Islamic finance may be tapped by European companies shut out of the markets by the debt crisis

A couple of weeks ago, I discussed (in my newsletter, available as a PDF) the retreat by conventional banks like HSBC from Islamic finance, primarily in smaller countries where the market is not large enough to move the needle for these massive banks.  As a result I expected smaller regional Islamic banks to take their place both in providing financing and being involved in sukuk issuance (which the large banks had only entered in a small way).  

Back in January, I thought the European debt crisis would limit any issue of sovereign sukuk by a European government because they have more pressing challenges to confront.  I wrote: "I think that a sovereign sukuk coming out of Europe in the next year or two is remote."  This has continued to hold true, but not entirely true with respects to government-owned entities like the Irish Electricity Supply Board announcing it is considering a sukuk in Malaysia (see my newsletter as a PDF for my comments a month ago).  

There haven't been any named companies from Europe following in the footsteps of the Irish Electricity Supply Board, but Mohd Effendi Abdullah the head of Islamic markets at AmInvestment Bank told Bloomberg: "We are getting enquiries from these countries because the European crisis is making it difficult to source financing in their home nations".  This sentiment was seconded by Badlisyah Abdul Ghani, the CEO of CIMB Islamic Bank who said promotional road shows in Europe by the Malaysia International Islamic Finance Centre (MIFC) were starting to bear fruit.  Neither, unfortunately named any names with respect to potential sukuk issuers.

As the resolution process of the European economy drags on as Spain weighs whether to ask for a bailout from the ESM, banks in Europe will remain hesitant to expand lending, which will lead companies to look elsewhere.  It would be a good thing in general for them to consider tapping Islamic finance with a caveat.  The financing should be provided only to those companies who in normal periods would be able to get financing locally and who are not impaired significantly in their business by the European debt crisis.  

There will be no benefit to Islamic finance if troubled European companies issue and then default on sukuk.  That will benefit no one except perhaps the management of these companies who will be allowed to limp on longer than their business performance would suggest.

Turkish participation banks should enter Europe

S&P recently suggested that Turkish participation banks, as Islamic banks are known in the country, could sustain their recent growth (they accounted for 5% of assets in the country at year-end 2010, compared with 2.8% in 2005) if they leverage their international ties further (three of the four participation banks have GCC-based owners).  I would take this one step further and suggest that they could provide a lead in continental Europe for Islamic banking with financial support from their owners. It is already underway with Kuveyt Turk, the Turkish subsidiary of Kuwait Finance House, opening a branch in Germany and Bank Asya planning an acquisition in the Balkans.

Not only does the bank's affiliation with larger GCC-based Islamic banks provide the financial resources to pursue international expansion, they are geographically closer to Europe than GCC-based banks are and Turkey has been in long-running talks to join the European Union.  In addition, the history of dealing with sensitivity towards the "Islamic" label in Turkey should make it easier for them to adapt the Islamic branding to local conditions better where the "Islamic" label could attract controversy.

There is nothing that requires an Islamic bank to drop the "Islamic" branding, although many people (I have heard Rushdi Siddiqui raise this point several times at various conferences) have suggested it is better if they do so in order to allay suspicions that Islamic banking is just for Muslims.  Removing the "Islamic" label--perhaps even by adopting the "participation bank" identity that they are used to in Turkey--will focus the attention of the regulators, politicians and the broader public (i.e. the bank's potential customers) on the products they are offering.

Given the general unfamiliarity with Islamic banking in Europe, the focus should be on the products the bank offers and not the fact that they were designed with a focus on Shari'ah-compliance.  If Islamic banks are offering a superior product, there is no need to introduce an element of unfamiliarity into the marketing process.  That being said, the Islamic banks have to make sure they focus on creating products that do actually provide a benefit to the bank's customers.  While initially the focus will (naturally) be on the Muslim populations in these countries (e.g. the large Turkish minority in Germany), sustainable growth will only come by attracting non-Muslims (as has occurred in Malaysia).

If non-Muslims are going to adopt Islamic banking, there has to be a benefit.  Saying the banks work without interest will only create more questions (are you giving away money for free?).  There has to be an actual benefit.  Perhaps a focus more on the prohibition of gharar and maysir would be better.  A European participation bank could attract non-Muslims by appealing to the restriction that prohibits banks from engaging in deceptive products that contain excessive contractual uncertainty and prohibit the banks from taking speculative bets through conventional derivatives, credit default swaps and collateralized debt obligations. 

This same exercise should not be limited to Turkish participation banks in Europe.  The Islamic banking industry needs to find some real reason why it is different.  Either it competes on cost or there has to be a substantive difference with conventional banks.  Appeals to Shari'ah-compliance alone will work for a time, but narrowing the potential market to just the Muslims who are otherwise unwilling to work with a bank risks the future growth prospects for the industry. 

Sukuk issuance from Europe, Amlak & Tamweel merger 'unlikely'

The Bank of London & the Middle East (BLME), a UK-based Islamic wholesale bank launched a division to advise on sukuk to attract investors from the GCC and Asia to UK and European companies. They expect to close their first deal within a year. The move comes shortly after the first UK corporate sukuk was launched. I have not had a chance to view the prospectus for that sukuk, but it was a 5-year convertible musharaka sukuk (with 10% coupon) issued to one investor, Millenium Private Equity. The conversion from debt into equity will occur on the meeting of pre-determined performance milestones, according to an article in Khaleej Times. The structure is likely to be complicated to incorporate both the convertible nature of the sukuk with a fixed coupon and remain in compliance with the new AAOIFI rules on musharaka sukuk. However, from the perspective of a private equity investor, the structure of a sukuk rather than an equity contribution makes sense. It gives the investor a higher priority claim on the business' assets than equity and also a coupon, although that will be unlikely to benefit the investor if the sukuk sours. The coupon on the sukuk (if both principal and coupon are convertible) provides the company with the incentive to meet the milestones for conversion earlier because the accrued coupon payments will translate into more dilution for the company's other owners the longer it takes to reach those milestones. One of the features of a musharaka is that both partners are permitted to be engaged in the management of the business (akin to private equity investors taking board seats of companies they finance). At the risk of generalizing without having read the prospectus myself, this structure sounds like a good way for Shari'ah-sensitive private equity investors to both provide themselves with greater security (or equivalent security to conventional private equity) but also use a structure that some scholars describe as "more genuine".

