More IDB sukuk will complement IILM short-term sukuk for liquidity management and compliance with Basel III rules

Islamic banks are continually in need of new avenues for liquidity management, and will also be required to adhere to Basel III’s stringent standards on the liquid assets they must hold.  The IILM is a step in providing an asset that can meet these requirements.  However, it is unlikely to be able to do so in sufficient size at least for the near-term.  Providing more supply of IDB sukuk—more likely now that the institution is expanding its authorized capital—can help provide a supplemental source of liquidity management products (via Islamic repo) while also providing an asset likely to be recognized as a HQLA for the purpose of Basel III.

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New Sukuk Insurance program could spur development in ICIEC member countries

Analysis of the ICIEC sukuk insurance plan, discussed in the IFG Weekly Briefing (subscribe here), has focused primarily on the benefit for issuers in accessing capital markets with new sukuk issuance, but there may be a greater benefit from modifying the incentives facing lower-rated sovereign issuers that can increase both the quantity of foreign investment they receive, as well as promoting fewer instances of default by mitigating a moral hazard problem facing low-rated sovereigns where insurance is not available.  Combined with more project-based sukuk like is proposed in Egypt’s sukuk law, could provide a way for sukuk to be used to promote development more effectively than conventional debt has in the past.

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ICD head gives interview to Arab News

Arab News had an interview with the CEO of the Islamic Corporation for the Development of the Private Sector, Khaled Al-Aboodi.  The ICD is the private sector arm of the Islamic Development Bank (similar to the relationship between the International Finance Corporation and the World Bank).  Here are a few sections that I thought were interesting: 

"While lack of access to finance by the private sector has opened new opportunities for ICD to support private sector development in a number of member-countries, a combination of factors such as social unrest in some member-countries, increased cost of funding and lingering effects of financial crisis has made it very difficult for ICD to operate as planned."

 ....

"ICD managed to approve 18 new projects and capital incease for three existing equity projects totaling 372.26 million in 1432H/2011. This was 58 percent higher than the previous year (2010), which reflects ICD's continuing robust support to private sector development in the member-countries. Equity investments accounted for the bulk of ICD's 1432H/2011 approvals, representing 38 percent of the total, followed by the line of finance (35 percent), long-term financing (22 percent), and short-term murabaha (5 percent). In terms of sectoral distribution, the three main beneficiary sectors were finance, industry and real estate, jointly attracting 85 percent of the total approvals. The financial sector accounted for the biggest allocation, totaling 201.26 million, or 54 percent of the 1432H/2011 approvals. In terms of regional composition, 31 percent of ICD's approved projects during 1432H were allocated to the Middle East North Africa (MENA) region, followed by South Asia (23 percent), Sub-Saharan Africa (16 percent), East Asia and Pacific (14 percent), and Europe and Central Asia (10 percent). In terms of recipient countries, ICD approvals were extended to 13-member countries, including three new countries - Algeria, Gabon and Turkmenistan. "

...

"In the past year, ICD successfully closed the fund-raising for Tunisia and Saudi Arabia SME funds, and also for the Central Asia Renewable Energy Fund. Furthermore, ICD has approved establishment of a Food & Agriculture Fund and Fixed Income Fund, and successfully secured some mandates in Tunisia and Cameroon for capacity building and creation of Islamic windows within conventional banks."

...

"To fulfill our mandate, we support the private sector through the following ways: First, we assist them alone or in collaboration with other financing institutions the establishment and expansion of enterprises. Second, we can make direct investment, through Islamic instruments, in the subscription and purchase of their share capital. We also promote with participation of other sources of financing, including the structuring of syndication deals, underwriting of securities, joint ventures and other forms of association. Moreover, we can get involved in issuing mudharba, leasing and istisna'a bonds and other financial instruments. At the top of these, private sector firms may benefit from our advisory services and technical assistance programs."

 ...

"ICD's accumulated approvals since it began operation reached 2.17 billion by the end of 1432H/2011, which has been allocated to 218 projects. The corporation approved about 60 percent of its investments through two main modes of finance - equity and murabaha. The cumulative gross approvals of ICD by mode of finance include 766.07 million of equity, 535.77 million of murabaha, 526.5 million of ijara, 223.13 million of installment sale, and 119.14 million of istisna'a. "

"The financial sector accounted for the largest share, amounting to 783.7 million, or 36 percent of the accumulated gross approvals since inception. The industrial sector had the second largest share with a total approved amount of 596.1 million, representing 27 percent of the gross approvals. This was followed by real estate, with a total approval of 276.2 million (13 percent)."

One thing I think is notable is that the ICD is becoming involved with both SME financing and renewable energy financing, which I have mentioned as important areas for Islamic finance several times.  One question that arose for me when comparing the inception-to-date statistics with the 2011 data was what the breakdown in terms of structure used by the ICD.  The inception-to-date numbers break down by equity, murabaha, ijara, installment sale and istisna'a, but the 2011 data show equity, line of finance, long-term finance, short-term murabaha. The data are not comparable without making some perhaps heroic assumptions about what structure is used for "line of finance" and "long-term finance" (which may be murabaha and ijara, respectively, but could combine a number of different structures in each category). 

Click through to the full article to read the rest of the interview. 

