through an apex institution that will spread many of the costs across a larger number of institutions, as well as making it easier for effective regulation of the BMTs, something which was--at least at the time when Dr. Seibel was doing research on the BMTs--much needed.
Monday, July 09, 2012
ISRA executive director on Shari'ah board governance
In his regular column, Rushdi Siddiqui interviewed Dr. Mohamad Akram Laldin, the executive director of The International Shari'ah Research Academy for Islamic Finance (ISRA), based in Malaysia, where Dr. Laldin offered a few interesting comments on the oversight of Shari'ah scholars (there's more in the interview, which I recommend reading in full).
On the Malaysian national Shari'ah board:
The national Shari'ah board does provide oversight in the types of products that can be used by Islamic financial institutions. This is probably the area where there is most disagreement regarding the move towards standardizing Islamic products versus allowing for innovation in new structures. They provide checks and balances only in whether products offered fit within their rules for what is and is not Shari'ah-compliant. They are not responsible for overseeing the conduct of the Shari'ah scholars in how they approve and review products, and to assess continuing compliance in Shari'ah audits. A few surveys of Islamic financial institutions (including in Malaysia) reveal a gap in the Shari'ah audit process where the auditors may in some cases not be well enough trained in understanding the Shari'ah rules laid down by the Shari'ah board in their fatwa, being instead more focused on auditing the financials.
On scholars' conflict of interest from sitting on multiple boards:
It is also important for there to be standards decided, made publicly available, as well as a regular review process for Shari'ah scholars, not because there is a widespread problem, but because of the ramifications if a problem occurred. The Islamic financial institution relies on the process of assessing Shari'ah-compliance of products and institutions to a large degree. If there were problems, the reputational damage would spread across the industry as consumers lost trust in the ability to rely on the fatawa stating that scholars were reviewing products and institutions for Shari'ah-compliance on an ongoing basis. Trust is a commodity that is very difficult to repair if it is damaged, and it will be far less costly to put in place ways of spotting problems in advance than it will be to clean up any problems.
On self-regulation by scholars:
As mentioned above, there should be standards for Shari'ah scholars conduct in dealing with actual or potential conflicts of interest, and in how they interact with the management of the companies who they are overseeing. Just because it would be beneficial to have a set of standards and a regular review process does not preclude these standards from being designed by the scholars themselves to ensure that their fellow scholars have sufficient knowledge of finance to dig through the massive offering documents and reams of product documentation and understand how the products work. They are also, being dependent to some degree upon the reputation of the industry as a whole, motivated to enforce any failings in meeting the standards.
On the Malaysian national Shari'ah board:
"The existence of the national board is important as it is the check-and-balance mechanism for the syariah advisory services, in the absent of any regulating body. "
The national Shari'ah board does provide oversight in the types of products that can be used by Islamic financial institutions. This is probably the area where there is most disagreement regarding the move towards standardizing Islamic products versus allowing for innovation in new structures. They provide checks and balances only in whether products offered fit within their rules for what is and is not Shari'ah-compliant. They are not responsible for overseeing the conduct of the Shari'ah scholars in how they approve and review products, and to assess continuing compliance in Shari'ah audits. A few surveys of Islamic financial institutions (including in Malaysia) reveal a gap in the Shari'ah audit process where the auditors may in some cases not be well enough trained in understanding the Shari'ah rules laid down by the Shari'ah board in their fatwa, being instead more focused on auditing the financials.
On scholars' conflict of interest from sitting on multiple boards:
"regulators, working with the industry and standard-setting bodies, must play a role to ensure the syariah (conflict of interest) risk, actual or perceived, is minimised.The lack of more organizations that set down standards for Shari'ah scholars in their professional conduct is an important gap. Shari'ah scholars may all act honestly when they are issuing their rulings to Islamic financial institutions, and may already address their conflicts of interest (actual or potential) so that it does not affect their ability to provide a fatwa that reflects only their true belief in the Shari'ah-compliance of a product. However, if there were a public instance where there were questions (for example, about whether the scholar had a pecuniary interest in an Islamic financial institution), there are no standards by which a situation could be judged.
For example a syariah scholar who sits on the syariah board of a particularly entity should not have a vested business interest in the entity in order to preserve the integrity of the scholar and avoid any conflict of interest.