The Amlak and Tamweel merger is now 'unlikely' according to the chairman of Tamweel following Dubai Islamic Bank's acquisition of a majority stake in the Islamic mortgage company in Dubai. The lender still has a significant way to go before it can resume operations as normal and will likely need a capital injection. Tamweel is working on a plan to resume lending in the market and expects to release a plan in 'the next few months'. Another article citing the chairman of Tamweel says that they expect Q3 results to resemble the first two quarters of the year. They took significant provisions in 2009 and expect to "translate our revenues into some profits". In many ways the issue facing Tamweel is similar to what is facing other mortgage lenders in countries that have experienced a real estate boom and bust. The pain may be over (or nearly over) but a resumption of 'business as normal' will not happen overnight. The economic recovery globally has remained slow and the appetite for new debt is likely to be significantly constrained (the 'new normal'). The recovery for mortgage lenders like Tamweel will most likely be slow both because borrowers are more hesitant to take on new debt but also because the standards on which Tamweel will lend are likely to be far more stringent than before the property bubble collapsed.

There is a fantastic article in The Asset magazine about an interview with CIMB Islamic CEO Badlisyah Abdul Ghani that covers a broad variety of topics including the impact (and potential impact) of the credit crisis on Islamic finance and the need for better regulation of Islamic finance. It is a good, brief read. A few exerpts:

"One reason why Islamic banks were not as affected as conventional Western banks, argues Badlisyah, is that they were not sophisticated enough to participate in derivatives and other leveraged transactions. "The situation could have been much worse if the Islamic banks had been as sophisticated in employing leverage as their conventional banks’ counterparts were in the previous years."

"As in conventional finance, he says, Islamic finance relies on the creditworthiness of an issuer or a client to decide where liquidity is channelled and directed. "Whatever structure is in place – whether it is Islamic or conventional – credit is still credit and it needs to be paid."

"Badlisyah argues that everything that exists in Western capital markets that is of genuine value to banks and corporates has already been incorporated in Malaysia under the Islamic derivatives regime. This, he argues, is the reason why Malaysian Islamic banks have been successful in managing the volatility and fluctuations that have buffeted the industry in recent years. The ban on credit default swaps is completely justified, he feels, and will likely be for keeps."

"From Badlisyah’s point of view, that Malaysian Islamic banks emerged from the global financial crisis relatively stable and unscathed is due to the regulatory framework that was put in place. "Malaysian banks found themselves totally isolated from the crisis because they had not been allowed to invest as much overseas after the Asian financial crisis."

• AAOIFI is expected to provide rules governing the entry into and exit from contracts that are Shari'ah-compliant. However, it is unclear at this time what this will mean.
  
• Central Bank of Bahrain Governor Rasheed Al Maraj is quoted from a dinner honoring Professor Simon Archer: "Many remain comparatively small and focused on niche markets. The result is that we have an industry that comprises many small-scale firms engaged in very similar activities and with comparatively high concentrations of risk. As I have said several times in the past, for the long-term health of the industry it is important to generate greater scale and diversity. [...] the events of the past few years should have given the industry a clear signal that it must reduce its reliance on real estate as an asset class [and] The industry should look instead at the scope for increasing the finance it provides for productive assets such as factories, ports, mines and oil processing facilities. Financing these activities may appear less profitable in the short-term, but may be a better proposition on a risk-adjusted basis." I agree.
  
• Islamic Finance Asia has a good article on the challenges to developing secondary market liquidity in sukuk.
  
• The IMF study on Islamic vs. conventional banks in the crisis has been released.
  
• A look back at the post-crisis (and especially post-Dubai debt crisis) dominance within the primary market for sukuk from Asia. A Bloomberg looks forward towards the potential issuance that could result from the 10-year, $444 billion Malaysian development plan.
  

Thursday bullets

• Dubai World formally presented its restructuring plan to creditors for $23.5 billion in debts. A Reuters article presents an analysis of what could come following a successful restructuring.
  
• A Bloomberg article describes the rally in Petronas sukuk, which are held by many conventional funds around the world. Petronas' sukuk is now yielding 3.13%, well below its 4.25% coupon.
  
• Bloomberg has an article on the Cagamas sukuk, which is structured to be acceptable in both Malaysia and the GCC.
  
• Citigroup is considering opening Shari'ah-compliant microfinance banks in Pakistan.
  
• The fund manager of the BLME Shari'ah USD Income Fund believes that there will be a revival in sukuk issuance starting this fall.
  
• There is another article on the struggles of the domestic Islamic finance industry in the UK which ends with a grim assessment: "Either way, it doesn’t seem like Shariah-compliant offerings in Europe will be the big boon many had expected a few years ago." I wrote a post on the issue comparing it with the US on Tuesday.
  
• Lahem al-Nasser writes that Islamic windows of conventional banks are viewed with suspicion by Islamic banking clients and it would benefit the industry for CIBAFI to commission a poll of Islamic bank's clients about attitudes towards Islamic windows.
  
• Chase Bank in Kenya is launching Islamic banking products.
  
• A spokesman for the government of Kazakhstan said the government is still "studying the possibility of selling Islamic bonds" despite a Finance Ministry statement that Kazakhstan's banks will not sell bonds overseas this year, removing the need for the government to issue a benchmark bond.
  
• A unit of Qatar-based property developer Barwa Real Estate received $3.5 billion in two murabaha facilities from Qatari Diar Finance. $1 billion will mature in 2015 and the remaining $2.5 billion will mature in 2020.
  
• Kuwait Finance House reported profits for the second quarter was up 22%. The profit was lower than what was reported by a newspaper citing an unidentified source last week.
  

