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. 

Commodity murabaha spreads to deposits

The Indonesian subsidiary of CIMB, CIMB Niaga, is planning on launching a commodity murabaha deposit account, according to Bernama.  A commodity murabaha is a product mostly used between banks to manage liquidity where one bank buys a commodity (like palm oil) in the spot market, sells it to the counterparty with deferred repayment, and the counterparty then sells the commodity in the spot market.  It is as close as you can get to a conventional interest-based loan in Islamic finance.  Its use has been controversial (commodity murabaha is the same thing as tawarruq) but deemed necessary to keep the Islamic finance industry running (and I accept its use where there are no or very few suitable alternatives, like in inter-bank money markets).

However, when it is introduced as a deposit account product, it is an unequivocal statement that 1) Islamic banking is not any different from conventional banking; and, 2) Islamic banking cannot offer anything new to consumers that will fulfill the role of deposits (liquid, safe places to store money and earn a return).

On the first point, the ideal structure (at least from early theoretical models) is that Islamic banks operate as financial intermediaries between depositors and borrowers (as in conventional banks), but introduce a profit-sharing mechanism that somewhat insulates the bank from the maturity mismatch in conventional banking because depositors are theoretically required to bear loss from their deposits.  They provide the bank with capital under mudaraba and the bank provides financing under mudaraba.

The mudaraba model of banking on the asset side is not common.  The asset side of banks balance sheets has always been more debt-based using ijara or murabaha (including tawarruq) to create a predictable stream of income and a financial statement that bank analysts can easily identify with (and which fits into regulations designed for conventional banks).  On the liability side of the balance sheet, Islamic banks have mostly left the mudaraba model intact.  Depositors are typically required to accept the possibility of loss, although in practice, they are protected from losses by surplus profit or profit-equalization reserve accounts, which shift the first loss position to equity holders and also hold the profits that would accrue to depositors in excess of conventional banks' interest payments on deposits.

In addition to the reserve accounts that protect depositors, there are other forms of deposit accounts like amanah, where the bank guarantees the principal of the account but does not pay a return.  There are other deposit structures like wadiah and wakala that are also used that also require the depositors to (mostly theoretically accept losses).  In the UK, the Islamic Bank of Britain was allowed to give customers the option to refuse deposit insurance if a loss in their deposits would occur due to bank insolvency (as far as I know this is not allowed in the US, although consumers could theoretically refuse to withdraw any deposits held in bank accounts of failed institutions which offer Islamic banking, if the FDIC got involved).

The striking thing about the use of commodity murabaha is that it acknowledges that any model where there is a possibility of loss (mudaraba, etc.) or where there is guaranteed principal but no return (amanah) is not enough to attract depositors.  Instead, the conventional deposit account with principal protection and a return on deposits has to be (re-)created.

There is one other alternative that I can think of and that this product is being used to create Islamic certificates of deposit for retail consumers where funds are locked up for a certain period of time with principal guarantee and a fixed profit.  If this were the case with this product, it would make some sense, but it still amounts to the bank managing its balance sheet into a form that is familiar to conventional bankers (and consumers!).

I would imagine that this type of deposit account is used by other Islamic banks, so I don't want to single out CIMB Niaga, but the implications of bringing commodity murabaha into the equation with depositors when so many near-equivalents are possible and already in use are not positive.  It adds one area of the balance sheet to the list of "things the industry does to make it as close as possible to conventional finance".  As much as I support using replicated products to offer new services to consumers in Islamic banking, I try to limit my support to areas where Islamic finance has not yet found a different way to do these things.  Besides equity, deposits stand alone as the area of an Islamic bank's balance sheet where other, less cynical products are available and already in use.

UAE central bank offering Islamic repo

The UAE central bank, which recently launched Islamic certificates of deposit to help Islamic banks manage their short-term excess liquidity needs is being expanded into a full repo (repurchase agreement) offering. I will discuss the structure in a little more depth (as much as I can based on the information now available), but the first point I find interesting is that it would be based on one model proposed in a paper by the International Isalmic Financial Market released last year, which I reviewed on my blog at the time it was released.

