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.

The Social Impact of Islamic Finance

Farooq Sheikh, a student at the Lahore University of Management Sciences, wrote a 2 part series for SocialFinance, a Canadian blog on impact investing ([Part 1] [Part 2]).  In a comment, he clarifies what he meant by 'social impact':

"I am referring to an influence which is beneficial to the society and delivers sustainable social and/or environmental benefits without negatively affecting the social fabric in the area one is operating. It means solving the problems of the society (e.g.  Providing equity financing to a project which would spur employment) and at the same time earning financial return on the capital for those who have provided the capital."

I am hopeful that Islamic finance will become more focused on the social impact of their activities, instead of just creating the easiest products for them to get Shari'ah approval and make a profit (while donating any non-permissible income to charity as their 'social impact').  There is definitely a wide range of Islamic financial institutions, so to some degree, statements about their concern about social impact are generalizations, but I think it is clear that most Islamic financial institutions are pre-occupied with acting as much like banks as they can. 

As much as it may have been the intent of Islamic economists for "money has no intrinsic value and hence cannot be treated as the subject-matter of trade. It is just a medium of exchange. Islamic financing is always based on tangible assets and inventories, unlike its conventional counterparts."  There is a significant question about whether this is the case in most transactions, for example, those based on commodity murabaha or tawarruq.  These transactions involve tangible assets, but the assets are involved to create a debt (through sale with deferred payment). 

For a while I have argued that this use of commodity murabaha is necessary, both to fit within regulatory requirements, but also in areas like liquidity management where other products do not exist.  I think this is the case, but without necessarily disagreeing with the idea for Islamic finance that Sheikh described.  This, I think, is a clear area where one can differentiate between different uses of commodity murabaha.  While I generally support commodity murabaha used for inter-bank money market transactions (though I have critiqued the use of commodity murabaha-based repo transactions collateralized by commodity murabaha-based certificates of deposit), I have been critical of the use of the same structure for deposits.

The difference, I think, is whether there are alternatives that would work as well that are not commodity murabaha.  In the case of Islamic repos collateralized by Islamic CDs, the commodity murabaha structure could be maintained for the repo with the collateral being tradable contracts like ijara.  In the case of deposits, there are a number of other deposit products like wadiah, qard and mudaraba which are widely used by Islamic banks. It doesn't necessarily address the social impact of Islamic finance, but it can help to combat cynicism that Islamic banks always take the path of least resistance in terms of diverging from the way conventional banks do business. 

Islamic finance complexity (Part IIh)

It has been a while since I added to the Islamic finance complexity series of posts, but I was reading an article that I thought would provide a return to the series (and also back to the liabilities side of Islamic banks' balance sheets).  The IFSB is beginning work on its standards for capital adequacy to incorporate changes in Basel 3, which prompted me to look at one of their Guidance Notes already out there (IFDB-4 [pdf]), which deals with capital requirements around profit-sharing investment accounts (PSIA), which are a large part of Islamic banks' liabilities (equivalent to deposits).

The standard from IFSB provides guidance to regulators to determine the treatment of liabilities (and the assets they finance) for capital adequacy calculations.  What is at issue with the PSIA is whether the assets financed by PSIA should be given a risk-weighting in the capital computation greater than zero (i.e. there should be some capital set aside for the assets they finance).

The theoretical proposition with PSIA is that the assets the bank invests the PSIA funds in should not be treated as assets needing capital set against it.  The logic is that since PSIA investment account holders (IAHs) are liable as rabb ul-mal (in a mudaraba) or muwakkil (in a wakala) to bear any loss and the bank only gets a share of profits (if any) or a fee, respectively, that are generated by the assets.

However, since most Islamic banks--either by choice or because they are required to by their regulators--set up profit-equalization reserves and investment risk reserves, and also can "[forego] all or part of its Mudārib share of profits on investing UIAH [unrestricted IAH] funds, or donating to the UIAH part or all of the profit on investments financed by shareholders’ funds, so as to enhance the profit payout to the UIAH".