Gulf sukuk market recovering, Asia leads; asset-based vs. asset-backed sukuk

The Gulf sukuk market may begin to open up as yield spreads fall with the issuance of sukuk from highly-rated issuers. This is one step in the process of recovering following the effect of the financial crisis which was most noticeably manifested by the Dubai debt crisis. Since the Dubai debt standstill, most of the few GCC-based issuers have been investment grade with the exception of Dar Al Arkan. GCC-based sukuk represented 30% of the Q2 and previous four quarters total global sukuk issuance value according to data from Zawya's Sukuk Quarterly Bulletin. HSBC expects to see a recovery in sukuk led by Asia as it has during the past year. [UPDATE: Bloomberg released an article about the shrinking yield spreads on Asian sukuk]

As the GCC market opens up and high-grade corporate and multilateral institutions like the Islamic Development Bank issue sukuk, it will provide somewhat of a benchmark for pricing other sukuk, particularly those from lower rated issuers. However, the benchmark from new issues will only become meaningful for encouraging new sukuk if there is liquidity in the secondary markets. In contrast to Malaysia, secondary market liquidity in sukuk is low. However, the new issuance is a start. Bloomberg provides a list of forthcoming or planned sukuk. One of those issuers is Abu Dhabi Islamic Bank, which filed a base prospectus for up to $5 billion in sukuk with the London Stock Exchange on July 8th.

Sheikh Yusuf DeLorenzo is quoted in an article in Bloomberg that suggests investors are more likely to demand asset-backed rather than asset-based sukuk based on the recent defaults. The difference is similar to the difference between a secured and unsecured debt and would also tackle the criticism that using an asset-based structure is fitting the round peg of Islamic finance into the square hole of conventional debt structures.

The European travel firm Thomas Cook failed to place $50 million in sukuk in the GCC because of its small size and investor's belief that the coupon of 7% was too low. It would have been the first European corporate sukuk. Based on its small size, I would tend to minimize the impact of the failure on future European corporate sukuk. If a larger European issuer fails to issue a sukuk, particularly if it is of benchmark size, then it may dissuade other European companies from issuing sukuk.

Indonesia auctioned only Rp246 billion ($27 million) in 15 year (Rp7 billion) and 20 year (Rp 239 billion) sukuk compared to the target of Rp1 trillion. As in previous failed acutions, investors submitted enough bids to cover (Rp 1.18 trillion) but the yields were higher than the Finance Ministry was willing to accept. The higher yields have been attributed to the lack of liquidity in secondary markets.

Other News

• Cagamas, the national mortgage company in Malaysia is expected to issue the first tranche of its sukuk which it developed with Al Rajhi Bank to be in compliance with AAOIFI standards. Many Malaysian sukuk are not accepted in the GCC. The sukuk is an al-Amanah Li al-Istithmar (ALIm). It will be backed by a mixed asset pool, but contain enough ijara assets to be tradable. The remainder of the assets will be based on bai, wakala and bai' bithaman ajil (BBA).
  
• A blog post notices the growth of Islamic banking and wonders if it could take a bigger role than it has. I think it can if Islamic banks decide that supporting and financing Islamic microfinance is a good way for Islamic banks to engage in corporate social responsibility.
  
• Malaysian bank Agrobank announced it plans to go fully Islamic by 2015. It has offered Islamic banking products since 2008. The bank reported that 60% of its non-Muslim clients choose Islamic banking products.
  
• Barwa Bank is close to completing its acquisition of First Finance Company.
  
• Gatehouse Bank acquired One Sovereign Street, a building in Leeds, for GBP40.175 ($60.9 million).
  
• Malaysian property developer LBS Bina is issuing a RM135 million ($42.1 million) sukuk to finance a housing project.
  

Dar al-Arkan swap, sukuk fund diversification

Dar al-Arkan, which issued a 10.5% sukuk in February to refinance its debts, has entered into a Shari'ah-compliant swap agreement to lower its financing costs. The arrangement swaps the current financing cost of 10.75% with a floating rate of 7.95% over 3-month SAIBOR (I would appreciate if someone could email me a source of SAIBOR rate data) for half of the sukuk, $225 million. The article discusses that the swap lowers the cost of financing, however, it should be remembered that if Dar Al Arkan is now exposed to interest-rate risk on this portion of the sukuk. If interest rates rise, the costs of the floating rate side of the swap to which Dar al-Arkan is exposed will rise. The sukuk matures in 2015 (the length of the swap was not included in the article) and interest rates are currently very low so if the swap covers the entire period of the sukuk, it could expose Dar al-Arkan to substantial additional financing costs.

European Finance House, an affiliate of Qatar Islamic Bank, released the performance of its EFH Global Sukuk Plus Fund. The performance was higher than its benchmark (3m USD LIBOR + 2%) by 780 basis points and the fund says it has experienced lower volatility than the sukuk markets as a whole in its first year. The article describes the diversification the fund was able to achieve across 13 sukuk in nine jurisdictions. This is not surprising, but it is also not very diversified. This is not a problem specific to this one fund; there are far too few sukuk that are available for sukuk funds. Until the growth in sukuk issuance increases--and it has rebounded this year--it will be difficult for sukuk funds to achieve diversification anywhere comparable to conventional bond funds. For comparison, one of the world's largest bond funds, the PIMCO Total Return Fund, has 11,619 holdings according to Morningstar.

Other News

• The Dubai bailout has increased demand in secondary markets for GCC-based sukuk.
  
• Gas pipeline company Trans Thai Malaysia, a joint venture of Petronas and PTT pcl, is likely to issue a sukuk.
  
• Bank Negara Malaysia, on behalf of the government, issued MYR2.4 billion ($743 million) of three-year Sukuk 1Malaysia notes with a 5% coupon. The transaction was facilitated through Bursa Suq Al-Sila', the commodity murabaha platform.
  
• Pakistan's government plans to issue $410 million in short-term (1-, 2- and 3-year) sukuk shortly once it receives government approval from the Sindh government and the Ministry of Defense. The sukuk will be based on land at a terminal at the Karachi airport.
  
• An article in a Turkish newspaper describes sukuk. The description included: "Sukuk are not debts of the issuer". This is technically correct because even asset-based sukuk involve the transfer of beneficial ownership, however, they are structured to be treated pari passu with the unsecured debts of the issuer and often provide recourse to the issuer through a purchase undertaking.
  

Future growth in Islamic finance, sukuk news

Future growth in Islamic finance
An article in the National newspaper provides a good summary of the growth areas in Islamic finance, as well as the areas of controversy which remain in these areas. The largest focus is on whether creating Shari'ah-compliant hedging contracts is a help or hindrance for the growth of the industry. In some aspects I can see how it reinforces the view that Islamic finance does nothing but mimic conventional financial products. However, as the article notes, longer term financing like what would be necessary for project finance, would be largely absent were there not a way to hedge against currency, commodity price or interest rate fluctuations.