The structure that Reuters is reporting is being used is one based on murabaha. There is nothing new about commodity murabaha being used for liqudity management, but the repo product would use commodity murabaha with the central bank's Islamic CDs being offered by the bank as collateral for the loan. There are currently AED12 billion ($3.27 billion) in Islamic CDs held by Islamic banks in the UAE, giving a relatively large pool of assets for the repo transactions to use as collateral.

The need for a repo facility is clear for both central banks and Islamic banks, but the model that will be used is the most cynical possible outcome. When I read the IIFM report last year, I commented on the collateralized murabaha: "The addition of transfer of securities as collateral (without compensation) on top of the use of commodity murabaha would raise the most objections, I believe, on grounds that the product is cynical and does nothing to really help the industry develop new products." At that time, I saw the collateralized commodity murabaha as cynical because, although it tries to find a solution to a problem, it does so by further entrenching commodity murabaha into the Islamic financial industry.

The UAE repo facility goes one step further. Not only does it use the collateralized commodity murabaha between the Islamic banks and the central bank, it uses as collateral an Islamic CD which itself is based on commodity murabaha between the central bank and an Islamic bank. So, if an Islamic bank has surplus capital, it can loan it to the central bank by buying an Islamic CD, in which it buys a commodity and sells that commodity to the central bank and the central bank will repay the debt sometime within the next year (depending on the agreed upon maturity). However, if the Islamic bank needs liqudity before the CD matures, it can pledge that debt owed by the central bank to the central bank in exchange for a loan structured as a commodity murabaha.

If one takes this a step further and the central bank finds a way to have enable 'netting' of the commodity murabaha products, then it will have developed a way to trade debt (final payment for commodity murabaha represent a debt), which is mostly (outside of Malaysia at least) viewed as not permissible. As much as the short-term liquidity management tools are needed for Islamic banks (and for the central banks that want to engage in open market operations), creating a system where the central bank and Islamic banks are trading back and forth debts from commodity murabaha seems like the worst possible way to find a solution that has any lasting impact on the Islamic finance industry besides just solving the problem of the hour.

The UAE Central Bank has two PDFs describing:
-The Islamic CD; and,
-The collateralized commodity murabaha.

UAE Islamic CDs

The UAE Central Bank released more details about its Islamic CDs that it will offer "soon" according to Zawya Dow Jones. The sukuk will be murabaha, issued in UAE dirhams, US dollars and Euros, with maturities of between one week and five years. It will be likely limited to banks in the UAE as they are being issued as "a monetary policy tool for the Central Bank of the UAE" and "as a liquidity management tool for the Islamic banks".

The circular (PDF) from the UAE Central Bank describes in more detail the product. It will be a commodity murabaha where the banks (through the central bank as agent) purchase commodities in the spot market and then resell them to the central bank with deferred repayment but immediate delivery. The central bank will then resell the commodity in the spot market.

The one year and less maturity will be auctioned to banks daily with T+1 settlement and early redemption at the option of the banks. The method of the early redemption is that the bank requests early redemption and the central bank replies with an offer for "full proceed for the redemption through Reuters Dealing System". The reason this is done likely is for Shari'ah-compliance because a murabaha represents a receivable and therefore there is no early redemption discount permissible (accounting for just principal and accrued interest). This has been an issue in Malaysia where many Islamic mortgages are done via murabaha and in cases of prepayment, banks typically offer a rebate (ibra) representing the portion of the markup that has not accrued (based on an equivalent conventional mortgage) to equalize the outcome. Bank Negara Malaysia earlier this year issued a Shari'ah resolution that mandated ibra in murabaha financing.

