The GCC embarks on the journey of developing a bankruptcy regime

The financial crisis of 2007 -2009 did not spare the GCC region or Islamic finance as many real estate-related companies, and some financial institutions with exposure to this sector, either failed or were forced to restructure their debt.  A number of these companies had Shari’ah-compliant financing that was involved.  One of the most well known is Nahkeel Development Company whose $3.52 billion sukuk led to the Dubai debt crisis.  

Kuwait Finance Centre (Markaz) released an interesting report in January 2013 (PDF) detailing how much development the GCC needs to implement bankruptcy legislation that meets international standards.  There have been some efforts—some more successful than others—like the Dubai World Tribunal (established by Decree No. 57 of 2009) and Kuwait’s Financial Stability Law which was passed in March 2009. 

The primary resolution in the GCC for corporate defaults is either liquidation of the company or a consensual restructuring of the debt obligations.  There is no established process for distressed companies to enter a court-led process that aims first for the restructuring of debts and the reorganization of the business so that it can become viable, as there is elsewhere (e.g. the Chapter 11 reorganization process in the United States).  Markaz described: “A closer look reveals that the Bankruptcy laws in GCC are primarily liquidation laws and are insufficient to help an ailing company to restructure its debt so that it can continue in business.” (emphasis in original). 

Markaz further comments that:

“There is a stigma associated with bankruptcy in the GCC, which makes filing for bankruptcy protection almost unheard of in the region. This is both due to the cultural stigma attached in addition to the inadequacy of regional bankruptcy laws where they exist.  The lacking regulation and legal framework came into focus with the financial crisis whereby many firms in the GCC encountered debt and insolvency issues with very little in the way of legal recourse for resolution.

The primary outcome of the financial crisis-related defaults by GCC corporates, including the government-related enterprises like Nakheel was that creditors were forced into some form of restructuring through an ad hoc arrangement outside of any established legal process and where an emergency legal process was imposed, it was subject to either significant uncertainties (e.g. Kuwait’s Financial Stability Law) or was limited in scope (the Dubai World Tribunal established by Decree No. 57).  It should not be surprising—nor is leveling too much criticism in hindsight particularly valuable—since many countries even where there were established bankruptcy laws resorted to one-off or otherwise unusual resolution processes for the financial sector following the financial crisis. 

However, the recent experiences do highlight many areas where improvements can be made so that future defaults can be better managed without leaving the restructuring to be done outside of an established process.  Because, while some restructuring outside of periods of financial crisis may proceed relatively smoothly (e.g. the restructuring of the $1bn Dana Gas sukuk) with minimum market disruption, it relies too much on the hope that there will not come a time when a voluntary restructuring agreement cannot be reached. 

A stopgap measure for some companies will be to use the bankruptcy law of another country, like Arcapita did with its Chapter 11 filing in the United States (PDF), which has led to a proposed reorganization plan that will allow the company to leave Chapter 11 and conduct an orderly exit from its investments with a formalized process for splitting up whatever value remains for the secured and unsecured creditors.  But, not all companies are eligible to file for Chapter 11 bankruptcy (which requires some assets in the US, where Arcapita had an office and many of its investments).  As an article on cross-border insolvencies by Howard Seife, a lawyer at Chadbourne & Parke LLP (PDF) explained:

“Section 109(a) of the U.S. Bankruptcy Code permits a Chapter 11 filing in a U.S. bankruptcy court by a person (defined in Section 101(41) as including a corporation) ‘that resides or has a domicile, a place of business, or property in the United States.’  Cases that have considered the ‘property’ requirement with respect to foreign corporations have found it satisfied by even a minimal amount of property located in the U.S.”

For example, the Dana Gas sukuk, where assets were located in the UAE, Egypt and Iraq would probably not be able to take advantage of the Chapter 11 process if it had failed to restructure its sukuk.  It could, instead, let creditors take Dana Gas to an English court (which was the law chosen for most of the dispute resolution for the sukuk), but as the prospectus notes: “in respect of foreign court judgements, the UAE courts are unlikely to enforce an English judgment without re-examining the merits of the claim and may not observe the choice by the parties of English law as the governing law of the transaction.”

The UAE is addressing one aspect of the problem with a new bankruptcy law that was expected to be enacted by the end of 2012, but it has since been pushed back to late 2013.  A managing director at Deloitte Corporate Finance explained the purpose of the new law as “provid[ing] a method by which stressed and distressed companies can either come to a place where they are able to resume trading profitably and to the advantage of all parties, or be wound up and liquidated in a controlled manner.”

Reuters reported that the draft law is likely to be based on the French bankruptcy laws, which is debtor friendly (the US’ Chapter 11 process is also viewed as being debtor friendly). 

The development of a bankruptcy resolution process is positive, and even with a delayed development of a bankruptcy law in the UAE will help attract investors.  If it is based on the French or US bankruptcy law, as indicated, it could allow for either reorganization (where the company remains in business with a modified capital structure where, for example, some debt is converted to equity) or liquidation, depending on whether the business is seen as viable.  However, as the Markaz report highlights (specifically in the table below), there are other factors that are important besides just the reorganization laws.