Accreditation, rules on Shari'ah scholar conflict of interest begins to gain traction

The move to formalize the requirements for Shari'ah scholars in terms of training (through an accreditation program) and managing potential conflicts of interest is moving forward as the International Shari'ah Research Academy, based in Malaysia, was working with its counterparts in the Middle East on a set of guidelines.  These counterparts include the Islamic Research & Training Institute (part of the Islamic Development Bank group).

The move follows a Malaysian initiative announced back in August to provide an accreditation program for Shari'ah scholars in that country, which was led by Aznan Hasan, the president of the Association of Shari'ah Advisors in Islamic Finance (ASAS), who is also a prominent Shari'ah scholar. 

The regulation and accreditation of Shari'ah scholars is one of the more important areas of standardization in Islamic finance.  If the participation of a Shari'ah scholar on multiple boards is limited, it could result in a more prominent role for junior scholars who sit on boards, but are only slowly gaining name recognition on their own, rather than by virtue of the senior scholars they have trained with. 

Increasing the number of scholars with name recognition has the potential to lower the Shari'ah fees for certifying deals because their fees are likely to be lower than for senior scholars.  However, I think there is a potential for fees on the senior scholars to increase if they are limited to serving on a more limited number of boards, and are likely to see their fees bid up, potentially to the exclusion of smaller Islamic financial institutions. 

However, this might not be a significant problem.  If the senior scholars with the greatest international name recognition shift their focus towards global financial institutions, it will open up more board seats for junior scholars on smaller, more locally-focused Islamic financial institution that will tend to rely more on their Shari'ah board's domestic name recognition, to demonstrate their Shari'ah-compliance to the local market.

Other aspects of the discussions are around Shari'ah board potential conflicts of interest, like owning stock in the institutions on whose boards they sit, and issues around limiting scholars from advising multiple Islamic financial institutions in the same sector or geography who compete against one another.  In Malaysia, for example, Bloomberg describes how Bank Negara regulations do not allow Shari'ah scholars to "sit on more than one board involved in the same business". 

This is likely to be only the first step down a long road of providing more formal oversight of Shari'ah scholars to ensure that the Islamic finance industry has the Shari'ah board capacity that can scale with it.  In addition, more stringent rules on accreditation and managing potential conflicts of interest can avoid problems down the road by mitigating or eliminating these conflicts and potential conflicts of interest. 

Malaysian banks, ITFC working to open up more Islamic trade finance

Three local banks in Malaysia are working with the International Islamic Trade Finance Corporation, part of the Islamic Development Bank Group, to provide trade financing for Malaysian companies working in emerging markets, including in the OIC.  The realm of trade finance has been developing under the radar within the Islamic finance industry, but it should get more attention.

The idea of providing financing and insurance for intra-OIC country trade (and for trade with non-OIC emerging markets) is an excellent place for Islamic finance to operate since many of the contracts used in Islamic finance are based on trading contracts (the most prevalent being murabaha).

There are also many other reasons to develop trade within emerging markets in general and specifically within the OIC whose member countries represent diverse geographies spanning from Indonesia and Malaysia to Western Africa.  Within the OIC, the countries with the largest total exports includes Malaysia (third behind Saudi Arabia and the UAE, whose economies are based on oil and gas exports, and behind Turkey, which is geographically near to the large import market of the European Union).

Encouraging trade between these countries financed by Islamic finance should develop connections that will help Islamic finance grow in the trade partners, but more importantly should lead to more pressure to open up bilateral trade flows so that countries with smaller economies can export their own products into other OIC countries in a way that helps their economy grow.  Islamic finance should work to be at the forefront of encouraging these trade linkages for the countries' mutual benefit.

Islamic Development Bank sukuk shows the buyers for future IILM sukuk

The Malaysian International Islamic Financial Centre (MIFC) June newsletter had an interesting article about the latest Islamic Development Bank sukuk, which had a 5-year tenor and a 1.357% yield.  The sukuk was issued for $800 million, with $900 million in orders.  Particularly interesting was the breakdown of buyers: 55% central banks and regulatory authorities, 35% banks, 6% pension funds and insurance/takaful companies and 4% fund managers. 

The breakdown of buyers with most of the issue subscribed by central banks and banks--making up 90% of the total subscriptions--should be seen as supportive for future sukuk issuance by the International Islamic Liquidity Management Corporation (IILM), which is now expected to issue its first $1 billion in sukuk later this year (a target which has been pushed back several times as the IILM waits for a credit rating). 

The same investors who bought the IDB sukuk (central banks and Islamic banks) are likely to be the same ones who will buy IILM sukuk.  The IDB sukuk, based on its high credit rating, is likely to be a commonly used sukuk in Islamic repo, which is becoming more standardized around a collateralized murabaha structure. 

That they are demanding such a low yield on IDB sukuk suggests significant demand for highly-rated sukuk (the 1.357% yield compares to the 0.50% yield on similar maturity German Bunds and 0.67% yield on US Treasuries).  The low yield is partly due to the preferred creditor status it has with preferred creditor status (financing projects in OIC member countries), as well as its ability to call additional capital from non-borrowing member countries ).  Now the next step, presumably, for the IILM to begin issuing sukuk is getting a rating. 