As a result, the bank is bearing some displaced commercial risk from the investments financed by IAHs because they will--to some degree--bear the risk of loss in the funds invested that were provided by IAHs.  As a result, while the contracts in their pure form would not expose the bank to possible losses, in actuality the bank has to set aside some capital to pay for these losses.  The IFSB guidance note provides guidance to regulators to determine the calculation of what portion of assets financed by IAH depositors should be considered "at risk" (thus needing a risk weighting based on their own structure).

One of the more interesting discussions in the guidance notes was surrounding the status of IAHs, in terms of how the regulators expect depositors to be treated should the bank become insolvent:

"In practice, there is considerable ambiguity in  the nature and characteristics of UPSIA, which vary among IIFS and jurisdictions. At one extreme, IAH are highly protected so that UPSIA tend to be deposit-like products where the returns are 'stabilised'". 

At the other extreme:

"UIAH have no claim as creditors over the assets of the IIFS (as do conventional depositors). Instead, they have a claim to the assets financed by their funds (including their share of any undistributed profits and less any losses), including their share of assets financed by commingled funds, in respect of  which they rank  pari passu with the shareholders after taking account of the fact that the latter are liable for amounts deposited by current account holders and other creditors."

One note here is that current account holders are depositors under, for example, qard hasan, who have their principal guaranteed, but are not entitled to profit.  Between the two extremes, there are any number of possibilities where depositors are neither treated like current account holders or fully liable to lose the full value of their principal.  The qualification of UIAH (unrestricted IAH) is done because a restricted IAH would have specific assets financed using their funds and therefore would have their funds at risk of loss based on the performance of the assets they finance. 

The distinction in regulatory treatment of mudaraba and wakala depositors across jurisdictions provides another example of how it is not necessarily as simple as arguing whether Islamic banks' deposits should be fully pass-through (a pure mudaraba) or not.  It also highlights the fact that the regulatory environment facing Islamic banks is not uniform and also not necessarily easily transferable to how Islamic banks work. 

UPDATE: I just saw an article which describes some of the different factors that affect whether PSIAs will impact Islamic banks' capital requirements, from the IFSB seminar in Malaysia. 

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

New country, same story?

The boom in Islamic finance in Dubai from 2005-2008 was built on the back of the real estate sector and when real estate faltered, it brought down several Islamic finance institutions.  So it should bring a bit of caution to see that the Participation Banks in Turkey are concentrated in real estate construction as well.  An article in Today's Zaman (ht Islamic Finance Turkey) breaks down the loans from Participation Banks into the uses of these funds:
 
Business Loans
 
Construction loans: $8.01 billion
Trade: $3.52 billion
Textile: $2.05 billion
Food: $1.35 billion

Consumer Loans

Total: $3.46 billion
Of which housing loans: $2.03 billion

Adding the construction loans and housing loans gives just over $10 billion (out of  $20.6 billion in total loans).  Is this too much?  Only time will tell if this is sustainable.  An IMF paper looking at the exposure of US banks before the credit crisis found that they had a higher level of exposure to real estate (62.4%), although the exposure to commercial and residential real estate combined for just over 50%. 

So far Turkey's economy has been growing rapidly--as has its banking system (Participation Banks included)--and hopefully there will not be surprises down the road.  But it is never too early to consider whether there might be warning signs, though more analysis than just looking at the share of real estate financing in Participation Banks' loan books is needed.