Islamic finance and sukuk in particular, the first three rows in the table are of particular importance.  Many sukuk issued by GCC corporates and governments are not rated and while ratings agencies have taken significant criticism following the financial crisis for the high ratings they gave to what turned out to be low quality securities, they can still provide information to investors.  Currently there is no requirement for new sukuk to be rated (e.g. in order to be listed), whereas Malaysia requires a rating for any sukuk that are offered to the retail market.

The second and third rows are all important as well in developing the ability of sukuk holders to take possession of the underlying collateral in asset-backed sukuk.  Currently, sukuk holders can enforce on some collateral because the sukuk are based on English law (mostly), but they are limited in enforcing on collateral within the GCC region.   

If more sukuk are issued using an asset-backed structure, which is often suggested as being preferable compared with the asset-based sukuk that mimic unsecured bonds through a purchase undertaking by the issuer, there will need to be the ability of sukuk holders to take possession of the asset to sell it to recover some of their investment if a sukuk defaults.  That will probably not happen in the near-term, but in the context of thinking about the role of a bankruptcy process in the GCC, it should not be ignored either.  

In the end, there is not a well-developed process for bankruptcy in the GCC and, particularly in the wake of restructurings necessitated by the financial crisis, might have held back the sukuk market (although from the growth in new issuance, it has not had a dramatic effect).  It is good to see the problem acknowledged and first steps made to fix the problem, but it is just the beginning of the process since even when laws are enacted it will take a while for enough cases that use the bankruptcy process to create certainty for investors about what they can expect if the issuer of the sukuk they buy needs to use it.  

Sign up for the ThomsonReuters Islamic Finance Gateway (it's free) and join the Morning Wrap as we discuss this subject and others, Tuesdays and Thursdays at 9:30am Mecca Time (GMT+3).

More Information

• Markaz. 2013. Dealing with Bankruptcy in the GCC: A Key Missing Block in the Reform Agenda.  Available from http://www.markaz.com/DesktopModules/CRD/Attachments/BankruptcyintheGCC-MarkazResearch.pdf
  
• Seife, Howard. 2004. “Bankruptcy for Bankers,” Banking Law Journal, 121(4), April, pp. 341-349.  Available from http://www.chadbourne.com/files/Publication/57a21544-1309-4974-acab-99c9cc612831/Presentation/PublicationAttachment/dcf5e197-7e13-4f70-99e9-9dd7ecfb6fef/BLJ-0404.pdf
• Financier Worldwide. 2012. “10Questions: The United Arab Emirates’ New Insolvency Law,” August. Available from: http://www.financierworldwide.com/article.php?id=9540&page=1
• Reuters. 2012. “UAE new law draft may be delayed until end-2013 –Lawyer,” Available from: http://www.reuters.com/article/2012/12/05/emirates-bankruptcy-idUSL5E8N54WC20121205

How can Islamic finance in the West grow?

One of the key drivers for Islamic finance in the West has been the immigration of Muslims into those countries. As these immigrants have moved in, the domestic banks have tried to develop products that cater to their needs. However, the process has been slower than one might expect, particularly in some countries like France and Germany which have relatively large shares of Muslim residents compared to their populations. The first Islamic bank branch in Germany, a branch of Kuveyt Turk, opened earlier this year in Mannheim. Al Baraka Bank says it plans on opening an Islamic bank in France in 2011, something it has planned for several years.

An article recently described the growth of multicultural banking in Canada and alluded to the relative shortage of Islamic banking in the country despite the growing Muslim population, that is growing in large part because of immigrants to the country. The country has had Islamic home finance co-operatives for decades and in the last several years, UM Financial has offered Islamic mortgages (as well as a pre-paid Shari'ah-compliant debit card and some work on forthcoming sukuk). The larger banks, including Bank of Montreal and Scotiabank are considering whether to enter the market while RBC offered Islamic mortgages, before dropping the product due to low volumes. In Canada, it appears that the large banks entering the market have been hamstrung by difficulties entering the Muslim marketplace, while the smaller institutions have been set back by shortage of capital for new originations. In the United States, the shortage of capital has been eased with the entrance of Freddie Mac, which provides the financing for Shari'ah-compliant mortgages. There is not a similar institution in Canada, so the best way forward may be for the large banks to work through the smaller providers to combine the former to benefit from the latter's better exposure within the Muslim community and the latter to benefit from the former's access to capital. Were this to happen, it would open up the possibility of the larger banks securitizing Islamic mortgages, which could then be sold to fund managers to allow them the investment possibilities they need to offer retail Shari'ah-compliant fixed income investment products to the Muslim marketplace where fixed income is always a challenge (and very often limited or absent from the market).