The article also discusses the lack of Islamic microfinance. Moinuddin Malim, the CEO of Mashreq Al Islami, is quoted as saying "We have not yet reached our real audience. We need to develop microfiannce to enable communities to thrive in their own right and bring living standards to them". I would disagree with his characterization of "bringing living standards to them" and replace that with bring affordable, Shari'ah-compliant financial alternatives, but it is definitely an underserved area of Islamic finance. The CGAP competition which recently closed (and I advised two groups who submitted proposals) is a good effort because it focuses on providing seed money to develop sustainable financial institutions (either non-profit or for-profit). However, outside of this and a few efforts by a couple small efforts by (mostly) global financial institutions in Islamic finance, there has been not much more than lip service paid to the need for Islamic microfinance.

There is a lot more to Islamic finance than just structured products that mimic conventional finance for large corporations and sovereigns. Islamic retail banking fills some of the need with a reach towards a larger number of Muslim consumers, but there are many Muslim (and non-Muslim) 'unbanked'. This is the consumer base that the Grameen Bank was formed to serve and it has now attracted a lot of attention from larger financial institutions. The same need is present for the Islamic financial industry to fill and it should be a quicker transition for Islamic financial institutions to recognize this need (and potential) now that conventional microfinance is well established with participation from the larger financial institutions. It is also ideally suited to the underlying ethics behind Islamic finance, which should feel a greater need to promote economic empowerment based on its ethical foundations.

Another article describes the re-emergence of innovation within the Islamic financial industry which has largely been absent during the recession. There are areas--like liquidity management--where innovation can be a positive development to increase the available investment opportunities (particularly short-term and overnight). However, there are also a lot of 'innovations' during the 2005-2008 period in structured products and especially real estate, where 'innovation' can turn into 'high fees with little other benefit'. One example of this that has been described in detail was Gulf Finance House, which was described in a recent paper by Mohammed Khnifer.

The issue of standardization remains contentious. The debate, however, depends on what standardization means, which Debshis Day of Clifford Chance pointed out, is unclear. "Standardization, what does that really mean? It is very difficult for everybody to agree on one thing. People need to understand that even in a conventional market there is not pure standardization". I would agree with him that complete standardization is neither possible nor probably desirable. There are certain areas (like the ISDA-IIFM derivatives standard and the IIFM standardized murabaha agreement) where standardization can be beneficial by reducing costs associated with replicating the same structure. However, these standardized contracts are not, nor should be, mandatory. There are numerous areas where improvements can be made and leaving the door open to new products or new variations of existing products makes sense for the industry as a whole.

Sukuk News
Unicorn Investment Bank and Standard Chartered report they have mandates to work on issuance of $6 billion in sukuk this year. Reportedly, over $4 billion of this amount will be advised by Standard Chartered. An executive at HSBC, Mohammed Dawood, says that issuance of dollar-denominated sukuk may reach $5 billion, matching the previous year's total. The total issuance may be $8.5 billion, about last year's level, but far below the pre-crisis levels in 2007 and 2008. However, due to the Greek crisis and Ramadan, most issuance will be pushed into the third quarter. Al Rajhi Bank, which has been largely absent from the sukuk market due to concerns by its Shari'ah board over the compliance of the sukuk in the markets, plans to launch a sukuk with Cagamas, the Malaysian housing finance agency, in June. Indonesia recently sold $467.5 million in sukuk to the government-managed Hajj fund.

U.S. issuers could make up part of the issuance in the second half of this year or in 2011. GE Capital, which issued a $500 million sukuk last year (my summary of that sukuk) is planning a 'benchmark' sized sukuk in late 2010 or 2011, which is generally over $500 million. In addition, Unicorn Investment Bank, which has a U.S.-based private equity subsidiary UIB Capital, is working on a $250 million sukuk for a U.S.-based company. The only two sukuk issued by U.S.-based companies so far have been the East Cameron sukuk, which ended with investors owning the underlying asset after the issuer entered bankruptcy, and the 2009 GE Capital sukuk.

Another rare issuer coming to market is Malaysia, which will likely offer its first international sukuk since 2002. The sukuk, expected to be an ijara sukuk with a 5-year tenor is said to be backed by government hospital assets. The issue is reported to be a $1 billion, however, it has not been formally announced and is expected to be announced at an Islamic economic forum in Kuala Lumpur.

Robin Amlot writes an interesting review of an e-book published by Euromoney, written by Parvez Daruwalla and Shahzad Siddiqui, in Islamic Business & Finance. The e-book talks about whether the sukuk structure, and in particular sovereign sukuk, could be done better.

Article by the CEO of Gatehouse Bank

Richard Thomas, the CEO of Gatehouse Bank, an Islamic wholesale bank in the UK, has an article about Islamic finance. While in general, he speaks to the general outlook for Islamic finance globally, he makes two notable points. First, he does not fall into the "Islamic finance is immune from the crisis" trap and secondly, he acknowledges the overlap between Islamic finance and ethical/sustainable finance. He writes:

"Islamic finance has, however, been met with enormous challenges. It has not escaped the global downturn despite Islamic banks being safeguarded by the nature of their Shariah principles against exposure to subprime mortgages and the other toxic assets that have hurt the balance sheets of so many of the world’s biggest financial institutions. "
[...]
As it is, a substantial amount of business transacted in an ethical or sustainable format may qualify as Sharia compliant. This demand for products and investments, while primarily fuelled by the world’s 1.3 billion Muslims, is supporting interesting crossover products that benefit from the same ethical criteria."

Other News

• Golden Belt Sukuk holders approved the dissolution of the sukuk trust, making the sukuk holders unsecured creditors of Saad Group.
  
• The Central Bank of Bahrain's sukuk al-ijara issue was oversubscribed by 230%. The sukuk has a maturity of 182 days.
  
• Dana Gas reset the conversion rate on its sukuk according to JPMorgan Chase & Co., the calculation agent.
  
• South African investment management firm is planning on launching its products outside of its home country including within Europe.
  
• Aston Business School will launch an MSc and PhD program in Islamic banking with sponsorship from the CEO of Dubai-based Surgi Tech.
  
• Al Rajhi Steel Industries, a Saudi rebar manufacturer obtained a $196.5 billion Shari'ah-compliant bank loan to finance construction of a new plant in Jeddah.
  
