AAOIFI needs to adapt

AAOIFI is undergoing a radical transformation under its new Secretary General since his appointment following his predecessor's, Dr. Mohamed Alchaar's departure to head the Economy and Trade ministry for the murderous Assad government in Syria.  The shakeup following Dr. Alchaar's departure is a welcome move for the industry since AAOIFI is one of the top standards-setting bodies in Islamic finance.  Until now, it has relied on revenues from publishing the dead-tree versions of its standards as a key revenue source. 

With most regulatory bodies moving online, AAOIFI has been decidedly behind the trend in keeping its standards only available in hard-copy, even while other Islamic finance bodies (e.g. the IFSB) have provided their standards online in freely available PDF files.  Reuters is reporting that AAOIFI is considering significant reforms of its policies, importantly including rules that would mitigate the potential conflicts of interest in the Shari'ah supervision process. 

The conflict of interest policies that AAOIFI is considering do not necessarily implicate Shari'ah scholars in any wrongdoing.  Most Shari'ah scholars are doing their best to adapt the financial structures used by Islamic banks to meet the real financial needs of Muslims who eschew conventional banks.  There have been a few instances where conflict of interest has played a role in scandals in the Islamic finance industry, however, that merit greater attention. 

For example, the president of Sunrise Equities, a purportedly Shari'ah compliant company in Chicago that ended up as a fraud with the company's founder fleeing the country had significant conflicts of interest with the Shari'ah board that ruled on the product being supported financially and operationally by the president of Sunrise.   A little further north, UM Financial in Toronto, had a Shari'ah board whose chairman is alleged to have been in cahoots with the founder of UM, Omar Kalair in diverting home financing payments out of the company through the Shari'ah board, in transactions that were supposedly payment for Shari'ah consulting services. 

Islamic finance, particularly in the West, is under a microscope for any wrongdoing.  I believe that most Shari'ah scholars are doing their jobs honestly and with the best of intentions, but there are critics waiting for any slip up to proclaim the industry corrupt.  The best way to counter the critics of the industry is to put in place rules that limit wrongdoing and that are fully transparent.  AAOIFI is currently the best venue for this to occur because it has the widest acceptance by Islamic financial institutions.  However, it must become much more transparent itself. 

Arcapita's portfolio company profine sold to private equity firm Hidden Peak Capital

Arcapita's subsidiary profine GmbH, a German-based plastics window frame manufacturer was sold to Hidden Peak Capital, a special situations private equity group based in Germany.  The terms of the transactions were not disclosed, but it likely includes the repayment of the murabaha loan from Commerzbank for up to €125 million that is guaranteed by Arcapita (total borrowing amount is not disclosed in the court filings). 

The murabaha facility entered the court documents when Commerzbank requested permission from the bankruptcy court to serve notice on Arcapita that the facility was in default to perfect their claim on Arcapita, which they contended should be exempted from the automatic stay. 

While the sale, which may need approval from the bankruptcy court, resolves one issue in front of the court, it will likely heighten the challenges by creditors on Arcapita's ability to continue to make inter-company transfers.  Not all of Arcapita's subsidiaries were covered by the bankruptcy, so there is a possibility that proceeds from the sale could be moved into non-debtor subsidiaries, away from the reaches of creditors. 

Too few sukuk!

Much of my research on Islamic finance has focused on the GCC because I think that the combination of petrodollars and a large Muslim population who opt for Islamic finance over conventional finance, the region has the potential to be center for Islamic finance in general and sukuk in particular.  I still think that in the long run that will be the case, but I think it will not be the case in the near term.  Instead, I think that Malaysia has the potential to see its Islamic capital markets remain the world's largest, even though it is much smaller in terms of economic size and population than the GCC. 

If you look at the population and economic sizes of the GCC and Malaysia, it isn't even a question that the GCC should dominate the Islamic finance market.  The GCC has 47 million people, most of whom are Muslims, while Malaysia has just under 27 million.  Malaysia' GDP is $237.8 billion according to the World Bank, while the GCC GDP is $1.4 trillion.   Malaysia is also reputed to have more liberal Shari'ah standards, which limits its ability to attract money from the GCC. 

However, Malaysia represents the majority of sukuk issued and has a much more liquid sukuk market than the GCC.  In years past it was legitimately mentioned that many of the sukuk issued in Malaysia would not pass muster by Shari'ah boards in the GCC, but this is a thing of the past with so many GCC-based financial institutions looking to Malaysia to issue sukuk.  Whether or not these institutions are looking to Malaysia, they are still subject to their own Shari'ah board rulings, which would subject them to the 'tougher' Shari'ah standards that prevail in the GCC. 

