Dr. Zeti speaks on the shift towards equity-based Islamic financing

Dr. Zeti Akhtar Aziz, the governor of Bank Negara Malaysia, spoke today at the Islamic Development Bank's Regional Lecture Series in Indonesia, and while there was nothing groundbreaking contained in her speech, there were a few parts that I think are important to remember (and I would recommend again that when Dr. Zeti speaks it is wise to be listening). A few quotes:

The recent global financial crisis provides a distinct example of how excessive leverage and exponential growth in financial activities that are detached from the growth trajectory of the real economy can become a source of instability. Leverage increased sharply in the years leading to the crisis, buoyed by years of strong economic growth. In the advanced economies, bank balance sheets exploded, growing to multiples of annual GDP.
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The sheer size, complexity and leverage in the banking system increased the fragility of financial institutions and limited their ability to absorb even small losses, thereby resulting in widespread and deep economic dislocations.

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There is also strong discouragement against excessive risk undertakings and a prohibition against speculative elements. These rulings also serve to insulate the Islamic financial system from excessive leverage, which in turn contributes towards promoting financial stability and its long-term sustainability. These fundamental elements resonate with the call for banking to focus on its core function of providing financial services that add value to the real economy.

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Whilst Islamic finance has all the ingredients and the potential to meet the needs of the global economy, the channelling of funds to productive activities in Islamic finance today is still largely being carried out through non-participatory contracts, that includes the mark-up sale (Murabahah) and the lease-based (ijarah) structures, which continue to remain essential to cater for financing trade and the purchase of assets. Such contracts are similar to lending instruments which expose the Islamic financial institutions mostly to credit risk elements. Whilst non-risk-sharing contracts will continue to contribute to the future growth of Islamic finance, the wider use of risk-sharing transactions and undertakings under participatory finance models have significant scope in evolving a broader representation of Islamic financial products that will spur the next phase of industry growth and development. This includes participatory or equity-based contracts such as Mudarabah and Musharakah that support ventures involving entrepreneurship endeavours. Greater use of equity-based models in Islamic financial solutions has been observed in the more recent period. This has been most evident in the sukuk segment, with Shariah structures evolving from predominantly ijarah and murabahah structures to musharakah partnerships as well as convertible and exchangeable trusts. 

The further development of participatory Islamic finance contracts on a broader scale offers particular potential in efforts to reinforce links between finance and the real economy. Several elements of risk- and profit-sharing participatory contracts support this. As profit-sharing and loss-bearing are clearly identified and agreed based on the contractual agreements between the financier and the entrepreneur, strong emphasis is placed on the value creation and economic viability of productive efforts that create new wealth. In equity-based contracts, the financial intermediation is thus also directed towards promoting entrepreneurship, in that the clearly defined risk- and profit-sharing characteristics of the Islamic financial transaction provides strong incentives for both parties to contribute to the success of the investment. This also provides the foundation for a long-term trust-based relationship, and a clear interest for the financial institutions to undertake the appropriate due diligence to ensure that the returns are commensurate with the risks being assumed. Aspects of governance and risk management thus strongly underpin these contracts. In particular, such contracts demand higher standards of disclosure and transparency to be observed, which in turn act to strengthen market discipline.

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Business risks of equity positions and ownership risks of underlying assets are, for example, embedded in these arrangements arising from the contractual relationships between the investors and entrepreneurs as well as the Islamic banking institutions as the intermediary of funds. Further in-depth applied research is also needed to develop more innovative financial products using risk and profit sharing structures with the corresponding development of risk management techniques. This also needs to be reinforced by enhanced consumer protection and education initiatives to deepen the understanding and awareness of consumers on the associated risks and rewards in the Islamic financial contracts, in particular for equity-based instruments.

Equally important in ensuring the institutional soundness of Islamic financial institutions is the need for robust liquidity management. Today, Islamic financial institutions operating in the different jurisdictions are still confronted with the challenge of managing their liquidity positions effectively, given the limited supply of high quality Shariah-compliant liquid instruments being the reason most commonly cited. The lack of high quality liquidity instruments for Islamic finance is not only constraining effective liquidity management, but it is also affecting the efficient cross-border diversification of financial flows. It is therefore our hope that through the mandate of the International Islamic Liquidity Management Corporation (IILM) in issuing high-quality liquid sukuks, it will contribute to promoting more efficient cross-border liquidity management by Islamic financial institutions whilst facilitating Islamic financial institutions in meeting the international requirements on liquidity.

A theme during the speech is a focus on keeping the Islamic finance industry focused on a connection with underlying economic activity, avoiding excessive leverage and maintaining as much diligence in the underlying businesses being financed.  This is, again, not anything groundbreaking, but it is interesting how she ties it in with the contractual form used in Islamic finance products (ijara/murabaha versus mudaraba/musharaka). 

The primary criticism I would offer of the Islamic finance industry's structure is that it is not only focused on replicating the same contracts as are used in conventional finance, it is replicating to a degree the same business models, with a skew towards the more leveraged business models (investment banking and private equity) at the expense of some that would fit in well with the ideal of risk sharing that Islamic finance is often described as being focused on

There is of course a need for Islamic finance to offer products with similar economics as conventional products for some needs (trade finance using murabaha, for example, or ijara as a substitute for conventional financial leases) but the danger comes when these contracts are used within the context of institutions that accumulate significant degrees of leverage on their own balance sheets. 

In this regard, Islamic commercial banks receive good marks since they have higher levels of capital for the most part and are not heavily leveraged, even though their balance sheets do include some leverage.  Islamic investment banks and Islamic private equity companies, however, which were the main casualties of the financial crisis, on the other hand, used high degrees of leverage in their business and paid the price when financial markets turned and they were unable to roll over their debts as the value of their assets fell. 

In the case of many of these, the institutions themselves were leveraged and their investments were also leveraged, amplifying the effect of a fall in the value of the assets they owned.  To use one company as an example (Arcapita), it had a $1 billion murabaha syndicated loan that the parent company took out to fund part of the investments it made in portfolio companies.  These companies were acquired as leveraged buy-outs, and Arcapita's equity interest was sold to investors, with a portion of the equity retained by Arcapita. 

While Arcapita would argue that it was the actions of an agressive minority of murabaha holders that led to their bankruptcy, these holders acquired the debt at a steep discount to par value because there was a fall in the value of their portfolio companies (many of which were acquired near the peak in 2006 and 2007) and the effect on Arcapita's balance sheet was magnified by the leverage employed on each buy out deal, which led to doubts that Arcapita had sufficient assets to pay its inter-bank liabilities, balances to unrestricted investment account holders and the murabaha holders.  Had the structure been less leveraged, it would have had a greater chance of avoiding bankruptcy. 

And this brings me back to Dr. Zeti's conclusion that the use of risk sharing contracts will force greater connection to the prospects of the businesses the Islamic financial institutions are financing.  While it will force some greater diligence because the risk assumed is more than just credit risk, there will be an important caveat that the market discipline from equity-based contracts will only be effective if the Islamic financial institutions themselves are not leveraged up and thus susceptible to the same types of risks that ended up bringing down many conventional financial institutions.