• The Iraqi bank Ashur Bank is exploring offering an Islamic banking window, for which it submitted an application six months ago to the Central Bank of Iraq. 7 of Iraq's 42 banks are Islamic banks.
  

Regulation in Islamic finance, Questions remain about Dubai GREs

Malaysia's prime minister Najib Razak said that the Islamic financial industry needs strong regulation to ensure it avoids future crises. This has been an area where the industry has been slow to recognize its susceptibility to a similar financial crisis that occurred beginning in 2007 in the conventional financial industry. For too long, there were many articles talking about how the Islamic financial industry was 'immune' to crisis because of the way it operated. I have been pointing out that there are some aspects of the Islamic financial system (including lack of deposit insurance and a true 'lender of last resort') that could even make Islamic finance more vulnerable to a crisis if there was a serious loss of confidence in one or a few large Islamic banks. It is good to see that there is a greater recognition of the need for regulation to prevent either poor risk management or damaging innovation from creating a situation where there could be a crisis. Now, all that needs to happen is for these regulations to be adopted. That could take a while, although the Islamic FInancial Standards Board has begun discussing liquidity standards that would address one potential area of systemic risks in Islamic finance caused by the difficulties of Islamic banks in managing liquidity and asset and liability maturity mismatches.

Some of the proceeds from the recent Dubai sukuk, which raised $1.93 billion, will be used to pay the maturing $1 billion sukuk from the Dubai Civil Aviation Authority, which matured today. The UAE said that the timing of the issue of a $10 billion bond planned by Dubai that may be used to redeem the Nakheel sukuk maturing next month will "depend on the needs at the time" according to the Minister of Economy. In a contrary development, ratings agency Moody's Investor Service downgraded five government related entities (GREs) because the government after the Dubai finance department relinquished its obligations to cover the entities' debts. Although the GREs are not part of the government and do not have a government guarantee, they are closely tied to the government and any defaults would likely have repercussions on the Emirate's perceived creditworthiness.

Other News

• Amlak and Tamweel, the two large Dubai-based Islamic mortgage firms will be merged beginning in January with their investors owning one-third of the resulting bank.
  
• Gulf Finance House is planning on converting into a commercial bank from an investment bank and will issue $100 million in a convertible Islamic instrument. GFH issued Macquarie Bank with a $100 million convertible murabaha earlier this year.
  
• The ISDA-IIFM template for Shari'ah-compliant derivatives will be released either this year or early next year.
  
• The IFC listed its $100 million sukuk on the Bahrain Stock Exchange and NASDAQ Dubai.
  
• The U.S. is selling the building in which its embassy has resided in London to Qatari Diar, which recently began the process of issuing sukuk to fund its European acquisitions. Al Salam Europe, the European unit of the Bahraini firm is also planning on expanding its investments in Europe with real estate and private equity investments planned by January.
  
• Islamic finance could continue its rapid growth and see total assets of $4 trillion in 8-10 years according to the CEO of Doha Bank in a speech recently.
  

Nakheel may try to tender its sukuk, interview with Anouar Hassoune, opinion piece by Rushdi Siddiqui

Nakheel may make a tender offer for its $3.52 billion sukuk that comes due in December at a discount. However, many investors are likely to reject the tender offer in the hope of receiving full repayment at maturity, in part because Nakheel may receive government support from the Dubai government if it is unable to make payment on its own, as Phillip Lotter, a vice president at Moody's Investors Services said June 10. The prices in the secondary market fell to 63.5 cents on the dollar before rebounding to 87 cents yesterday. I wrote a summary of the Nakheel sukuk on my Zawya blog back in May.

Emirates Business 24/7 has a great interview with Anouar Hassoune, the Vice President and Senior Credit Officer at Moody's Investors Service about the Islamic finance, in particular, the resiliency of the industry at a time when several stand-alone Islamic investment banks have defaulted on their obligations.

Rushdi Siddiqui, head of Islamic finance for Thomson Reuters has an opinion piece saying that Islamic financial institutions should undergo stress tests like the major banks in the U.S. did earlier this year to increase confidence in the industry.

European banks, including a German bank but no French banks, have expressed interest in financing and running the $3 billion IPO planned for Istikhlaf, the planned $10 billion mega-Islamic bank. Sheikh Saleh Kamel and Adnan Yousef who have been the driving force for the bank's launch are not going to take management roles in the banks following the IPO.

Other News

• The Islamic Development Bank is planning to issue the first $500 million sukuk over the next few weeks as part of its planned 5-year, $6 billion sukuk offering.
  
• Indonesia's exchange-backed bond pricing agency will begin publishing daily prices of bonds and sukuk to facilitate greater liquidity in the secondary markets and help issuers price new issues.
  
• The Dubai government is providing AED 5 billion ($1.36 billion) in financing to merge two banks together into the Emirates Development Bank. However, despite the expectation that Amlak and Tamweel, the troubled Islamic mortgage lenders, would be included in the new entity they were not part of the announced plan.
  
• The flood of new sovereign sukuk issues continues as the Ras Al Khaimah Investment Authority (RAKIA) is planning to issue a $500 million sukuk in July.
  
• A Bahraini Islamic investment bank is financing construction of a $50 million mall in the country.
  
• Gulf news has two articles about Islamic banking and in particular the use of Islamic financial institutions by non-Muslims in the Gulf.
  

Sukuk funds, Ernst & Young report on Islamic funds

Two sukuk funds were launched in the last few days. The funds, the Qatar Investment Bank-European Finance House Global Sukuk Plus Fund and the Tharawat Investment House Sukuk Fund. Sukuk funds have been fairly rare until now but provide an interesting development for the industry. Both firms noted that the sukuk market was experiencing some disruption and creating sukuk funds to invest in outstanding and new sukuk issues provide a good opportunity. The one challenge for the sukuk funds will be to find enough sukuk to invest in, especially if they attract significant investments. The sukuk secondary market is very illiquid and sukuk issuance has tumbled since its peak in 2007. The sukuk markets will see growing issuance as the conditions in credit markets and the economy improve, but whether the funds will be able to subscribe to enough of these sukuk will be interesting to follow.