Financing food and agriculture through Islamic finance

The Islamic Development Bank's (IDB) Islamic Corporation for the Development of the Private Sector (ICD) announced that it is partnering with fund manger Robeco to launch a $600 million agriculture private equity fund, $350 million of which will be raised by the end of the year.  The fund's investment focus is to "invest in projects that promote steady food supply [by making] private equity investments in food and agriculture projects as well as companies across various target countries in a Shariah-compliant way".  The CEO of the ICD, Khalid Al-Aboodi, said that the fund would "address the inefficiencies and wastage facing the food and agricultural sector throughout our member countries".  

The fund idea sounds to me like a great way to encourage Islamic financial institutions to finance projects which benefit a much larger number of people than building luxury resorts.  Food security is one of the most important issues facing many countries with high levels of poverty, so dealing with the issue using Islamic finance would be a way to demonstrate that Islamic finance does "get it" that financing activities that benefit people at all income levels is part of its ethical mandate. 

It is important, however, to clearly define the areas where the fund will focus, and identify investments at weak points in the food growing/distribution network so that it will accrue benefits to the investors as well as the people living in countries where financing is directed.  In particular, the fund should put a focus on not funding 'white elephant' projects that create a profitable cash flow for investors (e.g. from contracts with local governments to pay for services, but which are unable to provide a benefit to the population because other complementary infrastructure is absent). 

Addressing 'food and agriculture' sounds like a simple, narrow area, but it is easy to define investments in other areas that can be instrumental in reducing wastage, for example, in the food distribution process that could lead to significant 'mission creep' for the fund which would dilute its effectiveness.  For example, ensuring a reliable supply of electricity in rural areas where food is grown allows for refrigeration and freezing of food, which allows it to be distributed more widely, opening up markets for farmers.  From another direction, without a reliable supply of electricity, efforts to increase agricultural productivity in rural areas will accomplish little if most of the expanded productivity is lost to waste since it cannot be refrigerated or frozen and transported to the markets where it will be consumed.  

It is good to see the IDB's ICD put a focus on directing investors towards the Shari'ah-compliant financing of an area that can be hugely beneficial for the poor, while also having potential to deliver return to investors if it is done correctly. 

Islamic Development Bank sukuk size up-sized from expectations

The Islamic Development Bank is looking to tap the capital markets for $750 million to $1 billion when it issues its next sukuk later this year. The Bank, which holds a AAA rating from Standard & Poor's funds, should find it relatively easy to issue sukuk, given the demand for high-grade investments, and a general shortage of sukuk worldwide. 

Last year, after nearly reaching the limit of its $3.5 billion sukuk program, the VP of the Islamic Development Bank Abdul Aziz Al-Hinai said it would be raised to at least $5 billion and possibly to as high as $8 billion. Zawya's Sukuk database indicates that the remaining $600 million in unissued sukuk are due to be issued this year, so if the sukuk is larger than this, the Bank would have to raise its sukuk program size.  The IDB uses the sukuk to finance projects in OIC countries.

The rise of istithmar sukuk

From my newsletter:

On June 20, 2011, the Malaysian central bank, Bank Negara, unveiled its newest liquidity management product, although few details were offered. In the first auction on the following day, Bank Negara sold RM500 million.($165 million) of the 1- to 3-year sukuk. The product itself is based on the istithmar structure, which combines other receivables from murabaha as well as ijara transactions. In general, under AAOIFI rules, the portfolio must have at least 33% ijara sukuk in order to be tradable, although in many cases, a more conservative interpretation is used where 51% of the portfolio must be ijara.

It is always interesting to see new Shari'ah-compliant liquidity management products come out with different structures (istithmar, commodity murabaha, salam and ijara are the ones I have run across). However, beyond the liquidity management space, the istithmar structure is becoming more widely used with institutions like the Islamic Development Bank. The International Finance Corporation used a similar wakala (agency structure) which securitized a portfolio of other contracts.

The thing that I find about this interest in istithmar sukuk is that it (and/or wakala) have potential to replace mudaraba and musharaka sukuk, which were used (and misused) extensively before the financial crisis and the AAOIFI ruling clarifying the rules around the buyback clauses used at maturity of those sukuk. There may be less concern about misusing structures (or misapplying their rules) in an istithmar sukuk (compared with a mudaraba or musharaka) because the former type is designed to be specifically an investment portfolio, where latter is commonly associated with venture financing (either providing financing from one party in mudaraba or through a joint-venture financing in a musharaka).

It will remain to be seen how much uptake their is in the istithmar sukuk structure but they are likely holding many ijara and murabaha assets on their balance sheets that could be securitized. It will likely depend on whether they have sufficient ijara assets to match up with murabaha to get to the threshold to make their sukuk tradable.

As I re-read the newsletter, it occurs to me that the entire area of securitization has largely passed Islamic finance by, although it would be a natural source of new sukuk were Islamic banks to pass on their risk and return to investors. However, the likely reasons for the absence of securitization (with a few exceptions) is the absence of standardization of the contracts for securitization, as well as the collapse in the securitization market that occurred just as the sukuk market was reminded of the rules around mudaraba and musharaka sukuk, which had been widely used (and as I mentioned, misused).

Now that the securitization market is coming back to life in the conventional market, it would be a good time to look towards pure securitization. It has the "ideal" structure (in the eyes of many) of making investors participate in both the risk and reward, would allow for the relatively quick creation of a lot of new sukuk in a market that has been coming back strongly from the credit crisis and the istithmar and wakala structures are much better vehicles, at least on a high-level view view, than mudaraba and musharaka, which were somewhat co-opted for creating sukuk based on a pool of financial assets.