Gov. Zeti tells it (mostly) like it is

An article in Arab News describes the prospects for Islamic finance as seen by Zeti Akhtar Aziz, the governor of the central bank of Malaysia, Bank Negara.  Included in the article is a quote from Gov. Zeti which I think does an admirable job at describing the ways in which Islamic finance is affected by the global financial crisis and the recession which followed.  She said:

"The Islamic finance industry was insulated from the first round of the crisis (the global financial crisis). Islamic financial institutions (IFIs) are more resilient because they are closely linked to the real economy, with in-built checks and balances such as profit-sharing and risk-sharing. As such, there are greater elements of responsible lending. As economies slow down and financial markets experience a correction, these will impact financial institutions including IFIs. That is why it is important to have capital buffers, risk management and governance practices that are sound. We are continuing to develop mechanisms, institutional arrangements and financial infrastructures such as greater liquidity management and more so that the Islamic finance industry would continue to be resilient."

There are some things I think are not necessarily true.  IFIs do have some elements of responsible lending because they cannot move risk off balance sheet quite as easily (and in opaque ways) as conventional banks through credit default swaps (which the FT Alphaville blog described in two posts earlier today).  But, I am not sure that IFIs are any more linked to the real economy than conventional banks (with the exception of situations like before the credit crisis when some banks were loaded up with CDOs created (synthetically in many cases) from subprime MBS.  Most (smaller) banks didn't participate in these instruments, but were still hurt because of tightening credit, falling real estate prices and a slowing economy.

However, she is absolutely correct that IFIs are susceptible to a slowdown in the economy, which necessitates a similar level of regulation as other financial institutions.  Gov. Zeti is usually a good source for clear statements on the Islamic finance industry and this quote is a good example.

A couple other things in the article caught my eye.  First, the 3 applications for Islamic mega banks are not from Western institutions, and are reportedly backed by GCC-based investors, which continues the trend of convergence between the GCC and Malaysia.  Second, Governor Zeti is quoted saying: ""The IILM [International Islamic Liquidity Management Corporation] is currently obtaining the required rating, as well as fulfillment of all other parameters for the issuance including high quality underlying assets".  This to me suggests that the sukuk will be more likely an istithmaar sukuk, backed by Shari'ah-compliant financial assets from the central banks that are the members of the IILM.  Under standard practice, fewer than 50% of these assets will be murabaha and istisna'a if the sukuk are going to be tradable (though I think AAOIFI rules stipulate a cutoff of 33%). 

Could Tadawul become a regional sukuk trading center?

My earlier post on the expected $4 billion sukuk from the Saudi aviation authority GACA seems like it could be of even greater significance if the new rules allowing foreign investors to invest directly on the Tadawul exchange.  Currently the Tadawul sukuk and bond market has 7 listed sukuk from 4 issuers with a total size issued of SAR34.5 billion ($9.2 billion).

A sovereign sukuk (the GACA sukuk is guaranteed by the Ministry of Finance) with an issued size of SAR15 billion ($4 billion) would increase the total value of sukuk eligible for trading by nearly 50%.  If foreign investors were able to invest in sukuk directly through the Tadawul, and if foreign issuers were able to list their sukuk on Tadawul, it could create additional liquidity for sukuk, which is growing, but is still limited.

UPDATE: The activity on the Tadawul Sukuk and Bond Market for 2011 was very small (see Annual Report 2011, page 45 [pdf]).  On average, there was 1 transaction every 5 trading days (49 trades in 248 trading days) and the total volume was SAR1.8 billion ($480 million).

Combining Islamic finance and sustainable finance

I've been going through the Malaysian Financial Services Blueprint (2011-2020) and there are a number of interesting ideas in there about Islamic finance.  Hopefully, I'll get to some of the others in later posts; the first one is on the connection between the Socially Responsible Investing industry and the Islamic finance industry.  The report writes:

The demand for Islamic finance is expected to emanate not only from the Muslim population but also from those with affinity for socially responsible objectives and those seeking ethical financial solutions where the central theme is a more equitable model that would foster sustainable growth, whilst preserving the environment and improving the overall socio-economic landscape. This is spurred by the growing significance of global ethical consumer movement where Socially Responsible Investment (SRI) is expected to be an important mainstream asset class by 2015. With this development, Islamic finance has an enhanced growth prospect given its close synergy with ethical finance.