Ernst & Young released their Islamic Funds & Investment Report 2009 which contained several different pieces of information from the S&P report:

• "Shari'a sensitive investable assets in 2008 in the GCC and Asia touched US$736 billion as compared to US$267 billion in 2007 (in computing the total asset size this year, the report included Awqaf and Endowments, Takaful operators in Malaysia, SWFs in the MENA region and Asia, and it also includes the markets of Pakistan and South East Asia - all of which where not included in last year's figures)"
  
• "The largest concentration of Islamic funds remains in the Middle East and equity funds lead the field for choice of asset type. 19% and 23% of Islamic funds are domiciled in Saudi Arabia and Malaysia respectively."
  
• "Islamic indices have performed poorly worldwide - we see the average return from Islamic equity funds fall to minus 39% in 2008 as compared to a 23% return in 2007. In the first quarter of 2009, the average return stood at minus 3.7%. Average Islamic fixed income fund return dropped from 3% in 2007 to 1% in 2008 and Q1 2009."
  
• "Sukuk issuance has slowed as spreads widen - sukuks worth US$15.5 billion were issued in 2008 as compared to US$47.1 billion in 2007."
  
• "Omar Bitar, Managing Partner, Middle East Advisory Services at Ernst & Young Middle East, said, 'Two-thirds of all players manage less than US$100 million each in Islamic assets - the global competitive landscape is fragmented and a shakeout appears likely.'"
  
• "[Head of the Islamic Finance Services Group] Sameer [Abdi] said, 'The business risks landscape for Islamic asset management has changed substantially since 2008. Revisions of expected returns have caused some investors to withdraw capital and previously robust business models have struggled to cope with extreme market events. The economic downturn, a reduction in investor risk appetite and unclear valuations will be the most pressing business risks in 2009.'"
  

Other News

• A Malaysian perspective on the Standard & Poor's Islamic Finance Outlook.
  
• Kuwait Finance House-Bahrain is no longer in talks to acquire a 40% stake in Bahrain Islamic Bank from The Investment Dar.
  
• The Investment Dar will meet with creditors to update them on its restructuring plans sometime in June.
  
• Humayon Dar, head of BMB Islamic described the impact of the crisis on Islamic financial institutions very accurately: ""Clearly Islamic finance, along with the rest of the financial industry, has suffered from the downturn, but the effect came later and resulted in less of a slowdown because Islamic institutions were not exposed to any of the toxic assets which caused the slump. Islamic equity funds have clearly suffered because of the credit crunch which has seen all equities fall, but they have lost less than conventional financial funds." The chief economist at NCB Capital describes the evolution of the sukuk market well: "Initially sukuk wanted to mimic the conventional bond markets, but that is how new markets get started. Now they can move to where they have their own identity."
  
• US-based Thomas Weisel announced a partnership with Ideal Ratings to begin offering Islamic funds and separate accounts for helping investors invest in the small- and mid-cap sector in the US.
  

Reuters Islamic finance conference raises a number of important issues

Real estate exposure at Islamic banks

The Islamic International Ratings Agency reports that Islamic banks are weathering the economic crisis better than conventional banks, but "there will be an adverse effect of real estate exposure on their balance sheets, but we don't expect it to be critical". This is a point I have been making for quite some time as some industry practitioners have claimed that the industry is 'immune' to the current economic crisis because they were prohibited from the subprime lending and derivatives trading that sparked it. The reason is not difficult to understand: Islamic banks are closer to what banks have been throughout history in that they act as intermediaries between savers and borrowers to finance business and consumption. This is their appeal outside of their Shari'ah-compliance. However, their exposure to the economic activities they finance mean that changes in the general economic environment have a significant impact on their balance sheets. In the absence of perfect diversification which even banks in huge, developed markets lack, they will be hit by changes in asset prices in the economic sectors in which they have the most exposure. In the GCC for Islamic banks, this is largely (although not exclusively) in energy and real estate because both sectors are 'tangible asset rich'. Islamic financial products as they are designed currently favor these sectors because they provide a tangible asset on which financers can seek recourse if their clients run into difficulty and are not as susceptible to adverse selection. Adverse selection, having clients more likely to default because of the structure of products, is more of a problem with profit-sharing arrangements like mudaraba and musharaka because they give away more of any upside gain (profits) but cushion against some losses. The adverse selection process arises because clients who are most likely to be successful will seek more debt-like products to keep all their gains while those that are less likely to be successful (either naturally more risky projects or less qualified businesspeople) are willing to trade some possible upside for the downside protection that a profit-and-loss sharing arrangement provides.

Another idea that I have been pressing for several months, greater transparency, is also coming onto the front burner as AAOIFI highlights the need for greater disclosures from Islamic financial firms.

Sukuk

The sukuk market was negatively affected by Shari'ah-compliance standard changes during the second half of 2008. Contrary what has been reported, including on this blog, the fall of sukuk issuance during 2008 was probably impacted by the new AAOIFI rules issued in February 2008. According to the CEO of Dubai Islamic Bank which owns Islamic structuring consultancy Dar al-Sharia, "we lost at least $10bn to $15bn since the onset of the crisis". Among the reasons given were that companies approached the sukuk market with a mindset that was identical to that which they approached a conventional bond issue. DIB CEO Sohail Zubairi explained that "sukuk collapsed because the starting point was conventional. If the starting point would have been correct, I'm sure we would still have been up and running". While pinning much of the blame on the issuers not understanding the difference, the freeze up in the global economy still does bear some responsibility for the fall in sukuk issuance in 2008. A Shari'ah adviser with another Shari'ah consultancy Minhaj, Amin Fateh Amer says that "about 85% of what people are dealing with in the sukuk market are not Shari'ah-compliant at all". This was the same figure mentioned by Sheikh Usmani in November 2007 that caused the controversy which led to the AAOIFI Shari'ah board which he chairs to issue further guidance in February 2008.

Other News

• The takaful market in the GCC has a significant growth potential with estimates from Ernst & Young projecting it will rise to $7.7 billion by 2012. Other participants at the World Takaful Conference 2009 in Dubai provided estimates that it could reach $11 billion by 2015. The growth has slowed from previous estimates like one from HSBC which predicted that the global takaful market would reach $14.4 billion by 2010. European insurers are still weighing whether to enter the market to capture first mover advantage or wait for it to become better developed.
  