Friday Bullets

• The future of Islamic finance--outside of retail banking--is moving more towards asset management with institutions realizing that the recurring revenue from this business is important to offset the highly cyclical nature of investment banking. No institution perhaps stands as a better example of overreliance on private equity/investment banking in Islamic finance than Gulf Finance House, which is planning to build its recurring revenue business now that it has extended the maturity of several loans.
  
• Pakistan's central bank is urging Gulf-based Islamic banks to open branches in the rural areas of Pakistan as a way to increase the country's share of Islamic banking assets, which the bank wants to double in the next 3 years.
  
• A few more articles came out on the Deloitte report on Islamic finance. One article from Gulf News includes two charts from the report that point to the need for regulation, particularly in accounting standards, risk management, corporate governance and Shari'ah standards & compliance.
  
• Adnan Ahmad Yousef, CEO of Al Baraka Banking Group, says that sufficient financing is available for Islamic financial institutions and the banking group is planning a $200 million sukuk to finance the bank's expansion into France next year. Qatar Islamic Bank is also planning a sukuk issue of up to $750 million when market conditions are right, according to a statement from the bank.
  
• An article describes the enforcement of an ijara-based financing in Dubai that went through the UAE court system.
  
• The Islamic Bank of Britain released results for the first half of 2010.
  
• The Nakheel 5-year sukuk to pay trade creditors may be issued by year-end and is estimated to be up to $3.2 billion. It will pay a 10% coupon semi-annually, will be tradable and will be listed on NASDAQ Dubai.
  
• An article in Arabian Business highlights the degree to which credit conditions in sukuk markets have recovered this quarter (and also the amount they still have to go before conditions normalize): "The spread between the average yield for Islamic bonds in the UAE and the London interbank offered rate shrank 104 basis points to 507 basis points so far this quarter, according to the HSBC/NASDAQ Dubai UAE US Dollar Sukuk Index." Issuance is expected to be as much as $5 billion in the fourth quarter, the highest since Q3 ofo 2007, before the AAOIFI ruling and the impact of the financial crisis caused a sharp decline in the volume of sukuk issued.
  

Kuveyt Turk's sukuk, other news

Kuveyt Turk Participation Bank's recent wakala sukuk was backed by a combination of murabaha receivables and ijara contracts. This is generally tradable so long as 33% of the contracts are ijara contracts. Most of the issuance of this type of sukuk (e.g. by Cagamas and the Islamic Development Bank) adopt a higher 50% level for ijara sukuk. It appears that sukuk backed by murabaha and ijara contracts is becoming more popular among financial institutions since the structure used for mudaraba and musharaka sukuk prior to a 2008 AAOIFI ruling were ruled impermissible.

Other News

• France passed a tax neutrality law for Islamic financial products recently that could encourage more Islamic finance in the country. An earlier law on Islamic financial products was struck down by the high court largely on procedural grounds.
  
• Zawya reviews sukuk activity during August. Much of the activity occurring in August and expected in September is from Malaysia.
  
• Kuwait Finance House, which has a Malaysian unit, is planning further expansion across Asia, including China and is reportedly in talks with Japanese financial institutions regarding a strategic partnership.
  
• An article describes the potential for growth in Islamic finance but notes--correctly in my opinion--that while Islamic financial institutions were less exposed to the financial crisis in general, they have not reacted as quickly as conventional institutions and have been slower to fully recover (particularly in the GCC).
  
• Sukuk returns trailed emerging market bonds in August for the fourth straight month because of continued restructuring talks around some GCC-based sukuk.
  
• Bloomberg describes briefly the Dubai-based institution, Millenium Private Equity, which subscribed for the entire sukuk from UK-based company IIT.
  
• The International Islamic Ratings Agency and Dinar Standard released a report, called "Pulse of OIC Islamic Capital Markets".
  
• Indonesia's government is planning to issue another 2 trllion rupiah ($222 million) in sukuk to the government's haj fund by private placement. Selling the sukuk to the haj fund may be a response to the several failed auctions previously. The previous auctions saw enough demand, but higher yields than conventional bond sales of comparable maturity because sukuk are less liquid than conventional bonds.
  
• Islamic finance in Indonesia has been growing, albeit from a small base of around 2.8% of total banking assets, compared with nearly 20% in Malaysia.
  

Shari'ah scholar licensing, IIT sukuk, Islamic indices

Bloomberg has a more detailed article about the planned Shari'ah scholar certification body, although the details are not yet fully described. I think this is a positive development because it will provide a way for newer or less recognized scholars to build credibility and become selected to be members of Shari'ah boards. This will increase the number of qualified scholars with experience that could be the biggest development to get around the well publicized lack of scholars that are selected to serve on Shari'ah boards. Currently, most Islamic financial institutions select the most recognizable Shari'ah scholars to gain credibility about the Shari'ah-compliance of their offerings. This has led to the top scholars being on many, many Shari'ah boards, which limits the amount of time they can devote to each. This could lead to less thorough review of each product than if the workload were spread across a larger number of scholars. Hopefully the ISRA proposal will move beyond the planning stage and on to become an organization that carries as much weight and recognition as AAOIFI or the IFSB.