Add in the fact that the new issuer of global short-term sukuk, the International Islamic Liquidity Management Corporation (IILM), is to be based in Kuala Lumpur with Dr. Zeti Akhtar Aziz (governor of Bank Negara) heading it, and it becomes more clear which region is leading in facilitating sukuk issuance and secondary market activity in sukuk.  In the last two newsletters, which should be posted next week (sign up on the right side of the blog), I have analyzed the shortage of sukuk with respects to the effects on pension funds and takaful providers. 

One thing that surprised me about the shortage was that it was being articulated by Malaysian pension funds.  Even with the domination of the sukuk markets by Malaysia, the pension funds there were finding it hard to expand their sukuk holdings because of a shortage of sukuk. 

In my opinion this suggests that there remains much more demand for sukuk than there will likely be supply, even if there is $125 billion in issuance that is predicted for 2012.  When pension funds and takaful providers run into shortage of sukuk, it is indicative of one of the following situations: 1) there are too few sukuk being issued overall; 2) there are too many low-quality sukuk issuers trying to tap the Islamic capital markets ; or, 3) there are too many conventional funds trying to "find a new asset class". 

Explanations 2 & 3 might have held water before the financial crisis and Dubai's debt crisis, but are not the case today when most of the GCC-based sukuk issuance (and a good deal of the Malaysian issuance) is in sovereign sukuk.  The quality of sukuk being issued globally is of higher quality than it has been for many years, but there is just too little of it to satisfy the demand for it.   Unfortunately for lower quality issuers, there is probably not the same level of demand for lower-quality corporates (Malaysia, perhaps, being the exception). 

The sukuk markets are in a bit of a quandry.  The thriving market is in Malaysia, but most of the issuance from Malaysia is denominated in Ringgit, which adds currency risk compared to the GCC countries whose currencies are all linked with the dollar, which is viewed as the 'safe' currency.  The GCC has the economic size to compete with (and probably outweigh) Malaysia, but has is slowed by political unrest in the region and uncertainty about the stability and predictability of the legal systems. 

Will there be more dollar-denominated issuance out of Malaysia?  Will the GCC focus on creating more legal predictability for sukuk backed by assets located in that region?  Or will the shortage of sukuk continue and the long process of greater sukuk issuance along the lines we have seen in the past 3 years continue?  As much as I would like a quick fix, I think the third option is the most likely. 

Egypt as a microcosm of debate in Islamic finance

Reuters has an illuminating analysis of the questions facing the Egyptian government over how Islamic finance is regulated in the country.  The analysis compares the options facing the government in Egypt in terms of how other countries regulate their Islamic financial industry.  For example, the article describes the following dichotomies:

• Should Islamic banks be allowed to operate Islamic windows or should they be required to open Islamic banking subsidiaries?
• Should sukuk be allowed to be issued using an asset-based structure, or should they be required to be asset-backed?
• Should Shari'ah boards be allowed to operate on an institution-by-institution basis or should there be a national Shari'ah board (or use a lighter-touch approach used in Indonesia, which may be more suitable for Egypt according to Shari'ah scholar Mohammed Daud Bakar). 

As much as the debate between the pragmatic and the ideological may slow the development of more Islamic finance in Egypt, it also highlights some of the overarching debates within Islamic finance.  For example, Qatar (a financial supporter of Egypt's government) required the closing of Islamic windows at conventional banks citing, among other issues, the potential for leakage between the Islamic and conventional sides of banks that offer both types of banking [1]. 

By allowing Islamic windows, Islamic finance can benefit from the entry into the market of international banks that have larger balance sheets and can bring greater resources to bear on developing new Islamic financial products.  The flip side is that it may hamper development of solely Islamic banks, and may lead to the adoption of a mindset that favors developing Shari'ah-compliant of conventional products (however, solely Islamic banks may also have the same mindset due to either regulation or the reliance on management with experience in conventional banking). 

These discussions are healthy and should lead to more analysis of the industry as a whole.  There are enough different institutional forms in use across the globe for the costs and benefits to be weighted.  There is no "right" answer--each country may find one form or another more beneficial--but the debate should be encouraged and should be backed up by rigorous analysis comparing different institutional forms. 

[1] I have written a number of posts about the Qatar Central Bank directive:

• QCB announces directive
• Additional commentary on QCB announcing directive
• QCB directive leads banks with Islamic windows to sell retail banking units
• Unintended consequences of the QCB directive
• IMF Article IV report on Qatar addresses the QCB directive

Arcapita bankruptcy update

In the latest week's newsletter (sign up for the newsletter on the right side of the blog; an archive is available on my website), I included a summary of some of the latest developments in the Arcapita bankruptcy case[1].

Arcapita’s bankruptcy case is ongoing and a recent objection by Standard Chartered, which provided $100 million of murabaha financing to Arcapita in 2011, presumably to finance the company through its anticipated debt restructuring of the $1.1 billion murabaha whose imminent maturity led the company into bankruptcy. 