• There are a number of quotes compiled together from the recent Islamic Business & Finance conference organized in four cities around the world simultaneously by ThomsonReuters. Reuters also has a timeline of the growth of the industry.
  
• The Bahrain Financial Exchange plans on launching 10-15 contracts soon including metal-related contracts, up to one-third which will be Shari'ah-compliant.
  
• The market for Islamic financial products in Nigeria could grow significantly following the passage of the "Law Governing the Operation of Islamic Banks" which was introduced in mid-March 2009.
  
• The overall market decline has caused a proposed Islamic equity fund to be cancelled and put another one in doubt.
  
• Islamic investment bank Unicorn is planning a $425 million sukuk by the third quarter of 2009 to fund its expansion, planned largely through expansion. The bank had planned a $1.5 billion sukuk last year that was delayed because of market conditions.
  
• The head of the International Islamic Financial Market (IIFM) says that sovereign regulators need to establish more standards for Islamic banking and in particular he pointed out that "we don't have a lender of last resort". Reuters provides a factbox about the regulatory bodies currently operating to regulate the Islamic financial industry.
  
• HSBC Amanah, the Islamic finance division of the banking group has scaled back its plans for its worldwide growth and will focus on its largest markets, Saudi Arabia, the United Arab Emirates and Malaysia with a secondary focus on Indonesia, Pakistan, Egypt, Turkey and the U.K.. The group has offered Islamic financial products since 1994.
  
• Mashreq unit Badr al-Islami is planning an open-ended sukuk fund to capitalize on the high yields on outstanding sukuk include Aldar Properties, Dubai Electricity & Water Authority and Dar al-Arkan and perhaps also property developer Nakheel. As the sukuk market develops, foreign firms may tap the market starting in 2010.
  
• National Bank of Kuwait is awaiting central bank approval to buy 40% of Boubyan Bank, an Islamic bank partly owned by The Investment Dar which has considered selling its stake in Boubyan.
  
• Lloyd's plans to begin offering Islamic reinsurance (retakaful) globally beginning in 2010.
  

Islamic finance at risk from fall in prices in the real estate market; CGAP study on Islamic microfinance released

My fears that the credit crisis in conventional financial markets is spilling over to Islamic finance are becoming to be realized. The primary mechanism I identified in my blog (and in greater detail in a forthcoming opinion piece for Business Islamica magazine) for transmitting a crisis through the Islamic banks was falling property prices in the GCC countries that had mostly escaped the direct fallout from the subprime crisis that began in the United States. Although the prices have not fallen as dramatically as in Western countries, they are beginning to fall and this has an effect on Islamic banking because these assets are the underlying physical property used in many Islamic financing deals. From a Gulf Daily News article: "Falling prices in mainly Muslim countries in the Middle East and Southeast Asia are likely to affect the Islamic finance market due to heavy reliance on such assets to support deals." A senior analyst at Zawya, Alexandra Tohme, adds her opinion on the link between Islamic financial institutions and the global credit crisis.

The Dinar Standard has an interesting article about the potential for Islamic banking in Europe.

The Financial Times has a Q&A on the basics of Islamic finance, as do a number of newspapers in the U.S. and there is also an article on finance based in Christianity.

Islamic finance could still grow by 20-25% a year despite the financial crisis according to Rushdi Siddiqui, the Global Director of the Dow Jones Islamic Market Indexes, but "Islamic banks should diversify their investments to generate revenues from different areas."

Hedge fund managers are targeting Muslim investors in the Middle East by developing Shari'ah-compliant hedge funds, but is it too late for them to attract investors given their often poor returns during the past couple of years.

The DIFC has lent its support to the new Master Agreements for Treasury Placements (MATP), the standardized contract from the International Islamic Finance Market (IIFM) that was recently announced.

Zurich Financial Services Group has launched a joint venture takaful company with the Abu Dhabi National Takaful Company to expand their operations in the GCC region.

The Consultative Group to Assist the Poor (CGAP), a multi-lateral effort to promote microfinance and based at the World Bank, released a study of 125 Islamic microfinancial institutions.

Can Islamic finance have a crisis?

Umer Chapra, an Islamic economist, recently discussed the reasons he saw for the credit crisis and the reasons that Islamic banks would not create a similar crisis. While I agree that the Shari'ah restrictions on Islamic banks would limit the scope for excessive bad lending, I don't think that on its own Shari'ah-compliant banks would be completely immune from a similar crises caused by the growth of a bubble in real estate (or any other Shari'ah-compliant asset). The additional scrutiny that Shari'ah-compliant financial products face in the Shari'ah review process can potentially reign in excessive speculation and prevent some of the worst excesses that characterized the recent crisis in conventional finance. A lecturer at Al Azhar University, Shiob-bin-Mukhtar, goes further saying that there would be no financial crises if Islamic finance was exclusively used. The head of Global Council of Islamic Banks, Saleh Kamel, announces the failure of capitalism and suggests an Islamic financial system as a replacement.

An article discusses the possible regulatory and market changes in the GCC which are likely following the credit crisis.

An investment company in the UK, cru Investment Management, is creating an asset-backed investment fund that will invest in commercial agriculture in Africa. The investment is seen as good from both an investment perspective (the fund management expect a return of between 15-20 percent) and an ethical perspective: one of the stated goals of the investment fund is to "help to create jobs and give rural Africans the chance to help themselves out of poverty".

Islamic finance in Europe is set to grow, according to speakers at a conference in Paris. It is also starting to emerge and grow in Australia.

Islamic finance and the credit crunch

Islamic financial institutions are realizing that they're exposed to the credit crisis through their investments in the GCC real estate market which has begun to slow. The primary effect now is reduced profitability, but the lack of depositor insurance could allow falling real estate prices to feed through to depositors. In a few countries like Malaysia, the government has guaranteed all deposits even those at Islamic banks for two years. Islamic banks in Europe are also expected to see growth slow due to the credit crisis, according to the CEO of the European Islamic Investment Bank.

The editorial manager of Oxford Business Group in Abu Dhabi discusses the fallout from the AAOIFI ruling on sukuk and highlights the new, innovative products that are being developed.

Depositors in the UK have several alternatives to conventional banks, one of which is Islamic banks. A BBC news article discusses some of the opportunities and risks of Islamic finance.

In the U.S., Habitat for Humanity, a Christian charity, has built and refurbished many homes for Muslims and Muslims are now becoming involved in the organization.

