Islamic finance complexity (Part Ia)

Earlier tonight, I posted an article on Twitter from CGAP about microfinance product development that I think has lessons for the Islamic finance industry as a whole.

The article discusses the way that microfinance institutions use daily journals from a sample of their customers or potential customers to determine how people actually use their money and how they engage with financial institutions to develop what financial needs are not being met currently by financial institutions (i.e. what are they using cash for that a financial intermediary could help them get a better outcome).  While I don't believe that Islamic financial institutions are flying blind in regards to their clients needs, it does appear that in some cases they are developing products that they can make money selling and then taking them to market and hoping that the supply will create a demand.  In other cases, they see a need (e.g. a financial product not being offered by Islamic banks and developing their own Shari'ah-compliant version and bringing it to market).

The problem with these approach is that they take as their premise either that the products that they develop to be profitable (for the bank) have a natural market or that conventional banks are offering products that always suit the needs of consumers.  My idea of "going back to the basics" for Islamic finance is based on the premise that financial institutions creating products to suit their own needs (in terms of generating high profits) or by replicating conventional products (which creates added complexity) do not do the best job in fulfilling the financial needs of the consumers who look to Islamic banks for Shari'ah-compliant alternatives to conventional banks (mostly Muslims, but non-Muslims should be the market as well if Islamic banks have a change of growing across the world).

One aspect of the article that I think makes it useful for Islamic banks is that it is developed from the perspective of microfinance institutions that have a small market share in terms of the customer's business that they want to see grow.  Islamic banks start by trying to attract customers who either do not use banks or are with conventional banks.  Similarly, microfinance institutions are trying to get the business of people who rely on cash for most of their transactions because they don't have access to banks.

The analogy is not perfect, but an Islamic bank that is developing new products would be well served asking Muslims who don't use banks (or who have non-interest-bearing deposit accounts only) what aspects of their financial life are most inconvenienced by their lack of access to banks.  With that need in mind, they can develop financial products that fulfill that need, whether or not it ends up being a product identical to a conventional offering.  Instead, it seems that banks are assuming that people need a credit card (for example) and are structuring a complex series of murabaha transactions to create a payment/credit system that extends credit to the customer without formally being structured as a loan from the bank to the customer that is repaid with interest.

If Islamic banks want to cater specifically to the portion of the Muslim population that wants a credit card, but don't want to pay interest, then creating Islamicized versions of credit cards etc. will work fine, but why would a non-Muslim get an Islamic credit card that has all the metal trading behind that adds cost when a regular credit card will charge far less?  Even if the underlying goal is to include Muslims into the financial system, there will be plenty of Islamic banks offering complex structured versions of credit cards.  Working from a bottoms-up perspective (starting with the institution rather than trying to effect top-down change on the Islamic finance industry), an Islamic bank can choose not to offer every conventional product as an Islamic finance product without having to be concerned with overall access to finance among devout Muslims who don't work with conventional banks.

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

Truth and fiction in reporting the Islamic finance industry

As I began reading this article about the prospects for Islamic finance in the year to come, I almost cringed as it began with yet another denial of the reality that Islamic finance was significantly affected by the credit crisis that resulted from the subprime mortgage crisis in the United States. However, as I read further, there was a discussion of the impact from the credit crisis on Islamic finance and an acknowledgement of its severity:

"But to suggest that Islamic banking is set to grow strongly despite the global financial crisis may be stretching things a little too far. Last year’s credit crunch hit Islamic bonds much harder than other forms of debt as sharply lower international oil prices deprived oil-rich Middle Eastern investors of cash.

According to rating agency S&P, corporate and government sales of sukuk (syariah compliant bonds) reached US$30.8 billion in 2007, but plunged 56 per cent last year to just US$13.6 billion. By comparison, conventional international bonds and emerging-market debt dropped 5 per cent and 15 per cent, respectively"

The article ends with a very reasonable conclusion that the way Islamic finance is conducted without many of the financial instruments that cause excess speculation can serve as an alternate model to conventional finance. This, I believe, is the contribution of Islamic finance. It can provide an alternative model of financial services based on finance's underlying objective which is to facilitate the real economy. In the wake of the credit crisis, there is finally some understanding that all financial innovation is not necessarily beneficial and that there is too much of a draw created by financial services' pay packages for people qualified and talented in other areas besides finance whose efforts may better benefit the economy in these other fields. One lesson, however, that should not be underestimated is that even conservative areas of finance like Islamic finance can still become involved in speculative bubbles. Witness Dubai. A recent video I have seen on several blogs puts the popping of Dubai's real estate bubble in clear, on-the-ground terms, by interviewing a real estate agent in the Emirate.

Another article discusses the recovery in Islamic financial institutions and describes their advantages in both not being leveraged like conventional banks and also not having 'exposure' to the interbank lending market, which led to the illiquidity that doomed Lehman Brothers and Bear Stearns. On the first point, I agree (with a few exceptions) that Islamic financial institutions are more prudent about leverage than most conventional financial institutions. However, I find the liquidity risk of Islamic financial institutions to be more significant than for conventional financial institutions in most situations. The lack of access to interbank money markets (except in Malaysia) create a significant risk that illiquid Islamic financial institutions could be unnecessarily transformed into insolvent institutions. One area where illiquidity is particularly noticeable is in the secondary market for sukuk where government-backed companies like the Jebel Ali Free Zone (JAFZ) can see their sukuk trading at less than 60 cents on the dollar.