There is an article in The Banker about Islamic indices, which have only been around since 1999 when Dow Jones launched their Islamic Finance World index. The article is interesting and notable because it mentions the absence of ETFs (not total absence; there are a few, but not many and most are very small). The Islamic funds industry has grown significantly in the past 10 years, so it seems that the ETF sector would be a natural area for growth as an alternative to actively-managed mutual funds.

The small sukuk ($10 million) from the International Innovative Technologies, which is the first UK-based company to issue a sukuk, is being heralded as the first of many from the UK and Europe. However, I think it is unlikely that this small sukuk, which was subscribed by one entity, Millenium Private Equity, will have that effect. The sukuk--a sukuk al-musharaka--came obout when an investor in IIT suggested Islamic finance as a way to finance the business. This (along its small size and status as a 'first') reminds me of the East Cameron sukuk, which was issued by the US-based wildcatter oil & gas firm with properties offshore Louisiana. While I am not predicting that the sukuk will end up the same way the East Cameron sukuk did (with the bankruptcy of the issuer), I do think that the idea that a small sukuk from a relatively unknown issuer can spark further issuance is overstated. It will take a larger, more well-known issuer to demonstrate that sukuk are the "real thing" to other potential issuers in the UK and Europe. That may happen in the near-term, but it will not make IIT the one that broke the market open. However, it is a start--albeit a small one--that will generate plenty of media attention that could make a sukuk from a better known issuer less surprising. It will be interesting to see what happens from here.

The secretary-general of AAOIFI, Dr. Mohamad Nedal Alchaar, has an opinion article in The National about the potential for France to develop its Islamic finance industry.

Other News

• The current issue of Opalesque's Islamic Finance Intelligence has several interesting articles. One by Shahzad Siddiqui and Toby Birch discusses gold bullion and Islamic private equity. Mohammed Khnifer discusses what happens when sukuk default.  Nikan Firoozye discusses the structure of the consecutive or rolled murabaha. The full issue can be downloaded by clicking through to any of the articles.
  
• South Korea may revive the bill to put sukuk on par with conventional bonds, after it was scuttled earlier this year.
  
• According to an IMF report, the driving force behind the growth in the industry after 2000 was the rise in oil prices, not 9/11. I hope to post something on the report when I have a chance to read it.
  
• The Thai Securities & Exchange Commission will issue rules for sukuk in October, according to the body's Secretary-General.
  
• Kuwait Finance House-Turkey may issue $100 million more in five-year sukuk, after its first issue in August, which was also the first sukuk issued in Turkey. The government of Turkey may consider issuing sukuk "in the future" according to the Finance Minister Mehmet Simsek.
  
• The Central Bank of Bahrain's Sukuk al-Salam was oversubscribed with BD73.5 million ($195 million) in subscriptions for the BD12 million ($31.5 million) issue. The return on the three month securities will be 0.69%.
  
• DIFC Investments will make a scheduled $2.88 million periodic payment on its $1.25 billion sukuk on time, according to a statement posted on NASDAQ Dubai.
  
• A paper in South Africa discusses the basics of Islamic banking.
  
• Malaysia issued four takaful licenses, primarily to foreign companies as it liberalizes its financial sector in a bid to attract more Islamic finance.
  
• Islamic finance could exceed $2 trillion in the next three-to-five years.
  

Malaysia sovereign sukuk, Dubai World debt settlement, WIEF

Malaysia sovereign sukuk
The basics of the coming Malaysian sovereign sukuk were officially released (although the total size has not been except that it will probably be larger than the $600 million issue in 2002). The proposed sukuk received an initial rating from S&P is A-. The dollar-denominated global sukuk, issued by the government's SPV 1Malaysia Sukuk Global Bhd, will be a 5-year ijara sukuk will involve the sale and leaseback of 12 hospitals according to the CEO of HSBC Amanah, Mukhtar Hussain. The government is meeting with prospective investors and will do so until May 27th and order-taking will begin a few days later.

One of the reasons for the issue, and the primary importance of the issue for Islamic finance, is that there are few sukuk issued (only one other by Malaysia) and they provide an important benchmark for corporate issuers. The five-year maturity is short, but it is in line with the most common maturity of sukuk, so near term it will be relevant to create a pricing benchmark for short-term sukuk. However, it does not establish a sovereign benchmark for longer-term sukuk, which would have been noteworthy. However, with the European debt crisis in full swing with the yield premium for new issues (e.g. Spain today) rising, the fact that the sukuk is likely to be issued blunts some criticism of its 5-year tenor. If Malaysia wanted to continue to help the global Islamic finance industry, it should follow this 5-year sukuk with a 10- or 15-year sukuk to establish a pricing benchmark.

One concern remaining is that the sukuk will be issued in a time of rising yields among sovereign borrowers as a result of the European debt crisis and this could establish a benchmark yield higher than what might have been received six months ago or six months from now. Therefore, the Malaysian government should make an effort to ensure that this sukuk is tradable in a liquid market (Malaysian sukuk secondary markets are less liquid than conventional bond markets but more liquid than most sukuk secondary markets). That would allow secondary market activity to price the changes in a 5-year sukuk sovereign yield that would provide more transparency for pricing future corporate issuers.