The objection by Standard Chartered is based on the potential, according to Standard Chartered, for Arcapita to make inter-company transfers of dividends that should be held for Standard Chartered due to its mortgage on the equity of a number of Arcapita subsidiaries.  Standard Chartered, in a court filing, described that “if the value of the Subsidiary Guarantors, which is at best uncertain, is transferred to AIHL [Arcapita’s Cayman Islands holding company] or Arcapita Bank, Standard Chartered’s security interests could be rendered worthless and the Subsidiary Guarantors could impermissibly be rendered insolvent to the detriment of Standard Chartered”. 

Standard Chartered is asking the court to make the approval of any budgets the court is presented with by Arcapita require approval by Standard Chartered as well.  More concerning for the unsecured murabaha holders, the senior position of Standard Chartered means Arcapita will have to come up with more money before lower priority murabaha creditors get paid. 

In another document filed with the bankruptcy court, Barclays Bank, which is on the committee of unsecured creditors, has asked the court permission for its affiliates to trade claims on Arcapita’s debt, as long as it separates those trading activities from its position as a committee member to avoid potential conflicts of interest. 

As I mentioned in an earlier blog post, is the fact that the murabaha financing is being traded (and the trading is unlikely to occur at par).  Yet, there has been much less controversy about this than about the potential for the Goldman sukuk to be traded since it was listed on the Irish Stock Exchange (even though it was never likely to trade).  

There are a few filings so far this week including two (pdf 1, pdf 2) requesting an extension of the time Arcapita has to file its financial statements to June 21, 2012, from the previously extended deadline of May 3, 2012.  In their filings, Arcapita cite a need to consider "nuanced legal issues[...], in particular, payments and distributions to and from insiders and other affiliates".  They also cite as a source of delay, "the Shari’ah-compliant nature of the Debtors’ investments requires a thorough analysis of some of the characterizations required by the Schedules and Statements"

Another filing, this one from Commerzbank (pdf), asks the court to grant a relief from the automatic stay to allow Commerzbank to serve a notice of default on profine GmbH, a portfolio company of Arcapita that manufactures PVC window frames, on a Euro125 million murabaha line of credit (guaranteed by Arcapita), which profine defaulted on a week before Arcapita filed for bankruptcy.  Under the murabaha (the total amount outstanding is not specified in the filing, but is described as "principal plus unpaid profit"), Commerzbank could only exercise the guarantee once 14 days passed after the default.  Commerzbank argues that delivering a claim notice to Arcapita is only a ministerial act designed to perfect and crystallize Commerzbank's claim, and therefore it would fall outside of the automatic stay.  It is unclear whether the default was related to funding problems at Arcapita, but profine announced a management change on February 24, weeks before defaulting on the murabaha (followed of course by Arcapita's bankruptcy filing). 

[1] Note: I am not a lawyer, so this post represents my opinion from reading the court filings.

What could go wrong?

When I saw the headline "Emirates Islamic offers 100% financing for UAE homes", I thought I had traveled back in time to a bygone era (specifically 6-10 years ago in the United States).  I looked at the date on the article, April 14, 2012, and it surprised me that an Islamic bank would have stumbled upon a product that had so recently led to havoc in the conventional financial markets.  Sure, the US housing boom was fueled by other factors (securitization and re-securitization of mortgages into complex securities), but one of the reasons the problem spread into the real economy was that a fall in home prices pushed many homeowners into a position of negative equity (owing more on their homes than it was worth). 

The way that Islamic home finance works today would not insulate an Islamic bank offering this type of product from problems down the road, and since the product offered here is only for 5 years, it creates a potential refinancing risk, since most people cannot afford to pay for a house in just 5 years.  A 5 year loan requires that either refinancing will be a available five years from now, or a rise in home prices (and thus a buyer expects to sell within 5 years).   Both assume that the home will either remain the same price or increase, which the financial crisis and recession following it has demonstrated is a dangerous assumption. 

The difference between a 100% financing product and an 80% financing (e.g. 20% down payment) is that the former incentivizes greater speculation on home price rises because it doesn't require they buyer to have 'skin in the game'.  The incentive problem is made more complicated by the potential for buyers who default to be threatened with arrest. However, while this might limit the number of defaulters (in an non-optimal way), the incentive problem remains.  It is a frequent refrain that Islamic finance was spared some damage during the credit because it is different from conventional finance, but if Islamic banks start moving into the same types of products that caused problems in the financial crisis, will this hold true in the future, or are we on the road to Islamic CDOs?

Islamic mortgages: Is there anything new?