Indonesia may delay its dollar-denominated sukuk because of credit market conditions.

Islamic finance in the U.K. and the planned sukuk, AAOFI board issues guidance on ijara sukuk

Mixed signals are coming out of the U.K. regarding the potential issue of the first sovereign sukuk from a G8 country. The last year has seen a number of moves to make the U.K.'s regulatory environment more conducive to Islamic finance as the country sees great potential in the industry. However, recent news about the sukuk issue suggest that the government believes there are further regulatory changes needed to make the idea a reality. Although the sukuk issue may be delayed, Shari'ah-compliant home finance is growing rapidly. Other areas of Islamic finance are also growing rapidly in the U.K., which is seen as a gateway into Europe for many Islamic banks.

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the standards-setting body based in Bahrain released its much anticipated clarification of guidelines on sukuk (available as a PDF from AAOIFI). Sheikh Taqi Usmani, the chairman of the Shari'ah board at AAOIFI made headlines in November 2007 when he made comments that up to 85% of GCC-based ijara sukuk might not be Shari'ah-compliant because they contained repurchase agreements that set a fixed repurchase price for the assets on which the sukuk were based. The AAOIFI release as expected said that the use of repurchase agreements with fixed repurchase price were not permissible except when the fixed price is set for a lessee who is not an investment partner. Instead of using a fixed price repurchase agreement, the AAOIFI Shari'ah board allowed repurchase agreements where the price was determined by the fair market value of the underlying asset at the time of repurchase. This was largely expected and should not cause too much disruption because most of the ijara structure was upheld. The article on the AAOIFI release from Bloomberg contains reactions from Islamic financial industry participants.

DePaul University, a university in Chicago, Illinois has begun offering classes on Islamic finance making it one of few in the United States where classes are taught on the subject. The NY Times also highlights University Islamic Finance Corporation as one of the banking companies catering to minority needs in the U.S.

Kenya changed its regulations of the banking industry to allow Islamic finance and began granting license to retail and commercial Islamic banks in early 2007, the growth has not yet been realized as the banks are just beginning to open.

Lawyers with experience in Islamic finance are added to the list of professionals in short supply as the Islamic finance industry sees growth in demand outstrip the supply of capable professionals.

The Guardian profiles 'sharia technician', Humayon Dar, currently with BMB Islamic, a Shari'ah advisory firm owned by the BMB Group. There are few details about the BMB Group, although it is thought to be based in Brunei. Another Shari'ah-compliant consulting organization, Yasaar Ltd, based in the U.K., is focusing some of its attention on achieving standardization of Shari'ah standards across the different schools of fiqh.

ING in Malaysia, IIFF on regulatory issues in conventional systems, Shari'ah constraints in the U.S.

ING Investment Management, an investment manager affiliated with ING Group, plans on making Malaysia the center of its Shari'ah-compliant fund business.

The International Islamic Finance Forum (IIFF) Europe will explore how Islamic finance works from a regulatory perspective in a conventional financial system. Conference manager Swati Taneja is quoted in the article with a valuable insight: "The degree of success to which Islamic banking continues to emerge in conventional systems will hinge on whether Islamic banking is perceived as a transparent and well-regulated activity".

Shari'ah-compliance restrictions hold up the availability of Islamic products in the United States, describes Deborah Nason in Investment News.

New products, new IFSB members, new Islamic finance in Europe

CIMB Islamic will begin offering a new Shari'ah-compliant deposit account that provides the profit in advance using a commodity murabaha tawarruq.

Bank Islamic Malaysia Bhd (BIMB) signed an agreement to offer Shari'ah-compliant products in Europe including capital markets, treasury manangement and wealth management services.

The Bank of Japan became an observer of the Islamic Financial Services Board (IFSB).

Pakistani Islamic finance growing rapidly, Al Salam expanding to Europe & international commodity murabaha

Pakistan's Islamic financial services industry started later than in other countries but has been able to grow rapidly and will continue to grow over the near term. This is the message from Dr. Shamshad Akhtar, the governor of the State Bank of Pakistan and the deputy chairperson of the Islamic Financial Services Board, speaking with the Khaleej Times. Islamic financing currently makes up 3 percent of assets and deposits of the country's banking system and Dr. Akhtar expects that it could grow to 10 or 15 percent in relatively few years if the sector continues to grow at its current rapid pace. Currently there are six stand-alone Islamic banks and ten Islamic 'windows' at conventional banks. Dr. Akhtar also emphasized the ability to bring more people into the financial system who currently abstain because of their religious beliefs and, if microfinancing is used, could play an important role in the empowerment of women who make up the majority of microfinancing loans.

Al Salam Bank, headquartered in Bahrain with licenses to operate in Sudan and Algeria is eying Asia and Europe for expansion. Speaking to Reuters, Yousif Taqi, Al Salam's cheif executive, predicted that the bank would enter the European market, possibly Britain, in the next two years.

Short term funds using palm-oil murabaha will be exchanged between the Saudi Hollandi Bank and Malaysia's central bank, Bank Negara Malaysia.

KFH ups bid for RHB, GFH announces European private equity fund, Islamic banking in Pakistan

Gulf Finance House announces European private equity fund

Gulf Finance House, the Bahrain-based Islamic investment house which opened in 1999, announced the creation of a European private equity fund. The bank, which claims to have raised $1 billion in new private equity in 2006, also has a Middle East and North Africa regional fund.

Kuwait Finance House ups bid for RHB and RHB Capital

Kuwait Finance House one of two bidders for control of Rashid Hussain Bhd and RHB Capital, competing with EON Capital, has set a minimum price it will pay for shares of RHB and RHB Capital. Previously, KFH offered RM2.16 billion ($618 million) for Utama Banking Group's 32 percent stake in RHB, which owns 65% of RHB Capital. The new offer is RM2 ($0.57) per share of Rashid Hussain Bhd, RM1.8 ($0.52) per call warrant of RHB Capital and RM4.8 ($1.37) per share of RHB Capital.

KFH plans to invest $3.4 billion in RHB to turn it into a mega Islamic bank. The current EON Capital bid is $2.86 billion for RHB.

Islamic banking in Pakistan

The monthly magazine Newsline in Pakistan has an interesting article about the development of Islamic banking in Pakistan.