Dubai World agreement
The Dubai World debt agreement surrounding $24 billion in debt has been reached in principle. The FT Alphaville blog posts the entire press release with the table describing the terms. The repayment will total $14.4 billion ($0.60 on the dollar), split into two tranches. Each tranche will be allocated pro rata to the debt claims. Tranche A will have a five-year maturity at 1% interest. Tranche B will have three options, the first two will be available for holders of USD denominated debt, while the third will be available for holders of AED denominated debt. Tranche B will have a longer maturity with shortfall guarantee for 1/2 of the $10 billion size. The interest rate will again be 1% except for AED-denominated debts when the 1% will have EIBOR-LIBOR up to 1% added in.

While it is not clear whether the debt covered will include Shari'ah-compliant debt, it does puts some firm numbers on the outcome for these lenders compared with holders of the 2010 and 2011 Nakheel sukuk, who have or will receive full repayment of all principal plus profit. Last weekend, I addressed my concern that this differential treatment could negatively affect the ability and willingness of conventional issuers to also issue sukuk and the numbers, I think, make this concern even more relevant.

World Islamic Economic Forum

• Speaking at the WIEF, Prince Andrew said that the UK, and London in particular, will continue to build on its status as the largest Western hub for Islamic finance.
  
• The new UK government may reconsider a sukuk if the value-for-money can be demonstrated; that is, will the additional source of demand and encouragement for the Islamic finance work within London offset the additional structuring costs. Assuming tax laws are changed, the UK's first corporate sukuk could be issued this year, according to Humphrey Percey, the CEO of BLME.
  
• The Malaysian central bank, Bank Negara, has established programs to educate other central banks on regulating Islamic finance.
  
• The executive vice chairman of Ithmaar Bank, Khaled Abdulla-Janahi, said that there is need for greater education among Muslims about Islamic finance and says that the history of Islamic finance in the future may regard Gordon Brown, for his work as finance minister of the UK, and Christine Lagarde, the current French finance minister, as the two biggest drivers of growth in the Islamic finance industry.
  
• Five memoranda of agreement worth $125.3 million were signed at the WIEF.
  
• The CEO of Maybank MEACP Pte Ltd, Mumtaz Khan, suggests a G3+3 group to work with the G20 to develop Islamic finance. The parties involved would be the three G20 members with Muslim majorities, Saudi Arabia, Indonesia and Turkey, in addition to Malaysia, the World Islamic Economic Forum and the Islamic Development Bank.
  

Other News

• Rushdi Siddiqui continues his excellent line of articles in Gulf News with one on the need for a global Islamic sovereign wealth fund.
  
• The head of the DFSA warns that forcing Islamic financial institutions to operate under the same regulatory rules as conventional financial institutions could hurt its growth prospects.
  
• The governor of the Reserve Bank of India says that Islamic banking cannot be licenses under current regulation, but it is still exploring whether Shari'ah-compliant non-banking financial institutions are possible.
  
• Qatar Islamic Bank is planning to sell as much as $750 million in its first sukuk issuance. The sales of sukuk so far have risen year on year at the fastest rate since 2007 (albeit from a low base) as yields have fallen more than emerging market debt.
  
• Lipper Research describes the performance of Islamic equity funds by investment area and geographical concentration. 45% of all funds are in Southeast Asia while 59% of total assets in Islamic funds are in the GCC.
  
• Dubai Islamic Bank has launched a new unsecured consumer lending product based on a salam contract with the commodity used being sugar. As I understand it, the bank would provide financing and the customer would be obligated to deliver a given amount of sugar (incorporating a markup) at the maturity. The transaction involves a sugar wholesaler that collects partial payments from the customer and at maturity will deliver the sugar to DIB.
  
• The Commercial Real Estate Sukuk (Kuwait) for $100 million was paid on its maturity date.
  
• Ireland hopes to attract Islamic financial institutions and Islamic funds to the International Services Centre in the country.
  
• The president of CIMA writes in an opinion article in The Australian newspaper that Islamic finance has significant growth potential but is still hampered by a lack of people skilled in understanding the requirements for Islamic financial products.
  

Islamic finance was not unscathed by the global financial crisis

I am getting a bit irritated with some of the media coverage of the Islamic finance industry. It is not that the articles are repeating any of the easily disproved negative comments about Islamic finance; in contrast, I am disappointed by the reporting because it is too positive. An article by AFP provides a few of the specific claims that are either not true or exaggerations (although this article is not unique, there are many articles repeating the same claims). The subtitle of the article claims that "Islamic finance has emerged unscathed from the global crisis". This is not true. Profitability at Islamic banks are down because of the recession and there have been enough distressed Islamic financial institutions (The Investment Dar, International Investment Group, Gulf Finance House) to claim that the industry is 'unscathed'. The first sentence of the article qualifies 'unscathed' by adding the word 'relatively' to the statement in the subtitle and the remainder of the article is more nuanced (it focuses on the need for tighter regulations). The financial crisis disproved, hopefully for ever, the notion that Islamic finance can be 'immune' from crisis. The article notes that:

"However, the global economic turmoil, which felled some mainstream banking institutions, has highlighted the need for the industry to shore up areas where it may be on shaky ground.