An article I read tonight raised an old question about Islamic mortgages that I think is interesting, specifically, whether they offer anything different from conventional mortgages.  The answer (both yes and no) is a bit complicated for the basic question asked. The context is the UK market, but it applies in any market and has less to do with the specific regulatory requirements for companies offering home financing.  The article describes:

Risk sharing, not profiting unjustly or unfairly, not charging excessive charges; in a residential purchase context, allowing part rent, part purchase, sharing equity upside, sharing downside property risks. These characteristics apply equally to an approved Islamic home finance plan as they do to a new conventional purchase plan designed for a housing association in the north east of England.

There are a few different themes expressed here which affect Islamic mortgage financing.  The first comes up in the first two words: "risk sharing".  This is often used as the big difference between conventional finance and Islamic finance, in many cases erroneously (disclaimer: if you reverse the two words you come up with the brand I operate under).  There is nothing in Islamic finance that requires sharing risk any more than conventional finance.  It would be perfectly acceptable for a business to structure its contracts so that they are Shari'ah-compliant and where one party accepts only minimal risk beyond the credit risk that conventional banks specialize in dealing with. For example, an Islamic bank may only offer financing using murabaha, which is the most commonly used structure for assets on Islamic banks' balance sheet .

The next part is, in my opinion, more important for what Islamic finance is designed to do: "not profiting unjustly or unfairly, not charging excessive charges".  In the modern concept of finance, this is where Islamic financial institutions should be cleaning up and taking business from conventional banks (for both Muslim and non-Muslim consumers).  However it has not happened and there have been failures of business models (e.g. Arcapita and Gulf Finance House) and institutions themselves (e.g. UM Financial) where ethical behavior has converged with the conventional industry or even dropped below the (low) industry standard. 

This is more a problem of regulation.  The Islamic investment bank models practiced in the GCC where the banks would invest and then sell on to investors at a premium with minimal disclosure (I am speaking here more of GFH where there is more evidence of the practice) would have not been allowed in more strictly regulated markets.  In the case of companies like UM Financial, which escaped regulations almost entirely, had they been subject to even minimal standards of regulation in the industries they operated, they would have been shut down far earlier than they were. 

More than any other financial sub-industry, Islamic finance should welcome regulation (both in the traditional sense and in the additional Shari'ah regulation).  There are issues with how the industry imperfectly self-regulates today (on the Shari'ah side), with egregious abuses in conflict of interest have occurred in both Chicago (Sunrise Equities) and Toronto (UM Financial) where the companies' founders were excessively connected with the heads of their respective (supposedly independent) Shari'ah boards rendering them in practice as non-independent. One hopes that other regions have better standards, but I am not encouraged by the fact that UM Financial is still listed as a member of AAOIFI. 

Regulation to prevent bad actors is necessary to maintain the credibility of the industry as a whole, especially in overly politicized environments (like the US and Canada) where any wrongdoing (or even right-doing) by an Islamic financial institution is seized upon as "evidence of a plot to impose Shari'ah". 

But I have become distracted from the main point of this post, which is to address the description of Islamic mortgages: "allowing part rent, part purchase, sharing equity upside, sharing downside property risks".  This was the point that inspired the post and I think is the most interesting about how Islamic finance works in practice: it is much easier for Islamic mortgage companies in the US to share in the upside of transactions than it is in the downside, but it almost never happens. 

Banking regulations in the US are extremely hesitant to allow a depositor to lose money and most of the potential uses of deposits for an Islamic bank would be in mortgage financing.  However, the discussion always revolves around the banking side of the equation: why do Islamic mortgage providers use Freddie Mac to provide much of the liquidity to fund Islamic mortgages?  Why don't Islamic financial institutions use more of a profit-and-loss sharing method of mortgage finance?

The answer may not necessarily be the financial institutions' fault (they do have to fit within the US' financial regulations, but there are many forms they could take to serve the market if profit-and-loss sharing were demanded).  It may be that most potential customers demand a Shari'ah-compliant product that leaves them with the upside.  Given the evidence of the industry's roughly 40 year history, it appears that when presented with the costs and benefits most consumers prefer to keep the upside, and use more debt-based financing models for home finance. 

The present form for Islamic finance is, of course, not where it will be in 10 or 20 years and it will (should) change substantially over that time period, but the key for that change in the mortgage market will be consumers themselves giving up their monopoly on the upside gain.  Are financial consumers willing to give up a portion of the appreciation of their house's value to be able to pass along some of the loss if home prices fall, especially when Islamic mortgage companies are offering non-recourse Shari'ah-compliant loans?  I am not sure of the answer today.

Could off-balance sheet investment accounts become Islamic SIVs?

When I was going to look at the latest AAOIFI consultation paper on real estate, I noticed that I had missed a consultation paper (pdf) whose comment period expired recently that focused on the accounting treatment of investment accounts that use mudaraba and wakala. 