There are, of course, some caveats. The first would be to find and address the reason why Islamic banks are reluctant to securitize their assets. Perhaps they believe that they will be more highly rewarded by holding the assets themselves, although that creates additional risk within the system as a whole. Or, perhaps, the infrastructure for creating cheap securitizations does not exist. Compared to the first possibility, this would be the best case. The International Islamic Financial Market (IIFM) is already reported to be working with Hawkamah on a standardized contract for ijara sukuk.

There is also the ever-present risk to investors that Islamic banks will securitize their bad assets and keep the ones they believe will perform the best. Given the ability of some Islamic banks (Gulf Finance House is the best known name) to use questionably ethical business models, the potential for Islamic banks to dump risky assets into securitized sukuk risks creating Subprime (v.Islamic). Perhaps the Western Islamic banks could take the lead in developing the infrastructure for Islamic securitizations.

Shari'ah standardization: Inter- or Intra-regional

About a week ago, I called the idea of a GCC-wide Shari'ah board "largely unnecessary". John Foster, the Managing Editor of The Islamic Globe, a newspaper covering Islamic finance (for which I cover the Americas), offered a slightly different commentary in reaction to Dr. Hamad Hassan, the well known Shari'ah scholar, who supported the initiative. John wrote:

"No one doubts that there is a need for improved regulation and the streamlining of cross-border issuance of, for example, Sukuk. However, what the industry needs more is global standardization, not just standardization across the GCC, which is already very homogenized in its regulatory and Shari'ah regimes. The initiative - which does deserve some applause - does however run the danger of becoming a noisy sideshow, when the real challenge lies in finding a global language for Islamic finance - not creating another regional hub 300 miles away from one of the global centers for the industry. With emerging markets in Africa and Central Asia coming to the Islamic finance party, the industry needs one coherent voice - one leader - not three disparate voices calling from different directions."

I am mostly in agreement with his sentiment. The idea of Shari'ah standardization--while tricky--is necessary in some areas of Islamic finance. In the retail world, it is mostly unnecessary because retail banks are focused on their customer's demand and the prevailing Shari'ah standards in the countries where their customers are located. However, even in retail banking, using an interpretation of Shari'ah-compliance that differs in significant ways from the prevailing interpretation elsewhere could hamper the ability of the bank to raise capital needed to sustain and grow its business, unless this comes exclusively from regions that use the same Shari'ah standards.

However, the problem becomes much more significant when cross-border products are developed. These cross-border products will be limited significantly if large regions--for example the GCC--operate with a different understanding of Shari'ah-compliance. This was in part the case in the oft-mentioned difference in Shari'ah standards between the GCC and Malaysia. Many contracts used widely in Malaysia are not permissible under the standards used in the GCC and so the Islamic finance industry in Malaysia developed with a much stronger domestic focus than the GCC. This may have been fine when Islamic finance began to grow during the 1980s and 1990s, but as Islamic finance becomes more globalized, Malaysia has begun to reduce the use of contracts which are problematic. The best known effort to bridge the gap was the sukuk ALIM, developed jointly by Cagamas, the national housing agency, and Al Rajhi Bank, the Saudi Islamic bank which is one of the largest Islamic banks in the world.

I think this is a good example of the types of Shari'ah convergence which is beneficial--not just GCC/Malaysia convergence, but globally. Institutions and their respective Shari'ah boards working together to develop products that are globally accepted. This--rather than an intra-GCC Shari'ah board--should be the focus. It can, as I suggested in my earlier post, be moved under the banner of a standards setting body like AAOIFI or the IFSB or within the Islamic Development Bank, but the inter-regional differences are likely to be greater than intra-regional differences. These differences will also pose the greatest risk to the continued globalization of Islamic finance.

Whether you believe Shari'ah standardization is a fruitful exercise or not, the focus should be on bringing in regions that are diverse, not focusing on the regions where Shari'ah standards are already mostly the same.

Considering the possible IILM liquidity tool structures

The International Islamic Liquidity Management Corporation (IILM) announced that it plans to issue the first short-term liquidity management instruments by the end of 2011. This is disappointing because the products are needed, the sooner the better. However, it is usually better to get it right than just to get it out there quickly. The size of the first issue will likely have a minimum size of $300 million, depending on demand, which is tiny compared to the volume of commodity murabaha contracts used for liquidity management which is estimated at $1.2 trillion.

No structure has been announced yet for the IILM, but it would likely not be commodity murabaha, which is not tradable. An article from Bernama describes (citing Mohd Razif Abudl Kadir, the deputy governor of Bank Negara Malaysia): "the main function of the IILM is to issue high quality papers as the shareholders are the central banks, which recognise it as eligible papers that can be traded among the players". Commodity murabaha (all murabaha) is not tradable on the secondary market outside of Malaysia except at par because it represents a debt receivable, subject to restrictions on trading in debt (bai al-dayn). He added that the maturity can be short-, medium- and long-term and gave the specific example that "it can be an avenue for the Malaysian government to tap global funds for the Mass Rail Transit mega-project". The Mass Rail Transit mega-project is a nearly 10 year project to put in 150km of rail in the Kuala Lumpur area by 2020 that is estimated to cost RM36.6 billion ($12.1 billion).