The idea here is worthy and there is definitely a possibility for Islamic finance to attract non-Muslim consumers based on the ethical ideas that underpin Islamic finance.  Malaysia is noteworthy in this respect and estimates place the share of Islamic bank accounts held by non-Muslims at around 25%. 

The often attributed reason for the take-up of Islamic finance by non-Muslims in Malaysia is that the products are cost-effective or even cost-advantageous, in part due to the government's efforts to promote Islamic finance.  This is something which could work in some other regions, but in many countries--particularly those with small Muslim minorities--the idea of favoring Islamic finance over conventional finance is going to be a non-starter. 

Without a government-aided cost advantage, Islamic finance will have to offer something new that conventional finance ignores.  The most frequently offered suggestion is to move Islamic finance more towards profit-sharing contracts (e.g. mudaraba and musharaka).  While this may make Islamic finance more attractive (it is not necessarily certain that this is the case), it is unlikely that, outside of some areas of finance like stock markets, this will be possible in current regulatory environments. 

Therefore the suggestion from the report to focus more on activities that "foster sustainable growth, whilst preserving the environment and improving the overall socio-economic landscape" makes sense.  This is probably most likely way to tap the "enhanced growth prospect given its close synergy with ethical finance".  So far, Islamic finance has concentrated much effort in laying the groundwork and setting up Islamic finance to meet the financial needs in a way that is Shari'ah-compliant.  

Now, it should take the next step from expanding the breadth of product offering and focus on differentiation.  This need not be an industry-wide shift.  There are likely to be plenty of people who just want a Shari'ah-compliant alternative to conventional banking, so not adding complexity will make these services more competitive with conventional financial institutions.  

However, there is likely a market opportunity--among both Muslims and non-Mulims--by offering Islamic financial products with a focus on low-income communities, avoiding investments that are not environmentally sustainable, and to add other so-called ESG (environmental, social, governance) criteria to the investment decisions.  These may or may not be required to be Shari'ah-compliant, but there is nothing stopping Islamic financial institutions from adding more ethical criteria to their decision-making process. 

Largest sukuk ever - does it matter?

I am not usually impressed with most of the "first" or "biggest" news items relating to sukuk because there is usually more need for more plain vanilla sukuk and less need for overly complicated sukuk.  We all remember how the Nakheel sukuk worked out, and one of those was both a "biggest" and a "first".  However, the reports from Zawya that Saudi Civil Aviation Authority GACA is on the verge of issuing the first sovereign sukuk from Saudi Arabia, as well as the largest ever with a reported size of SAR 15 billion ($4 billion). 

This sukuk is significant because Saudi Arabia is the largest GCC economy and has been less active in both corporate and (of course) sovereign issuance of sukuk.  The $4 billion represents almost the entire total issuance for December ($5 billion) and a good portion of the average monthly issuance globally during 2011 ($85 billion total, or about $7.1 billion per month).  The sukuk is guaranteed by the Saudi Ministry of Finance, giving it a credit quality likely on par with the Saudi government's Aa3 rating from Moody's and AA- from S&P. 

The sovereign sukuk should provide a high quality for investors like takaful providers and pension funds, but not all of it is likely to end up being held-to-maturity and the sukuk, if it listed on the electronic market for sukuk with Tadawul, could provide a boost to the trading volumes in sukuk (e.g. an investor holding a corporate sukuk that wishes to remain invested in sukuk but not exposed to a corporate credit can sell the corporate sukuk and buy a sovereign sukuk, which they are not currently able to do). 

Indonesia inter-bank money markets

It is difficult to tell exactly how the inter-bank money market will work (described in an article from Bisnis Indonesia).  The article describes:  

 "According to him [an unnamed source at Bank Indonesia, the central bank], the underlying asset in the money market may be in the form of sharia commodity futures. Moreover, collateral may use government’s sukuk.