At the heart of the changes or refinements (not being able to look up the existing standard on the web, I cannot compare the new with the old) is that restricted mudaraba and wakala deposits will be treated as off balance sheet assets, while unrestricted mudaraba will be treated as on balance sheet assets.  In general the distinctions between how each type of account is treated (restricted mudaraba are investment accounts that are limited to a particular investment, unrestricted mudaraba are invested at the discretion of the bank, while wakala accounts are agency accounts where the financial institution acts as agent). 

One area of concern I have is that the standards as they relate to off-balance sheet accounts (restricted mudaraba and wakala accounts) are relatively untested in terms of whether those accounts would creep on balance sheet in a crisis.  An analogy to how they are treated is to remember back to the early days of the financial crisis when the structured investment vehicles set up off of bank's balance sheet (the shadow banking system at its worst) to invest in mortgage-backed securities). 

The way these SIVs worked is that a bank would set up an off-balance-sheet entity, which would issue asset-backed commercial paper (debt backed by collateral with a maturity of less than 270 days).  The proceeds would be used to buy MBS, as well as other higher-yielding, long-term investments.  The SIVs were engaged in maturity transformation (borrowing short-term and lending long-term), a typical role of banks,. except that the SIVs were acting outside the banking regulations because they were off-balance sheet.  The key for them to maintain their solvency was to keep a very high credit rating on their ABCP; any doubts about the assets backing the commercial paper could (and would) lead them to implode. 

During the financial crisis, the fall in value of MBSs, CDOs and the rest of the mortgage-related alphabet soup led to concerns about the solvency of the SIVs and made it more difficult for them to roll over their commercial paper.  Facing the prospects of the SIVs collapsing, the banks which sponsored them in most cases stepped in to provide financing when the market for commercial paper closed completely. 

After that travel back through time, an Islamic financial institution that offered a restricted mudaraba or wakala may not be legally required (and may be specifically prohibited by the Shari'ah board from offering such a guarantee) to repay the entire principal amount of the off-balance sheet accounts as if it were a deposit, but may still face market pressure to treat all off-balance sheet items equally to the unrestricted investment accounts that reside on their balance sheets. 

Just as the SIVs were their own separate entity, and the banks had no legal requirement to bail them out (they were supposed to be able to sell assets to meet any liquidity needs, but those markets had become distressed as well), an Islamic financial institution may also feel the need to bail out the restricted mudaraba and wakala deposit holders in order to maintain their reputation in the market (reputation specifically around their solvency).  In finance, the loss of confidence can be a death knell, even if the institution is fundamentally solvent. 

In the end, there is not necessarily a better way to handle the on-vs-off-balance sheet treatment than the AAOIFI rule does, so long as Islamic financial institutions offer sufficient disclosure (and investors read the disclosure) about off-balance sheet assets.  With Arcapita in bankruptcy now, it would be tempting to look to that case for some precedent, but that is not likely since they had few deposits, and what they did accept (which they said was more of a favor to investors in their deals, but which ended up becoming a significant source of funding for their portfolio companies) was unrestricted investment accounts, which would have been treated as an on-balance sheet investment account under the new AAOIFI standard. 

Unfortunately, the other cases of financial distress among Islamic financial institutions since the crisis probably have not been required to make as many disclosures about the resolution of their financial distress, mostly because a lot have stumbled on in shadows of their former selves with their investors agreeing to "extend-and-pretend".  Others have been folded into other banks and have not unfolded in public view. 

Islamic finance should support greater diligence of offshore companies

It would be a welcome development if Islamic finance were to take the lead on a contemporary financial issue, rather than just wait for new developments to sprout up and then find ways to benefit.  The Economist this week described the profitable business of registering companies in offshore locations (and some surprising onshore locations as well), based on a World Bank study released in late 2011 [pdf] that focused on the potential for these companies to facilitate money laundering because they are not required to undertake the level of diligence required by banks and other financial institutions.

Most of the structures that use the companies and other corporate entities detailed in the report have legitimate economic uses (for example the SPVs used in sukuk transactions), but many of them can also be used in money laundering by corrupt government officials, for example.  At issue in the report is the flimsy diligence required by the service companies who help set up the companies and get them bank accounts.  There is little that can be done by the Islamic banking industry in this regard, at least directly, since they are already subject to much more stringent anti-money laundering (AML) laws.

However, as a growing segment of the financial industry, and one which is frequently subject to the false accusation that it facilitates money laundering and financing of terrorism, it could benefit the industry if it were to advocate for strengthening the requirements by these service companies to perform additional due diligence on the companies they set up, including the SPVs that are used to facilitate sukuk issuance.