These areas of shaky ground for the most part reflect areas where there is not sufficient products available to Islamic financial institutions to survive downturn in asset values and (for banks) liquidity crunches.

Remember, the final nail in the coffin for many of the conventional investment banks was not necessarily the asset price deterioration of the toxic mortgage-backed products they held. That contributed (just as any asset price deterioration would), but the institutions were felled by a shortfall of liquidity after their funding dried up. During September and October 2008, the investment banks fell one after another and the primary thing that allowed JP Morgan and Goldman Sachs to avoid similar fates was their conversion to commercial banks, which allowed them access to the Federal Reserve as the lender of last resort. Had the Fed not been willing to step in, those banks might well have met similar fates as Bear Stearns and Lehman Brothers. The situation for Islamic banks will be similarly precarious in any future financial crisis: there are not lender of last resort facilities available that are Shari'ah-compliant and without this, the maturity mismatch between demand deposits and short-term sukuk (liabilities) and longer-term assets could turn a liquidity crisis into a solvency crisis as the banks would be forced into a firesale of assets.

The continuous reporting that Islamic finance emerged unscathed by the recent crisis lends some authority to belief that it will be impervious to future crisis and breeds dangerous complacency within the industry. It also somewhat minimizes the significant challenges that Islamic finance faces in its maturation process. If it withstood the most severe financial crisis since the Great Depression, the thinking might go, it will not have much to worry about until the next big global crisis which could be decades in the future. It would be far easier to worry about potential problems now when financial stability is in the forefront of the news than to wait and try to either develop it when the Islamic financial markets are booming, much less when the crisis does in fact hit.

Other News

• The central bank in Malaysia is drafting regulations covering ibrar, the rebate used in some contracts. In general, ibrar is used where a customer defaults on a murabaha or BBA transaction because under the cost-plus sale, the full amount is due in a default including the profit for the entire amount. In contrast, in a conventional mortgage, the balance due is the unpaid principal plus interest. Ibrar is used to make the economic outcome in an Islamic finance transaction equivalent, but is discretionary for the Islamic bank, which has created uncertainty and legal disputes. The central bank is expected to put the policy in front of its Shair'ah board by the end of May.
  
• France is seen as moving 'too slow' on Islamic finance.
  
• An article by Morrison & Foerster LLP describes (with transaction diagrams) the structure of principal-protected structured products.
  
• The latest sukuk al-ijara from the Central Bank of Bahrain was oversubscribed by 310%.
  
• The government of Indonesia is planning another global sukuk for October 2010. The government is also considering Islamic T-bills and retail sukuk to diversify funding sources.
  
• The Jordanian government is interested in issuing sukuk.
  
• South Korea's legal changes for companies to issue sukuk have been held up in the National Assembly. The chart for sukuk issuance looks inaccurate. It projects $30 billion in issuance in 2010 exceeding the 2007 total. IFIS reported that total issuance in 2007 was $47 billion.
  
• Pakistani Islamic banks are considering into Afghanistan.
  

Reuters Islamic finance summit

I don't have as much time to comment as much on the articles today, so I'll just give a few general comments. Any forum or conference is unlikely to get a full, detailed overview of any of the topics covered, but the Reuters summit, in my opinion, has done a good job at describing some of the issues raised by participants in the articles released about the summit.

The four themes that I took from an article about the Reuters summit before it happened were all covered with differing degree of depth (from my reading of the articles about the summit; I wasn't there). The maturity mismatch was not covered in particular depth, although it was mentioned within the context of the second theme of a reliance on transitory sources of profits like private equity and investment banking. It is becoming more evident that at least some players in the industry are willing to say that there has been too much focus on big real estate projects, private equity and investment banking at the expense of plain vanilla banking. With the higher returns from the transitory sources of profits, there will always be a bias towards those areas in boom times because there is more money to be made there and periods of recession and financial crises will see some of these go away. This is unlikely to change, although one would hope that the most recent crisis will instill some more risk management in the riskier areas of Islamic finance to prevent the next crisis from being even bigger for Islamic finance than this one was.

The issue of size of Islamic financial institutions was barely touched with the exception of a timetable for the launch of a mega Islamic bank. Much more attention was paid to the regulatory challenges facing Islamic finance and there are still major differences among different institutions and people within the industry, which is not out of line with the conventional financial industry's views on regulation. There are some special areas where Islamic finance regulation is different from conventional regulation, but in both segments of financial services, regulation is one of the slower moving areas that cannot be resolved by a 3 or 4 day conference covering so many different topics. In this area, there will be much more work to come and hopefully the need for sensible regulatory standardization (across countries and between Islamic and conventional banks) should be more in the forefront of people's minds.