From this point, it is only speculation what the IILM product will look like, there are a few established and developing liquidity management tools (described well by Simmons & Simmons in a document from 2008 [PDF]; they are the basis of the descriptions I provide of the products):

Wakala/Mudaraba: In a wakala, two Islamic financial institutions (IFIs) enter into an agreement where one places funds with the other, who invests it on their behalf. The party placing funds (the lender) bears responsibility for losses. This could be a viable option for the IILM, but only on a short-term basis (unless a secondary market developed quickly). The IILM could provide an "indicative" rate of return, but is non-binding and is not a guarantee. However, the IILM would face a credibility problem if it did not meet the "indicative" rate of return. Central banks undoubtedly want to avoid losses, even if they are less concerned with generating a profit. Once the funds are placed with the IILM, they would have to be invested in something which generates a return that meets or exceeds the "indicative" return investors expect.

The advantage of this structure is that it could provide perpetual sukuk (or sukuk that were issued in equal amount as they matured), so long as the IILM is able to find things to invest in to generate a return sufficient to meet the "indicative" return (adjusted for changes in interest rates; the indicative return may even be calculated as a spread over a benchmark like LIBOR or KLIBOR). This would define the focus of the IILM. Instead of rotating assets from member banks to use as backing for, say, ijara sukuk, the IILM could focus on generating a return with the funds and on facilitating the secondary market.

However, this strength would also create a weakness. It would force the IILM to compete with the Islamic Development Bank and would also limit the size of the tradable market to the amount of funds the IILM could invest in quality projects to generate a return sufficient enough to make profit payments to the holders of the certificates. This is less of a hurdle than it appears at first. If the figure above were only for overnight liquidity management (i.e. the same amount was created and redeemed each day), it would represent just under $5 billion in certificates (i.e. $1.2 trillion divided by 250, the rough approximation of business days in a year). Assuming that the demand for these certificates increase 20% per year for the next 10 years and only 1/2 of the outstanding certificates trade in a given day, that would allow $60 billion in certificates in ten years to replace the equivalent of $7.5 trillion in commodity murabaha contracts. [Note: my assumptions for this calculation is by no means realistic, but used as an exercise to put the $1.2 trillion of commodity murabaha into context]

While the wakala/mudaraba structure seems like it is viable as a structure (there are many asset managers with more than $60 billion in assets), it would be difficult to create the liquid market for the certificates. Pricing would be relatively easy if the IILM is able to garner a credit rating at least as good as its member states (for comparison, the Islamic Development Bank has a AAA rating).

Wadiah: The two IFIs agree that one will place funds with the other and the one receiving the placement invests the funds like in the wakala. However, the placing institution does not have the right (although the receiving institution can voluntarily make profit-sharing payments) to any profits, but is entitled to a return of capital in the full amount, regardless of the performance of the investments made with the funds placed. This has the benefit that the IILM could use it as a way to get certificates into the market. However, it would be more likely to incur losses in adverse market environments. This is unlikely because although the IILM would be forced to pay out deposits in full (in contrast with the mudaraba/wakala), in both situations it would be expected to incur these costs to keep its credibility.

The benefit of the wadiah for the IFIs would be that even though they give up the legal right to a share of profits, they are entitled to their deposit back in full. Given the way markets and institutions operate, the IILM is likely to pay out profit-sharing payments in the good times and make good on deposits in bad times. However, this introduces a new risk to IILM member central banks. Under wadiah, they are obligated to make full payment of deposits on request even if the investments turn out to be unprofitable. It is definitely a "tail risk", but it is worth considering with the hindsight of the experience in the US with Fannie Mae and Freddie Mac, which operated under implicit government guarantees from the US government that were called upon following the US financial crisis. In wadiah, the guarantee would be explicit, while under mudaraba/wakala it would remain implicit.

Accrued Notes: An accrued note works like the wakala product but allows the IFI to either reinvest the profits or take them out in specified intervals. This would allow the IILM to underake longer-term projects with its capital because instead of paying out profits every period (month or quarter), it would issue new certificates to investors who reinvest the profits. Depending on the percentage of certificates held for a longer term (e.g. cash held by money market funds), this would both require less capital to be held in liquid form (i.e. cash) if new certificates could be issued for the same par value as the outstanding certificates. Longer-term investments have the potential to generate higher yield but are also have more risks, which would introduce a greater likelihood of a 'tail event'.

Capital Protected Products (including multi-currency products): In a capital protected note, there is a combination of a commodity murabaha and a wa'd-based swap of returns from a specified index. This is an unlikely structure for the IILM because trading would be difficult because of the commodity murabaha to create the capital protection. It would also be relatively unnecessary if the IILM were able to get a high rating that I would expect (i.e. similar to the Islamic Development Bank). If the IILM is operating on a global scale, it would be able to issue multi-currency certificates and the wa'd-based multi-currency feature would be better served by the Islamic window at a conventional bank, which could limit its currency risk by using conventional hedging tools.