There would be some cost if the additional requirements were placed on the service companies (who would undoubtedly pass the cost on to their clients), but it would likely be minimal for the end users since the costs associated with the SPVs are de minimis compared to the transaction sizes involved in most sukuk.

The benefits, however, would be much greater.  It would show that the Islamic financial industry is not only committed to applying the current AML laws, but that it is interested in encouraging greater disclosure in financial transactions and curbing avenues for money stolen through corruption and money destined to fund illegal activity to move around undetected.  Islamic financial institutions expend considerable efforts to make commercial activity work in a way that is fair to both parties through disclosure, risk sharing and by limiting transactions where one party gains at the other's expense.

Encouraging the world to take relatively modest steps against money laundering, especially when a lot of the money involved is proceeds from corruption, would be a good way to offer evidence that Islamic finance is not just about replicating the conventional financial industry's products, but wants to take the lead in creating a more just world.

TheCityUK report on Islamic finance

TheCityUK, the trade group for London's financial services industry released its annual report on the Islamic finance industry, showing the growth of the industry to $1,130 billion in assets at the end of 2010 with an estimated growth in 2011 to $1,289 billion. This report is useful because at this point there are several years of report to look for trends, in part to identify areas where the data are more or less likely to reflect reality.  The Islamic finance industry is notoriously opaque, so hard data, even data on the aggregate size of the industry, are unreliable. 

For example, on of the areas that I am skeptical of the data is the inclusion of the Iranian financial institutions.  The reason why I am skeptical of the Iranian data is that, despite accounting for 36% of total assets and facing tight international sanctions, there has been no spillover to the rest of the Islamic finance industry in terms of growth.  Viewed a different way, as of the end of 2006, Iranian Islamic financial institutions had $154.9 billion in total assets as of the 2008 version of this same report.  By 2010, this had increased to $388.0 billion, an annualized growth rate of 26%.  The Iranian economy was growing during this period (pdf, page 5), but with international sanctions tightening, and limited financial market development and integration with other markets for Islamic finance, it is unlikely, in my opinion, that the Iranian Islamic finance industry grew at a more rapid pace than the Islamic finance industry in the rest of the world.  Another factor that casts doubt on the rapid growth is that the banks that would represent much of this growth are specifically targeted by sanctions, and are also large banks (it is much harder for a big bank to achieve and sustain such a high growth rate). 

However, the rest of the report is worth reading because there are few other sources of data on the industry as a whole.  For example, a new table this year (I think) shows a data series of the average management fee of Islamic funds.  The interesting thing in the table is that the average management fee has been declining from 2006 to 2011Q1, from over 1.5% to just above 1.0%.  This is a positive development for Islamic investors, but may hamper the entry of new fund managers.  However, one area where growth is due is in fixed income funds, which only make up 6.8% of total assets under management in Islamic funds.  The demand for Islamic fixed income funds is likely to be strong, since there are few offerings and it is difficult for all but the largest investors to invest directly in a portfolio of sukuk.  The upside from the fee perspective is that most conventional fixed income funds charge lower management fees than equity funds, so prospective entrants will be less concerned with the dropping average management fee in the Islamic fund space.  

Is Islamic finance beneficial for non-Muslims?

Reviewing a little bit of the backlog of articles I have that I passed over in the past few weeks, I found two that I think get at an important but difficult topic with Islamic finance: how open Islamic finance is to non-Muslims.  The first article was one from Rushdi Siddiqui discussing somewhat controversial comments from Badlisyah Abdul Ghani, CEO of CIMB Islamic, that conventional banks should not be allowed to issue sukuk (except for multilateral development banks). 

Rushdi counters with a number of good articles about why scholars have allowed conventional banks to issue sukuk and for Islamic banks to use conventional banks as counterparties for their commodity murabaha. Another article comes from Faizy Syed, who focuses his article on India, with reference to other countries where Muslims are in the minority, is more concerned with the role Islamic finance can play within non-Muslim majority countries. 

I have a slightly different view from either, but that does not mean it is necessarily contradictory of their perspectives.  Islamic finance is in fact present in many countries whose Muslim minorities may be too small to support an indigenous Islamic finance industry, and in many of these countries the Islamic finance industry is not focused on the local market.  For example, Ireland and Luxembourg, are often held up as Western nations trying to attract Islamic finance.  However, they are no more interested in attracting Islamic finance for a domestic purpose except to bolster their status as offshore locations to facilitate international finance. 

These countries all see Islamic finance as no threat, and really no different in purpose in the economy from conventional finance and see the potential to expand their market share compared to the Cayman Islands, Guernsey or Bermuda as low-tax-rate countries that are also used to faciliate international transactions.  Both Ireland and Luxembourg are viewed as attractive because of their experience serving as domiciles for UCITS directive compliant funds offered across the European Union. 