Reuters Islamic finance summit

• The Islamic mega-bank is expected to launch within six months to a year according to Sheikh Saleh Kamel, one of the founders of the bank. The launch was delayed by the financial crisis, but is expected to have capital of $3 billion to $4 billion when it is launched.
  
• The head of Islamic finance at Ernst & Young, Sameer Abdi, says that Islamic finance should refocus its efforts on building a retail base, which provides a more stable base than wholesale funding and investment banking and could allow Islamic banks to compete with global financial institutions with Islamic windows. One comment that may explain the lack of push for retail business is particularly accurate: "What you make in one transaction [in investment banking] may take you three years in a retail book, but ... retail is sustainable". Mr. Abdi also spoke about the need for Islamic finance to move away from real estate.
  
• Not surprisingly, there are differences in opinion between regulators, Shari'ah scholars and practitioners in Islamic finance about the best way to regulate the industry and ensure there is adequate transparency to protect investors in Islamic financial products. One of the interesting things, which I have raised before, but which has not received much attention in articles about Islamic finance is that corporate restructuring involving Islamic finance need to be reviewed for Shari'ah-compliance. This point was raised by Muneer Khan, a partner at Simmons & Simmons. Looking forrward, there will be much more discussion of these topics at the 7th Annual IFSB Summit, which will be held in May in Bahrain.
  
• France or the UK should move forward on bringing corporate sukuk to market to retain their leadership role in Western Islamic finance, according to several participants in the summit. Several participants expressed skepticism that any European sovereign sukuk will be issued in 2010, although expressing optimism for corporate sukuk from European companies.
  
• John Sandwick says that Swiss banks should focus on providing Islamic wealth management services. He criticized the focus of the industry on private equity at the expense of other areas that would help asset managers be able to invest in more prudent asset allocations.
  
• Indonesian banks should focus on providing Shari'ah-compliant financing according to Achmad Riawan Amin, chairman of an association of Islamic banks in Indonesia.
  
• An executive at Citi Islamic Investment Bank, Samad Sirohey, said that sukuk funds should develop not just to purchase distressed assets, but to draw other players into the Islamic securities market. This would, in my opinion, provide greater liquidity that could spur supply of new sukuk because issuers would have to pay lower liquidity premia to investors who now are limited in their ability to sell sukuk in the secondary markets and find other sukuk to replace it with.
  
• Dubai World is planning to present its restructuring plan to creditors in march, although the details will not necessarily be released publicly. According to a spokesperson for the Dubai Government, "That's a confidential matter between the company and its lenders". While that may be strictly the case, the uncertainty about the restructuring of the debts, including several Shari'ah-complaint debts, is very important to the regional credit markets and it would be beneficial to investor perception of the creditworthiness of the Dubai government for these details to be made public. Given their importance to sentiment, they may be leaked anyway. A number of participants at the Reuters summit reiterated the valid point that the problems at some of the Dubai government-related entities like Nakheel should not be taken and generalized across the Islamic finance industry. I agree.
  
• Global sukuk issuance last year (February 2009 to January 2010) was $19 billion, of which $5.6 billion originated from Saudi Arabia and $4 billion was from the UAE.
  
• An article describes the countries where Islamic finance could expand and the factors that could hamper this growth.
  
• A Malaysian takaful firm Etiqa Takaful has seen strong growth recently as many Muslims and some non-Muslims in the country choose takaful over conventional insurance. However, the growth could be restrained by a shortage of long-term Islamic instruments for them to invest in and a shortage of retakaful providers. An Indonesian takaful provider said that it is considering investing directly in domestic equities which rose 87% in 2009 in Indonesia (measured by the Jakarta composite index) for investors with high risk profiles. It will be seen whether this investment in the stock markets will be beneficial for the investors after the significant rise last year.
  

Reuters Islamic finance summit

Reuters Islamic Finance Summit

There are a number of articles about sukuk from the Reuters Islamic finance summit. This is not terribly surprising because of the place of sukuk as the 'face' of Islamic finance, especially among Western investors. There are a few issues raised in these articles.

One article describes how the development of sukuk by French issuers, in particular, an $1.37 billion (1 billion euro) sukuk from an unnamed corporate issuer, has been delayed by the uncertainty about legal rules about sukuk in France. The French parliament passed a law recently clarifying the legal and regulatory treatment of sukuk, but it was thrown out by the courts on procedural grounds. France has said it wants to be a European hub for Islamic finance, but in the absence of a resolution of these issues, it is unlikely that it will be able to catch the U.K. quickly where regulatory and tax changes have already been made to put Islamic finance on a level playing field.

There are a few somewhat conflicting articles about Islamic finance in the Gulf that, despite the seeming contradictions, describe the situation facing Gulf issuers in the wake of Dubai World's request for a debt standstill (which investors were reminded of by recent news as well as other sovereign debt issues in Greece). The capital markets for new sukuk are relatively frozen right now, especially in the UAE and there have been few non-sovereign issues in the past year. However, there is significant latent demand by money market funds for high-grade corporate and sovereign issues.