Sukuk, new investment banks, Islamic credit cards

Following the Rupiah-denominated sukuk, Indonesia's first dollar-denominated sukuk "will probably be slightly more ambitious than intended" according to an anonymous person involved in the offering.

Several GCC banks are launching three new large investment banks with focuses on infrastructure, agricultural and hospitality. The banks will use the excess liquidity created by high oil prices to direct investment in large projects with long time horizons.

Not everyone is happy about the development of Shari'ah-compliant credit cards. Some of them are significantly more expensive than their conventional alternatives without much difference in terms of how the issuer earns money from customers.

Islamic finance growing globally, particularly in the GCC and U.K., although the industry is not completely immune from the credit crisis

The rapid growth in Islamic finance has begun to receive interest from Western financial institutions and others like rating agencies (e.g. Moody's and Standard & Poors), consulting companies (McKinsey) and news organizations (Financial Times and Bloomberg). This is a credit to the industry's rapid growth and potential to emerge from being a niche industry to one that could become significant in the global financial system. The Islamic financial industry is also expanding into Europe, particularly the U.K. (although there are many other cities vying to become a hub in the global Islamic financial industry) The Independent newspaper in the U.K. has an interesting article on the different Islamic financial products available in the U.K. A recent event called 'Microfinance in the Islamic world' was held at the House of Commons and featured a presentation by Muslim Aid, a charitable organization which has done a significant amount of Shari'ah-compliant microfinance. The conservative nature of Islamic financial products has increased their attractiveness as more risky products have run into problems recently.

The first multi-asset class investment fund was launched on the AIM in London last Friday trading under the ticker FSF.

France is continuing the process of figuring out legislative, tax and regulatory changes needed to rival London for the center of Islamic finance in Europe. Despite having a Muslim share of the population many times that of the U.K., Islamic finance is still nearly nonexistent in France. Switzerland, although prominent in international finance, has lagged behind on Islamic finance.

AAOIFI is developing a governance standard for corporate social responsibility. This is a very important step because it will provide a way to monitor whether Islamic financial institutions are meeting their ethical responsibilities that are the core of their differentiation from most conventional financial institutions.

The Indonesian rupiah-denominated sukuk will be placed in mid-August with a listing expected on August 27th. Doha Bank has delayed their planned $1 billion sukuk to develop an exchange for carbon emissions trading in the Middle East because of poor market conditions. Thai property developers should finance their businesses using sukuk, according to the former head of the Islamic Bank of Thailand Dheerasak Suwannayos. Since 2006, the growth in sukuk has outstripped the growth in conventional bond issues in the GCC, and almost half of this has financed real estate projects.

The Netherland Antilles are exploring legal and regulatory changes needed to attract Islamic finance.

Islamic economist Humayon Dar is working with a group called Charity Bank to develop Shari'ah-compliant financing for non-profit organizations in the U.K.

Dubai Islamic Bank recently launched a Shari'ah consulting group, Dar Al Sharia, to provide research and development and consulting services in Islamic finance transactions.

Islamic banks in the GCC are planning expansion into North Africa and Asia to find new opportunities to grow.

NPR has an article on Islamic home finance in the United States.

IBF Net is launching an institute studying Islamic microfinance in the state of Orissa in India. I have had the pleasure of speaking with one of the founders of the Institute of Microfinance and Development, Dr. Mohammad Obaidullah who is also a Senior Economist at the Islamic Development Bank, and I anticipate that they will make a very positive impact.

Islamic credit cards are becoming more available, although they differ little from conventional credit cards. Usually, the either offer a line of credit with a fee based on the amount used, a murabaha structure where the card issuer 'owns' the goods purchased for an instant when they are purchased and charge a markup, or a lease-buyback where they own the goods until they are paid for and 'lease' usage. They seem to be virtually indistinguishable from conventional credit cards in impact, more so than other Islamic finance transactions where there is a chance for the Islamic finance company to take ownership.

KFH buys stake in RHB, Islamic credit cards, Miscellany

Kuwait Finance House buys stake in RHB

Despite the denials issued yesterday, Kuwait Finance House announced it had reached a Memorandum of Understanding for the purchase of 32.8% of Rashid Hussain Bhd Group, parent company of RHB Islamic Bank from Utama Banking Group.

Shari'ah-compliant credit cards

Abu Dhabi Islamic Bank has concluded its drawing
for monetary prizes for using its Shari'ah-compliant credit card. They note that

"All ADIB contracts, operations and transactions are carried out under the Islamic Shari'a principles with a strong focus on customer needs and innovative products and services in order to provide a customer focused ethical banking solution. [...] ADIB’s lines of products and services are 100% Shari’a compliant and offer the lowest profit rates available."

The idea of a Shari'ah-compliant credit card seems to stretch the credulity of Islamic finance as something more than myopic reductionism towards a focus on the term 'interest', rather than the concept of exploitative, usurious lending behavior. In the previous description, the difference between the Islamic and conventional product is the word 'profit' being used instead of 'interest'. To add what is essentially a lottery to the credit card adds to the image of a product missing the intent of the prohibition of riba.

Miscellany

Bahrain Islamic Bank (BIsB) announced a 77 percent increase in profits in 2006.

Islamic International Rating Agency (IIRA) voted Best Islamic Rating Agency in a poll from Islamic Finance News.