While in that sense, Islamic finance has integrated itself in the international financial market, which is good for its development (something that Rushdi mentioned as well).  However, the other idea that is often expressed is that Islamic banks because they are guided by Islamic principles are therefore beneficial for all people, including non-Muslims.  I think the connection is more tenuous there.  Most Islamic (retail) banks operate to provide Muslims with Shari'ah-complaint financial services, which is good on its own by promoting greater financial market integration for Muslims. 

There are also widely cited examples, such as the high penetration of Islamic banks in the non-Muslim population in Malaysia.  In many cases this has arisen because Islamic banks can offer cost-competitive products and may also include some provisions (such as non-recourse mortgages in some countries) that conventional banks choose not to.  This is the best way I think for Islamic banks to expand their take-up by non-Muslims. 

One of the least effective, in my opinion, is to say that Islamic banks were insulated from the financial crisis by virtue of their inherent 'better-ness', or by repeating claims that Islamic banks are just 'better' than conventional banks (even while the Islamic banks are replicating the conventional banks' business models with higher fees).  There are many intriguing possibilities for Islamic finance that are appealing to many non-Muslims (like me), but they are based on specific cases, not broad generalizations. 

One of the things that allowed the financial sector to take over the American (and to some degree global) economy before the financial crisis (as measured by the share of total profits generated by financial institutions compared to the economy as a whole) was that it believed it was (to borrow from Goldman Sachs' CEO Lloyd Blank phrase) "doing God's work".  That it was inherently productive to the economy as a whole.  Instead, the correct description is that finance has a purpose which is productive for society as a whole (allocating capital to productive enterprises).  When it strays from this role (for example, by encouraging subprime mortgage lending to fill securitizations and re-securitizations, or by contributing to a real estate bubble topped off with newly created islands shaped like palm trees), it is not acting productively.

There is nothing inherently better about Islamic finance than conventional finance, and asserting its superiority compared to conventional finance as if the two could be compared each as a single monolith, is a fruitless discussion (and one that is unlikely to expand its appeal for non-Muslims who may not really understand what Islamic finance even means).  There are good products and bad products and the former can offer something to everyone that will help finance return to its productive roots and perhaps also improve it.  The latter, however, are not any better than the bad conventional products, or really any worse.  It is just that the conventional financial industry has a much greater reach so the bad products in conventional finance spread faster and more widely and thus have a much greater impact on the global economy. 

Instead, the path forward, if creating finance that is good and beneficial for all, is to ask "can Islamic finance offer a product that is cost competitive with conventional finance, and which offers something of value to consumers that conventional finance does not?".  If so, let's proceed post-haste.  If not, there may still be value (e.g. integrating Muslims into the financial system), but just recognize that the potential for the product to get widespread appeal among non-Muslims.  It is not necessarily a bad thing to develop a product that may only appeal to Muslims, if it can bring them into the financial system in a way that benefits them.  But this is a far cry from the idea that Islamic finance in its entirety is inherently better than conventional finance and therefore should appeal to all people. 

Malaysia's Security Commission-OCIS forum details shared

I was critical recently about the Malaysian Securities Commission and the Oxford Centre for Islamic Studies holding a closed door forum, then issuing a press release about it with few details.  Whether or not it was in response to my post, I was nonetheless happy to see a more complete discussion in the Malaysian International Islamic Financial Centre (MIFC) email newsletter.  I have posted it below.  As I said in the post, transparency is important in Islamic finance and, while it does not have to be applied in every case (there are valid reasons for not everything to be disclosed all the time, but usually in those cases there is not a press release issued), it can benefit everyone to bring discussion on the big issues in Islamic finance into the public view. 

I think there are some very interesting ideas proposed, not all of which are new, but which need to be repeated until they are addressed.  In particular, I think that Neil Miller's comments on sukuk secondary markets should be a focus in liquidity management (as Ijlal Alvi mentioned when discussing the use of sukuk as collateral in tri-party repo).  There are a lot of areas in the sukuk market that need development, and among the points that the summary describes from Neil Miller, the most important in my opinion is adding depth and breadth to the sukuk market (an issue I have discussed several times, including one rough estimate at the potential for sukuk issuance in the GCC if it reached the size relative to the economy as Malaysia, and if corporate issuers in the GCC became more active). 

There can be little development in sukuk markets and in sukuk-backed repo transactions if there are not enough sukuk issued.  In order to develop trading markets, there should also be a variety of sukuk (many different issuers, tenors, ratings, etc) to make it more worthwhile for investors to sell one type in order to buy another (to move from lower to higher quality, or from a longer to shorter maturity). 

There are many thought provoking questions raised, even in the short article about the forum, but having the subjects revealed publicly should start many more discussions than the original press release will. 