Furthermore, another possible way to ensure the effective implementation and enforcement of syariah governance is to have a global market-driven entity to establish syariah advisory standards for the scholars. For example, in Malaysia, we have established the Association of Shariah Advisors that will draft the standards and code of conduct for syariah advisers and eventually issue licence for those who want to practice in syariah advisory services. This body will ensure that all its members will uphold integrity in providing their syariah advisory services by abiding to a strict code of conduct and guideline."
It is also important for there to be standards decided, made publicly available, as well as a regular review process for Shari'ah scholars, not because there is a widespread problem, but because of the ramifications if a problem occurred. The Islamic financial institution relies on the process of assessing Shari'ah-compliance of products and institutions to a large degree. If there were problems, the reputational damage would spread across the industry as consumers lost trust in the ability to rely on the fatawa stating that scholars were reviewing products and institutions for Shari'ah-compliance on an ongoing basis. Trust is a commodity that is very difficult to repair if it is damaged, and it will be far less costly to put in place ways of spotting problems in advance than it will be to clean up any problems.
On self-regulation by scholars:
"Scholars, as consultants, are similar to other individuals or bodies that provide services to banks, companies and governments. To date, there is no comprehensive governance framework regulating the syariah advisory services across the globe.
Therefore, similar to other professions such as lawyers, medical practitioners, etc. It is vitally important to have a self-regulated industry syariah advisory body to preserve the industry's integrity. Although syariah advisory services are different from the dimension that is religious-driven, it should have its own code of conduct as Islam emphasises integrity in all undertakings."
As mentioned above, there should be standards for Shari'ah scholars conduct in dealing with actual or potential conflicts of interest, and in how they interact with the management of the companies who they are overseeing. Just because it would be beneficial to have a set of standards and a regular review process does not preclude these standards from being designed by the scholars themselves to ensure that their fellow scholars have sufficient knowledge of finance to dig through the massive offering documents and reams of product documentation and understand how the products work. They are also, being dependent to some degree upon the reputation of the industry as a whole, motivated to enforce any failings in meeting the standards.
Sunday, July 08, 2012
Sukuk market development
As I was finishing up my weekly newsletter, I had a few extra thoughts to add to what I included in the newsletter. Here's a portion of the newsletter (sign up on the right hand side of the blog, old issues of the newsletter are available at the Sharing Risk website) for context:
I ran across a presentation from 2005 where the head of IIFM, Ijlal Alvi (PDF) lays out a broad prediction for sukuk markets (with a few recent relevant news items added):
- Increasing demand from issuers to tap sukuk markets (South Africa is planning to issue sovereign sukuk) IFIs want tradable sukuk with fixed income profile
- Development of sukuk funds followed by growing demand for sukuk, causing issuance to “surge exponentially” (Indonesian sukuk fund managers want to expand fund size, but fear demand for sukuk will outstrip supply. This is also true in Malaysia).
- Sukuk will be used for liquidity management and as a money market instrument. (IIFM held a meeting on collateralized murabaha with sukuk as collateral, which is rapidly becoming the standard alternative for unsecured commodity murabaha in inter-bank lending markets)
The items for the sukuk market to develop laid out by Mr. Alvi 7 years ago seem to be falling into line quite well, after being interrupted by the financial crisis. There is however, a key item missing in the sukuk markets across the items above: tradability is possible, but it remains limited.
What surprised me is how well articulated the needs for the sukuk market have been over several years when the global economy and financial markets have gone through significant changes. The problem for Islamic finance is not necessarily that the problems are not articulated, it is that there are so many different factors in play, and the sukuk market is not a unified market, so different markets around the world have a different set of items to change that have moved to the top of the list for stakeholders.
For example, the GCC is largely dominated by sovereign (and government-related entity) issuance, which probably mitigates some of the risks to coporate sukuks that are more common in Malaysia, but the GCC sukuk markets are relatively illiquid and dominated (in terms of size) by fewer, larger sukuk. The Malaysian market is more liquid, with a larger number of issuers, particularly corporate issuers, although there are a number of very large government- or GRE-issued sukuk (the difference is that the secondary market is better developed).