Tradable Sukuk: Besides the wakala/mudaraba and wadiah, this is the most likely product. In fact, it might be more likely because of the relative familiarity that the market has for sukuk. The biggest problem in sukuk markets besides lack of supply is liquidity. Where the wakala/mudaraba product needs both a new market for the certificates and sufficient liquidity, an IILM sukuk issuance needs only a liquid marketplace. The central bank members of the IILM might not have the assets needed to issue a large volume of sukuk, but the comment in the Bernama article that the IILM would consider short-, medium- and long-term products and could use the funds for domestic projects suggest that other assets that are not directly owned by the central banks could be used to back sukuk.

The risk from IILM sukuk being used to fund national projects (like the Malaysian rail project mentioned in the article) is political. How will the assets be selected to back IILM certificates? Even with an IILM guarantee, the certificates would not be identical. You could buy a sukuk that was backed by the transit system in Malaysia (which has Ringgit exposure) or the one in Luxembourg (which has Euro exposure) and your sukuk might be denominated in dollars. It would be preferable to reduce external factors by having the certificates backed by a large number of diversified assets.

This could be accomplished either by the use of wakala or murabaha contracts or by the IILM issuing sukuk using mudaraba or wakala as the underlying contract. Reflecting on the description of what is created with mudaraba or wakala certificates, I think I was essentially describing sukuk certificates. In my opinion, an IILM wakala or mudaraba sukuk is the most likely structure.

Sukuk repos: This is an unlikely product for the IILM because it would duplicate the efforts of the IIFM (which is on the first stages of a difficult road towards a repo master agreement) and would step on the member central banks' toes because one of the primary uses of repos is for monetary policy. It also requires a larger supply of sukuk than exists today (particularly higher-quality sukuk) for it to become feasible.

I would hope that more details are released as we see the IILM develop and the next opportunity for further announcement is coming up when the IFSB holds a seminar on liquidity management in Islamic finance in Istanbul, Turkey on April 6th and 7th.

Islamic Commercial Paper

NOTE: This is the latest email newsletter (issue 28).  To sign up for the newsletter, enter your email on the left side of the page.

The Banker has a fantastic article on the liquidity management tools currently available to Islamic banks.  At the end of the article, it briefly covers an effort by Geert Bossuyt, formerly the head of Islamic finance at Deutsche Bank now with Dar al-Istithmar, to establish an independent Islamic commercial paper (CP) facility for Islamic financial institutions.  The article offers few details about the CP plan he is developing, which is based on using a single SPV owned by a charitable trust (to make it independent) using a double-wa'd structure.

The Dar al-Istithmar website provides a little more details, although just in the form of a transaction diagram.  From what I can gauge, it is the same structure used by Deutsche Bank for their Al-Mi'yar platform (which I wrote about in a 2009 post).


Source: Dar al-Istithmar.

The structure uses the wa'ad Shari'ah wrapper, which has attracted criticism in the past, although depending on what returns are being swapped, it may not be as controversial as when it was used for generating returns from conventional hedge funds inside of a Shari'ah-compliant wrapper.  Here is my best guess on how the product works:

The independent issuer SPV is established and issues its CP certificates to the investors (Islamic financial institutions).  The proceeds of these funds are invested in a Shari'ah-compliant asset, whether that is a basket of Shari'ah-compliant stocks, commodity murabaha contracts or any other asset that is Shari'ah-compliant (the diagram says "Shari'a compliant shares", suggesting stocks).  The SPV then enters a dual wa'd undertaking with a counterparty to swap the returns of the Shari'ah-compliant asset (presumably) with the returns on conventional money market funds.  The dual wa'd would have to be structured to ensure that only one side of the dual wa'd will be exercised (otherwise it would run into Shari'ah-compliance questions).

At this point, the SPV generates a return that is equivalent to a conventional money market fund to pay to the holders of the CP certificates it issued.  The counter-party is receiving a stream of returns based on whatever the Shari'ah-compliant assets are invested in, which it can separately hedge using conventional hedging tools (unless it is an Islamic financial institution itself).  The investors can hold their CP certificates as long as they have surplus liquidity and if they need liquidity, they can sell the CP on to other investors, who will then receive the stream of money market returns from the SPV.

The risks to the investors and to the SPV is that its swap counterparties are unable to fulfill their side of the swap.  If one counterparty became insolvent, the SPV might have difficulty continuing operations because the payments expected by investors would have to be generated by the investments of the SPV.  This would likely have a destabilizing impact on the entire platform because it is likely that there would be some general financial market stress, which would lead to lower asset values for the assets held by the SPV.  This would probably be accompanied by greater cash needs for the investors in the Shari'ah-compliant CP (and a general desire to hold more safe assets with limited counterparty risk).

If doubts became widespread about the counterparties of the SPV, it could trigger a 'run' on the SPV to redeem shares (if that is possible) or at least pressure on the price of the CP in the secondary market, which would be akin to the problems facing the conventional money market funds that came close to 'breaking the buck' or falling below the $1 net asset value.   These problems could be mitigated if not entirely avoided if the counterparties to the platform were one or many central banks of countries viewed to be stable (US or EU for example), although any central bank that had access to the Fed swap lines during the recent crisis would probably suffice (or a multilateral institution like the Islamic Development Bank with a AAA rating and many member countries who could support the bank in its role as the dual wa'd counterparty).