Solutions for Liquidity Management in Islamic Finance

The Securities Commission Malaysia (SC) and the Oxford Centre for Islamic Studies (OCIS) organized the 3rd SC-OCIS Roundtable which was held at the Securities Commission, Kuala Lumpur on 12-13 March 2012. The theme for this year's Roundtable was 'Solutions for Liquidity Management'. The Roundtable had three main sessions each comprising two presentations, two respondents and Questions & Answers and a Chairman. There was also an opening session with keynote speeches and a concluding session where Chairs summed up the proceedings of each respective session and made recommendations on 'Solutions for Liquidity Management' going forward. The session topics included 'Reaching Consensus on Sukuk Trading'; 'Developing Participatory Instruments as Liquidity Tools'; and 'Commodity Murabahah and its Variants' respectively. For the benefit of MIFC Community members and EPICENTRE readers, this Briefing highlights the main issues and conclusions that were discussed during this closed-door Roundtable. The Session on 'Reaching Consensus on sukuk Trading' saw two robust presentations - one by Neil Miller, Global Head of Islamic Finance, KPMG, Dubai, who highlighted several constraints in sukuk trading and suggested some solutions which would help overcome some of these constraints to achieve liquid markets; and the other by Ijlal Alvi, CEO, International Islamic Financial Market (IIFM), Bahrain, who proposed the use of sukuk as a form of collateral at both a domestic and cross-border level, and the development of a Three-party Islamic alternative to repurchase contracts (REPOs) based on the principle of l'aadat Al Shira'a - the lack of which is considered a major impediment in the development of an Islamic inter-bank market. Neil Miller suggested several solutions for sukuk trading to develop further: A need for a steady supply of liquid securities with different risk profiles and maturities - in other words more depth and breadth in the market; The emergence of cross-border liquidity framework; Greater integration of Islamic financial centres to promote a vibrant secondary market; A regulatory environment that promotes meaningful disclosure and transparency; The establishment of a bespoke trading platform to facilitate the listing and subsequent trading of a wide universe of sukuk and other Shariah-compliant instruments; and The inclusion of built-in controls in the proposed Platform to prevent the market from misusing the trading of sukuk or controlling junk sukuk trading. Ijlal Alvi alluded to various AAOIFI standards which allow for the addition of extra collateral. On this basis he suggested the use of sukuk as a form of collateral. He highlighted the following considerations: Understanding the Shariah issues, for instance under the Shariah collateral must be in kept in a separate account; Taking security, where under the Shariah it is not possible to rehypothecate securities as practiced in conventional banking; Margin maintenance and accounting treatment; and The establishment of an International Triparty Agent which he said was essential to be developed in Islamic finance jurisdictions. The Session on 'Developing Participatory Instruments as Liquidity Tools' comprised presentations by M Iqbal Asaria, Associate Afkar Consulting Ltd and Visiting Faculty, CASS Business School, UK and Rushdi Siddiqui, Global Head, Islamic Finance & OIC Countries, Thomson Reuters. Iqbal Asaria warned against the debt-based market fundamentalism that spurred the growth of the West. Islamic finance grew within this debt based system, creating pressure for Islamic banks to replicate and mimic the conventional products. He questioned the current state of Islamic finance which is still plagued by lack of standardisation, continued use of Inah and Dayn, the growth of Tawarruq and Commodity Murabahah. There is little progress in cross-border liquidity and challenges relating to Basel III. He urged among others; Islamic finance should move towards equity oriented financing, Islamic finance should use the sukuk experience to develop and participatory instruments such as Corporate Musharakah Certificates. Rushdi Suddiqi on the other highlighted the need for sophistication and efficiency in the commodity murabahah platform in the areas of such as news data , central counterparty clearing entity, greater use of electronic processes and the introduction of a screen-based platform for trading. The session on 'Commodity Murabahah and its Variants' comprised presentations by Associate Professor Dr Said Bouheraoua, Chief Academic Officer and Dean, International Shariah Research Academy for Islamic Finance (ISRA) Malaysia, and from Khairul Nizam, Assistant Secretary General, Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), Manama. The conclusions were that: Commodity Murabahah is acceptable to manage solutions in liquidity management of an Islamic bank despite varying Shariah views; AAOIFI recognises Tawarruq subject to pre-conditions and that regulated Tawarruq is an alternative such as the Bursa Suq al-Sila' platform; It is imperative to have mutual recognition on Shariah positions amongst jurisdictions to facilitate cross-border transactions to facilitate liquidity management; Liquidity management is intended to preserve the 'health' of the Islamic banking system that will allow Islamic banks to serve the society/public and this is consistent with the objectives of the Shariah (Maqasid al-Shariah); and There should be much greater cooperation and contact between market practitioners, Shariah scholars and economists in addressing the above issues.