An advisor to Morgan Stanley, Yavar Moini, does provide some background for what is needed to unlock this latent demand and bring new sukuk to market: domestic capital market development. However, in order for this development to occur, there needs to be greater legal certainty about how sukuk behave in different situations and for different structures. The advantage that many sovereign issuers have over corporate issuers in this environment is that many Gulf states (Dubai excepted) have signficant oil reserves that finance the government budgets and with oil prices having recovered, the revenue to repay debts on time is less uncertain than with corporate issuers whose ability to pay is less certain and more dependent on local economic conditions. This is, of course, accentuated for issuers looking to issue sukuk backed by real estate projects like Dar Al Arkan, which issued a smaller than expected high-yield sukuk (10.75% coupon) to raise $450 million compared to expectations of between $500 million and $750 million.

Worldwide, Mohd Daud Bakar, a Shari'ah scholar, expects that the leading country for new issues (ex-Malaysia) will be Saudi Arabia, based on its need for infrastructure projects and economic growth fueled by the rebound in oil prices. He expects 10 to 15 sukuk issues from Saudi issuers during the year. Bakar is also working for the South Korean Korea Investment & Security Company, which is structuring a sukuk for issue after the country passes a proposed bill to create a tax exemption for sukuk.

Apart from these new issues, there could be additional sukuk activity in the secondary markets with several Gulf-based banks launching sukuk funds. There have been a few sukuk funds launched since the onset of the financial crisis beginning with one launched by Algebra Capital in August of 2008. These funds will probably try to tap the desire for investors to invest in sukuk while taking advantage of depressed prices in some sukuk in the secondary markets. The growth in secondary markets will be aided by these funds who will provide a bid for distressed and other sales of sukuk holdings. The test for the markets will be whether these funds will then warehouse these sukuk until maturity or whether secondary markets will become liquid enough for them to sell holdings before maturity. If these funds become active players in the sukuk secondary markets, they could lower pricing for new sukuk by increasing the liquidity of sukuk (which would lower the liquidity premium attached to new sukuk issues).

An article with quotes from a lawyer in Islamic finance, Farmida Bi, and Toby Birch, the founder of Birch Assets Ltd., provides some interesting comments on the difference between sukuk and conventional bonds. Ms. Bi is quoted: "Investors have realized after Dubai World that what they are buying is not typically something that (gives) recourse to an asset". Mr. Birch described that "If bonds were properly Islamic there would be no guaranteed rate of return: the idea of a sukuk is you share the income flow because you are a co-owner of the real assets". This is, I think, the correct assessment of the situation of the sukuk market, but I am concerned that the selling of Islamic finance as asset-backed, while selling asset-based sukuk may reflect a flaw in how the industry markets itself and in particular, the difference between substance and rhetoric. If Islamic finance promotes itself as different because it is asset-backed, it should offer product that are secured by assets. In other cases, it should use investment structures that share risk between issuer and investors (like the Saudi Hollandi Bank sukuk). What is creating confusion is where structured of a sukuk based on an asset leaves investors without recourse to that asset. Islamic finance is not always asset-backed, but in the structures where an asset is involved, investors should have recourse to that asset.

In a related article, Mohd Daud Bakar, describes that the industry was developed to allow Muslims to buy houses and cars and has not yet moved beyond this area to involvement in the real economy. He is right to some degree; the Islamic finance industry is largely contained to offering products to others within the financial services industry with the exception of retail institutions which....offer financing for houses and cars for consumers. Another article describes the prospects for private equity in Islamic finance and real estate is now again in vogue in Islamic finance. The debate on the connection between the Islamic finance industry and the real economy is somewhat constant in the background, but the questioning of this connection (and the same discussion in conventional finance) somewhat loses the point that finance is by its nature somewhat disconnected from the real economy except that it is engaged in providing financing for everything else. If there were a concern about financial industry people becoming involved directly in the economy to directly benefit others, I think the best outlet would be Islamic microfinance. It is still relatively underdeveloped and could use the (volunteer) efforts of the top minds in Islamic finance.

Despite the growth touted for Indonesia in an article I linked to yesterday, there are a number of hurdles for Islamic finance in Indonesia, despite its large Muslim population. The primary obstacle is tax and regulatory difficulties for Islamic financial products (and I have seen other articles which cited endemic corruption as another obstacle. However, if the information in this article is correct, there may be a simple lack of demand from consumers, either through lack of understanding of Islamic finance or a belief that Islamic finance is not authentic or necessary in its current for, which replicates (or 'camouflaflaged' as it was described by the cheif economist at Bank Danamon, Anton Gunawan) conventional finance.

A company, Halal Industries, plans to establish a halal park in Wales.

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While many Islamic investment banks are selling assets, Unicorn Investment Bank is considering raising between $250 million and $500 million in equity for acquisitions and distressed asset sales.