There are always going to be risks that contagion develops for money market products unless they are somehow guaranteed by "reliable" sovereigns.  Developing a structure for money market funds will be a tricky business.  The current setup of ad hoc bilateral commodity murabaha also creates the same type of counterparty risk, so whether the replacement structure uses a  network of commercial counterparties or sovereign counterparties, the success of each product should be viewed on how cost competitive it is to conventional liquidity management tools, as well as how much it reduces counterparty risk over bilateral commodity murabaha.  Finally, there will also be an impact of the structure on how widely used it is.  The more controversial a structure, the less likely it will be to gain wide acceptance unless it offers something compelling on the other metrics.  What is undoubtedly positive is that liquidity management has moved the the fore for new product development.  This is probably the best legacy of the financial crisis for Islamic finance.

What should the Islamic Development Bank do to help Islamic finance?

The Islamic Development Bank is now taking on the 'Islamic mega bank' envisioned by Saleh Kamel, according to Arab News. As Mushtak Parker writes,

"But [Kamel's] failure to get the project started off through the support of both government and private investors saw the project somehow passed on to the IDB. Instead of mega commercial, investment or universal Islamic bank, the plan is to launch a mega bank that will effectively be an Islamic Interbank bank, with the aim of providing short-term liquidity to the global Islamic banking market and of promoting the trading of sukuk in the secondary market by acting as a market maker."

The failure to launch an Islamic mega-bank (although there may be one launched by other groups in Malaysia) is likely due to the recession limiting investors' willingness to invest in a new Islamic bank. However, the idea that the IDB bank would focus on short-term liquidity tools and secondary market sukuk trading may be good, as long as its focus is not spread too thin. It may be a duplicative effort for the bank to develop government-supported liquidity management tools when the ILMC has just been established (with shareholders from the GCC as well as Asia) to develop just such a thing.

In my opinion, it would be much more beneficial for an IDB-sponsored initiative to focus on only one thing, secondary markets for sukuk, where there is not another effort underway to address an issue. However, I suspect that the IDB would have trouble addressing the lack of secondary market liquidity in sukuk by acting as a market maker. The problem in the secondary markets is not a lack of market maker. The spreads between bid and ask in sukuk markets are large enough to bring a private firm into the market if there were enough volume to support it. The problem is the lack of sukuk--primarily the lack of sellers. With a shortage of sukuk available, most investors who hold sukuk are hold-to-maturity investors and unless that problem is dealt with, either by providing an 'offer' in the market or by issuing more sukuk, a new market maker will have a limited impact. The IDB is probably better served by continuing its now regular issuance of sukuk.

However, the article from Arab News adds a potentially troubling detail. The article cites an unnamed Islamic banker:

"However, with all these issuances, the IDB is building up a sound asset pool base. Some of the proceeds of the new offerings will also be used to redeem earlier issuances. So it is a virtuous circle of financing, according to one Islamic banker."

In my opinion, this is not necessarily a virtuous circle. If the Islamic Development Bank is taking on long-term assets and using these as collateral to issue new sukuk to repay the existing sukuk, it places the institution in a potential crunch unless it can depend on its member governments to finance it if its assets lose value.

This criticism is somewhat unfair. The business of banks is to borrow short-term and lend longer-term and the IDB likely has no future liquidity worries given the oil wealth of many of its member states (which is reflected in its AAA rating). However, it does lead to questions about why it doesn't use these assets to provide a greater diversification in maturity profile of its sukuk, if not for anything but to help the market for sukuk, which is dominated by 5-year sukuk. The IDB could, for example, add 3-year, 7-year and 10-year sukuk offerings to the 5-year offerings (matching the mid-range of maturities of another AAA rated issuer, the US Treasury).

If the IDB focused on creating more maturity diversification through its new issues, it would both support the development of sukuk secondary markets by increasing the sukuk available (which would help create business for market makers), but it would also not compete (but rather supplememnt) the ILMC's efforts to develop the short-end of the curve. Large multilateral institutions can provide valuable services, but when they leave their primary mandate, their impact is usually diluted. The IDB is a development bank, and it should concentrate on that activity. In doing so, it can use its assets to issue sukuk (to finance itself), which can benefit the Islamic finance industry. Moving beyond this role sets it up to spread itself too thin.

QIB sukuk issued, Islamic Development Bank raises sukuk program size

The Qatar Islamic Bank sukuk for $750 million received subscriptions of $6 billion and pricing at 237.5 basis points above midswaps, which was 25 basis points below expectatons. This represents a step forward for primary markets in sukuk in the GCC and should encourage other companies (partcularly those with investment grade ratings) to bring sukuk to market. The resolution of Dubai World's $25 billion debt restructuring, which had made investors more reluctant to invest in the GCC (compared to Asia and particularly Malaysia where sukuk issuance had recovered much more from the financial crisis).

With the purchase of a majority stake by Dubai Islamic Bank, Fitch raised its rating watch on Tamweel to 'positive', although noted significant headwinds for the Islamic mortgage company. The other Islamic mortgage company in Dubai, Amlak Finance, may become part of Emirates Islamic Bank, which is also in talks to acquire Dubai Bank to create a "massive Islamic banking unit".

The Islamic Development Bank increased its sukuk program from $1.5 billion to $3.5 billion, with an unnamed source saying the additional sukuk would be issued to fund rebuilding assistance the IDB was planning in Pakistan after the huge floods in the country. This is positive for the sukuk market and increases the pipeline of new issuance, which seems poised to grow significantly in the GCC over the next few quarters.