From the top-down perspective, the GCC would be served by a greater diversity of issuers, while Malaysia is attracting more buyers chasing the available sukuk that causes the market to become relatively more illiquid if holders of sukuk don't wish to part with their holdings in fear of not being able to find another sukuk to replace it. The discussion above itself is mostly from a high-level, and there are many other nuances that distinguish aspects of the sukuk markets in these regions and across the countries in the GCC.
However, with different needs in different markets, it is difficult to address the underlying difficulties to even accomplish and agreed-upon goal: creating an Islamic repo product. This is being adopted, using a collateralized murabaha structure, in both the GCC and Malaysia (the latter in part to provide GCC-connected banks with acceptable short-term liquidity management products as a substitute to the domestic inter-bank market which those banks won't use).
An Islamic repo product in order to remain viable even in periods of financial stress, need to have highly-rated and liquid collateral (an equivalent to US Treasuries for conventional repos). There is a shortage of this collateral, which is in part what the IILM will provide (if an inaugural sukuk is ever launched), will have to be issued in large enough supply and with enough diversification across the short end of the yield curve and across different currencies to get a secondary market developed. Otherwise, issuers will be forced to pick and choose from among the sukuk outstanding, which could lead to increased pricing distortions in the yields between liquid and illiquid sukuk as banks bid up the liquid sukuk to use for repo transaction.
So, while individual markets will have their own challenges to address, it is important for the Islamic finance industry to find areas where there are similar challenges--and solutions--to tackle in a cooperative way. One of these challenges is liquidity management and the solution, which is on the right path even if it is taking far too long, is the IILM.
Monday, July 02, 2012
Islamic Development Bank sukuk shows the buyers for future IILM sukuk
The Malaysian International Islamic Financial Centre (MIFC) June newsletter had an interesting article about the latest Islamic Development Bank sukuk, which had a 5-year tenor and a 1.357% yield. The sukuk was issued for $800 million, with $900 million in orders. Particularly interesting was the breakdown of buyers: 55% central banks and regulatory authorities, 35% banks, 6% pension funds and insurance/takaful companies and 4% fund managers.
The breakdown of buyers with most of the issue subscribed by central banks and banks--making up 90% of the total subscriptions--should be seen as supportive for future sukuk issuance by the International Islamic Liquidity Management Corporation (IILM), which is now expected to issue its first $1 billion in sukuk later this year (a target which has been pushed back several times as the IILM waits for a credit rating).
The same investors who bought the IDB sukuk (central banks and Islamic banks) are likely to be the same ones who will buy IILM sukuk. The IDB sukuk, based on its high credit rating, is likely to be a commonly used sukuk in Islamic repo, which is becoming more standardized around a collateralized murabaha structure.
That they are demanding such a low yield on IDB sukuk suggests significant demand for highly-rated sukuk (the 1.357% yield compares to the 0.50% yield on similar maturity German Bunds and 0.67% yield on US Treasuries). The low yield is partly due to the preferred creditor status it has with preferred creditor status (financing projects in OIC member countries), as well as its ability to call additional capital from non-borrowing member countries ). Now the next step, presumably, for the IILM to begin issuing sukuk is getting a rating.
The breakdown of buyers with most of the issue subscribed by central banks and banks--making up 90% of the total subscriptions--should be seen as supportive for future sukuk issuance by the International Islamic Liquidity Management Corporation (IILM), which is now expected to issue its first $1 billion in sukuk later this year (a target which has been pushed back several times as the IILM waits for a credit rating).
The same investors who bought the IDB sukuk (central banks and Islamic banks) are likely to be the same ones who will buy IILM sukuk. The IDB sukuk, based on its high credit rating, is likely to be a commonly used sukuk in Islamic repo, which is becoming more standardized around a collateralized murabaha structure.
That they are demanding such a low yield on IDB sukuk suggests significant demand for highly-rated sukuk (the 1.357% yield compares to the 0.50% yield on similar maturity German Bunds and 0.67% yield on US Treasuries). The low yield is partly due to the preferred creditor status it has with preferred creditor status (financing projects in OIC member countries), as well as its ability to call additional capital from non-borrowing member countries ). Now the next step, presumably, for the IILM to begin issuing sukuk is getting a rating.
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