As expected based on prior Shari'ah rulings, the sukuk will be non-tradable except at par ("due to Shariah limitations"). There will be no use of these securities at the central bank's repo facility "at the moment", which indicates a potential in the future for creating a repo facility based on the Islamic CDs.

The daily auctions of under 1 year maturity bills will be done for AED denominated bills and USD and EUR only "based on demand". Issuance of longer-term notes will be done "on bilateral arrangement".

In general, I think the new issuance is positive and it adds another country in the GCC (to Bahrain) whose central bank offers liquidity management tools for Islamic banks. Bahrain has offered limited issuance of salam and ijara sukuk with 3 and 6 month maturities, respectively. The CBB issues its sukuk monthly (compared to the UAE issuing daily) and the CBB sukuk are all denominated in Bahraini dinars, so the UAE Islamic CDs will offer the option of currency diversification for banks that have assets and liabilities with exchange rate exposure. In addition, the UAE Islamic CDs will have greater maturity diversification with 1 week and 1, 2, 3, 6, 9 and 12 month bills in addition to the 2, 3, 4, and 5 year sukuk. Both the CBB sukuk, which have been issued for several years, and the new UAE Islamic CDs are precursors to the International Islamic Liquidity Management Corporation (my thoughts on the ILMC) short-term sukuk, which will be issued in US dollars and Euros.

What will interest me is whether the ILMC sukuk will follow the murabaha model (used in the UAE) or salam (in Bahrain), both of which are not tradable in the secondary market except at par. The CBB sukuk al-ijara sukuk are tradable, although I don't know whether there is a market for them. The non-tradability of murabaha sukuk is a limitation in terms of establishing a pricing benchmark (my thoughts on an Islamic pricing benchmark) as an alternative for LIBOR, but if the ILMC were issued daily like the UAE Islamic CDs will be, it would reduce significantly the drawbacks of the murabaha model. The next 6 months should be interesting as information is released on the ILMC's methodology.

TID, Islamic CDs, the halal market and sustainability

The Investment Dar
The Investment Dar case became more complex with the Shari'ah board of TID requesting that the bank stop contesting the claim by Blom Bank based on the wakala contract's non-compliance with Shari'ah. In addition, the Shari'ah board asked that a similar defense not be used in the future without first consulting the Shari'ah board to determine the legitimacy of its contracts. An article in Arabian Business comments that "While the sharia board's statement puts a wrench in Investment Dar's ability to move forward with a case against Blom regarding the deal, legal experts say the reputational damage to the industry has already been done".

I disagree with the contention that TID's case has damaged the Islamic financial industry. In contrast, the UK courts held a skeptical view of TID's defense and now the institution's Shari'ah board has come out in support of the wakala product's Shari'ah-compliance. This accomplishes two things for the industry. First, the court's skeptical ruling on TID's defense provides another secular court precedent that a party to an Islamic contract cannot, ex post, argue that the contract is not Shari'ah-compliant to get out of their obligations. I have argued before that the court's ruling provides Shari'ah scholars and boards with more freedom to change their mind on Shari'ah-compliance without worrying about upsetting existing contracts.

Second, I believe it is positive is that TID's Shari'ah board came out against the institution and upheld their initial ruling. There is always a potential conflict of interest between a Shari'ah board and the institutions for whom they work. However, this provides one example of a Shari'ah board publicly demonstrating that their duty to ensure Shari'ah-compliance and preserve the integrity of their ruling is placed above their employment with one institution. The only clear loser in this development is TID, who are stuck between an adverse court ruling in a secular court and their own Shari'ah board's ruling that contradicts their claims in that court.