IMF report, UAE Islamic banks, tawarruq attracts criticism, effects of the Dubai World debt agreement

The IMF released a study in August 2010 that provided an interesting analysis of what drove growth in Islamic banking from 1992 to 2006. The main finding of the study was that oil prices (which created a significant inflow of liquidity into the GCC, which is a major region for Islamic banking) had the largest effect. One interesting specification they used included both the price of oil and a dummy variable to measure the effect of 9/11 (to see whether growth was higher after 9/11, all other things being equal) and found that it did on its own, but when the effects of the oil price were included, the impact of 9/11 became insignificant. This suggests that the rise in oil prices in the 2000s was much more impactful on the growth of Islamic banking than 9/11. The argument for the impact of 9/11 was that following the attacks, many funds that were invested in the West were repatriated to (mostly) the GCC.

The head of Shari'ah at the Islamic Development Bank, Sheikh Mohammed Mukhtar Al Salami, says that tawarruq is 'usury' and therefore is 'haram'. His argument is that the transaction is "being carried out by Islamic banks as mere concealed usury operations as they are done not only at one place but at two place", reiterating an argument made by the Fiqh Council of the OIC. The OIC Fiqh Council's argument differentiated between classical tawarruq and organized tawarruq. In a tawarruq transaction a bank sells a metal of a client with deferred repayment (cost-plus-profit) and then the client sells the metal to get cash. In an organized tawarruq (also called reverse murabaha), the bank facilitates the sale of the the metal in the spot market (although the metal brokers used on each side of the transaction are different). Tawarruq is a commonly used product by Islamic financial institutions and greater Shari'ah risk around the product highlights the need for short-term liquidity management tools for institutions and new products for consumers, as tawarruq attracts more criticism.

Several articles describe the effect of the Dubai World debt agreement on other sukuk. Bloomberg reports that it is unlikely to lead to a 'massive' rally according to the CEO of Mashreq Capital in Dubai. Another Bloomberg article notes that the Dubai World agreement has failed to benefit Tamweel sukuk. Tamweel is a troubled Islamic mortgage company in Dubai that may be merged with Amlak Finance, another Islamic mortgage company, with assistance from the Dubai government. The Dubai World agreement could move the spotlight onto Nakheel, which has paid its trade creditors in cash and sukuk and has also repaid 2 of its 3 sukuk with assistance from the Dubai Financial Stability Fund. The Dubai World deal does raise an issue with Nakheel: the first two sukuk were repaid at par whereas Dubai World creditors accepted a writedown of principal and an extended maturity. The next key date for Nakheel is January 16, 2011 when the Nakheel Development 2 sukuk (the final one) is scheduled to mature. Will investors be forced to take a haircut or will the DFSF step in again to ensure repayment at par? It is too early to tell.

Profits in UAE-based Islamic banks fell 17% in the first half of 2010 compared with the same period in 2009. This is somewhat expected as the impacts of the financial crisis hit this region slightly later than in other parts of the world. However, despite the fall in profits, analysts believe the banks have not provisioned enough for non-performing loans, particularly in real estate in construction, the two sectors hit hardest.

Takaful continues to grow, but it is several years behind the growth in Islamic finance. Prudential BSN Takaful, a joint venture between Prudential PLC and Bank Simpanan Nasional Bhd in Malaysia, is launching three new takaful plans. An African Reinsurance company African Re, is launching a retakaful subsidiary with a wide focus on Africa, the Middle East and Asia. The Bahraini takaful compay t'azur recently announced a retakaful agreement with Hannover Re, a large conventional reinsurance company. Retakfaul is the Shari'ah-compliant version of reinsurance and has been very limited in availability. The Sri Lankan takaful firm Amana Takaful says that its operations are hampered by a lack of enough Shari'ah-compliant investments. If the takaful plan were managed like a conventional insurance pool, it would invest most of its assets into sukuk. However, the sukuk market has not been large enough to support the needs of takaful companies as well as other Islamic investors and unless there is significant growth in sukuk, takaful companies will have difficulties. They could invest in other assets: real estate, equities, commodities. However, all of these are more volatile than fixed income and it will probably not end well if a significant proportion of takaful fund assets were invested in these asset classes if there were a repeat of the financial crisis or even a less severe recession. It also makes it more difficult for the managers of the takaful funds to project its long term assets and ensure they match with expectations about its long term liabilities.

Other News

• The Javelin JETS Dow Jones Islamic International Index Fund, the first US-based Islamic ETF, will close. The company cites limited investor interest "through the marketing channels typically used by ETFs" according to Javelin's president Brint Firth.
  
• Mapletree Industrial Trust, a Shari'ah-compliant REIT, is raising $800 million in an IPO in Singapore.
  
• Indonesia plans to issue sukuk and global bonds in the first half of 2011. The government reduced its sukuk issuance in 2010 when deficits came in lower than expected. Several of the sukuk auctions failed during 2010 because investors demanded a higher yield than conventional bonds to account for the lower liquidity of sukuk compared to bonds.
  
• The development of Islamic banking in India is still not possible and the Indian Centre for Islamic Finance has approached the Reseve Bank of India, the central bank, and asked it to allow a few banks in Mumbai to open Islamic windows on a pilot basis before it considers any regulatory changes.