Taking apart the parts of this sentence, I would imagine that the "sharia commodity futures" refer to using a commodity market (for cocoa, cashew or arabica coffee, as the article suggests later) to back commodity murabaha between Islamic banks in Indonesia.  A commodity murabaha is a common inter-bank money market instrument in the GCC and Malaysia.  The latter has set up an exchange, Bursa Suq al-Sila, to connect palm oil producers with financial institutions that want to use palm oil to back commodity murabaha transactions.


The difference between most commodity murabaha inter-bank lending and the Indonesian plan, from my reading, is that the inter-bank commodity murabaha would be collateralized using government sukuk.  Bank Indonesia announced in the first half of 2011 that it planned to issue 3-, 6- and 12-month Sharia T-bills and was scheduled to issue the first 6-month T-bills in early August. 

Collateralizing inter-bank commodity murabaha transactions is a good move from a risk management perspective, where lack of confidence by counterparties can lead to withdrawal of inter-bank lending and turn a liquidity crisis at a bank to a solvency crisis.  If the inter-bank lending is collateralized, the counterparties to a bank that runs into a perception that it is in trouble will be less hesitant to withdraw funding to that bank (although they will certainly not be patient for ever).  This is the reason that repurchase (repo) transactions have become a large source of short-term funding for many banks (with the caveat that the security of repo transactions is only as good as the credit of the collateral; the European debt crisis shows that even seemingly solid sovereign credit can lose their value as collateral very quickly).


The difficulty with developing this type of collateralized inter-bank lending is from a Shari'ah-compliance perspective.  The issue of collateralized commodity murabaha was one of the proposals considered by the International Islamic Financial Market (IIFM) (see my initial comments here). It is still not necessarily widespread, but it is a promising way to make inter-bank lending more secure (which prevents funding from drying up as quickly and gives time to deal with troubled banks).  However, there are obstacles--about which I cannot speak with authority---that make it more difficult to ensure it is widely accepted as Shari'ah-complaint.  But, it adds to the forthcoming International Islamic Liquidity Management Corporation (IILM) as a new source of inter-bank liquidity management tools that will strengthen the Islamic finance industry. 

In the end, we will have to wait and see what the final regulations around collateralized inter-bank Islamic lending from Bank Indonesia.  However, I think that the development is positive and could help Indonesia be an area of growth for Islamic finance and banking in 2012 (more in terms of being rapidly growing; not necessarily having a large quantitative impact on the size and growth of Islamic finance as a whole).  One area where it does not have much impact is in moving Islamic finance away from murabaha.  However, it is probably better for Islamic banks and financial institutions to move other parts of their balance sheets away from murabaha and towards profit-and-loss sharing instruments before the inter-bank money markets are shifted away from murabaha.

Islamic banking growth in Indonesia

One of the regions I see continued growth for Islamic finance in 2012 is Indonesia, which is geographically close to Malaysia where Islamic finance is as developed as anywhere in the world.  There are also links between the two countries banking systems, with several Malaysian banks with Islamic windows (e.g. CIMB). 

The central bank, Bank Indonesia, reported that (ht IF Indonesia for translating the article) in November 2011, Islamic bank financing had risen 45% over the same period in 2010 to Rp. 31.9 trillion ($3.5 billion).  For the fourth quarter Islamic bank financing was Rp. 102 trillion ($11.2 billion), 45%.  At the same time, non-performing loans fell from 3.12% to 2.85%, indicating that the increase in quantity has so far not come at the expense of quality. 

However, the Islamic banking industry in Indonesia is tiny compared to the overall banking system, representing between 3.8% and 3.9% of the total banking system.  This small size and rapid growth, represents an opportunity to expand, which I think it will in the next year. 

There are also developments in how the central bank interacts with Islamic banks, with the launch of repo transactions on Islamic Treasury Bills, which I discussed in an earlier post.