UAE central bank to offer Islamic CDs to Islamic banks
The UAE central bank is planning to offer Islamic CDs as short-term money market instruments for Islamic financial institutions. The lack of short-term money markets outside of Malaysia (and to a limited extent in Bahrain) hampers the Islamic banking industry because it leads banks to hold excess reserves in cash, which lowers Islamic banks' returns compared to conventional banks because they cannot generally generate returns from this cash. The Islamic CDs received preliminary approval last week from the Shariah Coordination Committee with what Hussain Hamed Hassan, the committee's chairman, described as "minor changes". It may receive final approved next week according to Mr. Hassan. Islamic CDs are offered in the US by one institution, the University Islamic Financial Corp and are used by some of the Islamic mutual funds in the US as a way to generate a return on their cash balances.

The halal market and social responsibility
The Managing Director of Al Islami said that Islamic branding is a "myth" at a halal market conference in Brunei. The point being made was that the halal brand--the certification--was important but without a quality product, it is not likely to succeed. The point was expanded by Shahed Amanullah, the founder of Halal Media, as a way to expand the market to non-Muslims as well either from incorporating organic and socially responsible halal certifications in food and through social responsibility in the broader marketplace so that "non-Muslims can see Muslims promoting halal values which includes social responsibility, stewardship of the earth and economic justice". I think that this is an often understated point. Although Islamic products, particularly in the financial world, were created to cater to Muslims' needs, they do not need to remain constrained to just Muslims. However, to reach out to non-Muslims, incorporating other shared ethical values and leverage the success of sustainable finance to expand the potential market for Islamic financial products.

Other News

• Hussain Hamad Hassan said it was "not a far-fetched reality" for a Gulf-wide Shari'ah board to be in place by 2013.
  
• Gulf Finance House continues to restructure its debts. In May, Mohammed Khnifer, Aatef Baig and Frank Winkler released an article called "The Rise and Fall of Gulf Finance House", which analyzes the pre-crisis years and how they might have led to GFH's current problems.
  
• Cagamas Bhd, the Malaysian national housing company, may issue up to RM1 billion ($303 million) in sukuk that are designed to be acceptable in Malaysia and the GCC.
  
• The Shari'ah-compliant non-bank financial company being established in the Indian state of Kerala has received significant interest from GCC- and Indian-based institutions (Doha Bank and Reliance Capital, respectively), although the government has said it will not sell more than 20% of the NBFC to any single investor.
  
• The Islamic Bank of Thailand became a major shareholder of a Thai leasing company, Nava Leasing Plc, in which it will own 49%.
  
• A Malaysia law firm has released a booklet in Australia to explain commonly misunderstood aspects of Islamic finance among Muslims as well as non-Muslims. The headline writers, of course, took the most sensationalistic topic titling the article: "Islamic finance not jihad".
  

Describing Islamic finance, Islamic CDs, sukuk and Saba IB joins IFC

Good description of Islamic finance

Often, news sources use simplistic language to describe Islamic finance which leaves those unfamiliar with the field with an incorrect impression that Muslims are forbidden from making profit because the phrase "Islam forbids interest" is used without explanation. However, the article about TSB Lloyd's new Shari'ah-compliant business account describes Islamic finance in a much clearer way:

"Muslims are thus also permitted to profit from financing businesses, but they must take equity risk in the manner of a stockholder, rather than have a guaranteed return, as is the case with bank accounts and traditional bonds."

This description provides unfamiliar readers with a clearer explanation closer to the Quranic verse "They say 'Trading is only like riba,' whereas Allah has permitted trading and forbidden riba" [2:275]

Other news

The Central Bank of the UAE plans on creating an Islamic CD to manage short term liquidity. The issue of liquidity is one of the most challenging issues facing Islamic banks. Their deposits are short-term and most investment opportunities that are Shari'ah-compliant are long-term and very illiquid. Malaysia has created an Islamic interbank money market (IIMM), but many scholars in the Middle East do not consider it Shari'ah-compliant.

Islamic bonds (sukuk) could provide a significant future opportunity for London according to the director of Islamic finance advisory at KPMG, Darshan Bijur.

Saba Islamic Bank joins International Finance Corporation becoming the first bank in Yemen to do so