Islamic finance can learn from the credit crisis, Malaysia mandates rebate in mortgage products

The CEO of Capinnova Investment Bank had some interesting comments about Islamic finance in an interview with Emirates Business 24/7. He believes that there should be a unified Islamic banking authority to create more standardization and facilitate cooperation between different entities. He also suggested that it is "worth looking at the current credit crunch in conventional finance to see how easily one problem can spiral out of control. This is something that Islamic finance practitioners need to take on board and make sure that they are prepared to expect the unexpected". I think this is essential because Islamic finance institutions, particularly banks, can be subject to a crisis that could impair the confidence in their ability to survive which could turn into a destabilizing process where depositors 'run' on the banks. If this happened, the bank would have one of two choices: fail or turn to a conventional lender of last resort.

In both cases, the Islamic banking industry would be hurt. If a large Islamic bank failed, it could lead to questions about the solvency of other Islamic banks and make it harder for them to attract and retain deposits. This would force them to turn to other sources of capital which could be either more expensive or shorter-term, or both. The other alternative--an Islamic bank turning to a conventional lender of last resort--would raise questions about the bank's Shari'ah-compliance and also create questions about what other Islamic banks would do in a similar situation (with added confusion from the impact of different country's regulatory systems). For example, banks offering Islamic deposit products in the US are required to have those deposits FDIC insured (for banks) or NCUA insured (for credit unions). If the institution were to be seized by the regulators, would depositors have a choice about whether they wanted to avail of the non-Shari'ah-compliant deposit insurance?

The best time to determine what needs to be done in a future crisis is now, before a crisis starts. Once a crisis is in full swing, there will not be sufficient time to consider these potential pitfalls. This was demonstrated in the recent financial crisis. The cause of the crisis was not addressed; the focus was entirely upon preventing it from spiraling further out of control.

Malaysia's central bank, Bank Negara, has said that Islamic mortgage products offered using bai bithamin ajil (BBA), and murabaha must include language in the contracts that make the rebate (ibrar) mandatory. Previously, in a default followed by an asset sale (or a prepayment), the lender was entitely to the entire loan amount (cost plus profit) for the entire term of the mortgage. Most banks granted the rebate of what in a conventional mortgage would have been future accrued interest. However, when the rebate was not granted, it often led to court cases.

Other News

• Mushtak Parker criticizes the article about Islamic banking being 'a flop'. He places much of the blame for IBB's loss-making on the bank itself being undercapitalized and without an experienced Islamic banker running it. He also criticizes the product mix that was offered by the bank. In a different article, Mr. Parker describes the progress being made in Australia towards equal regulatory treatment for Islamic and conventional financial products.
  
• The UAE Ministry of Economy issued a law that regulates the takaful industry. It had been previously regulated under a law for conventional insurance companies.
  
• Sukuk prices are at their six-month highs following a number of sukuk restructurings, according to the Dow Jones Citigroup Sukuk Index. The yield on the Malaysian sovereign sukuk has fallen to 3.61%, a spread of 175 basis points over similar maturity US Treasuries.
  
• One of Nakheel's largest trade creditors Arabtec expects the inital payment by Nakheel soon with the remaining amount in a sukuk within a few months.
  
• Funds continue to flow into US-based socially responsible funds, including faith-based funds like the Amana Funds.
  
• Jordan is speeding up the issuance of a planned sukuk as its borrowing costs rise.
  
• Kuwait Finance House (Malaysia) set up an internal department to control non-performing financings, which were 6.72% in September 2009. It also defended its dismissal of one of the firms which rated it, RAM Ratings. KFH Malaysia's parent company is expected to post a higher profit in the second quarter compared to the first, which was 21.4% from the first quarter of 2009.
  
• Dubai-based Fajr Capital will invest in Bank Islam Brunei Darussalam (BIBD), an Islamic bank in Brunei.
  
• The Islamic Bank of Britain won a dispute in the World Intellectual Property Organization (WIPO) with a technology service company that had decide to auction the domain name used by the IBB.
  

Malaysia sovereign sukuk issued for $1.25 billion, Dubai, Islamic repo

Malaysia sovereign sukuk
The big news of the day was Malaysia's latest foray into the sukuk markets, the first by the sovereign since 2002 when it issued $600 million in sukuk. The latest issue was expected to be $1 billion, but with an order book reported to be between $4 billion and $5.5 billion, the issue was increased to $1.25 billion. The pricing, expected to be 180-190 basis points over US Treasuries of similar maturity, came in at 180bps on the low end of the range. This is the largest sukuk issuance since Dubai's $1.25 billion issuance in October 2009 before the Emirate saw its government-related entities like Dubai World run into trouble servicing its debt. Along the trend of the post-AAOIFI ruling market, this was an ijara sukuk which has become the most common form of sukuk issued since the rules on mudaraba and musharaka were strengthened to be more restrictive. In the first day of trading, the yield narrowed as investors bid up the sukuk. The sukuk was issued at 3.93% and finished its first trading day yielding 3.87%, 171bps higher than US Treasuries, a narrowing of the issue spread by 9bps. The state-owned oil company Petronas has seen its 4.25% sukuk issued last year trading with a 2.07% yield, which is in line with the historical spread between the sovereign and state-owned company's yields.

Prior to the issue, I was concerned that there would be too little trading to provide guidance as the economic and interest rate environment in Europe and globally evolved, but it appears that there is already secondary market activity, which should allow this sukuk to serve as a useful benchmark for corporate sukuk issuance (at least within comparable maturity range, denominated in US Dollars and issued by Malaysian issuers). As I mentioned, the issuance of another 5-year sukuk does little if anything to provide a lead for issuers looking to issue longer-dated sukuk, which are an important need for takaful providers and other investors looking for long maturity assets. However, with the difficult financing market globally because of worries about the fate of the Eurozone as well as continuing concerns over sukuk defaults, it is good sign that Malaysia's sukuk offering received such strong interest. We will have to wait another day for a sovereign sukuk with a 10-, 15-, 20- or 30-year tenor.

Dubai
In another hit to Dubai's reputation, cooling company Tabreed missed a periodic payment on its AED1.7 billion ($462.8 million) sukuk. The company is currently working on a recapitalization plan. The restructuring plan includes not just this sukuk, but debts totaling $1 billion. The two largest holders of the sukuk who collectively own more than 50% of the sukuk were consulted before the missed payment and one, Mubadala, provided an AED 1.3 billion facility to Tabreed as part of the recapitalization. The company expects to make a payment due in July on its $200 million floating rate sukuk.

Dubai International Capital, a private equity unit in Dubai Holding, is requesting a three-month delay on repayment of some of its debts. In an article, Noor Islamic Bank CEO Hussain Al Qemzi says the bank continues to expect to achieve profitability by 2012. He also said that Dubai Holdings is not another Dubai World and that Noor Islamic Bank has a small exposure to Dubai Holding, which owns Dubai International Capital.

In a case of "less bad" news, builder Arabtec says Nakheel is not in arrears to the company "as much as some analysts fear". That is hardly a ringing endorsement for efforts by Dubai to bring Nakheel current with many of its trade creditors.

Islamic repo and liquidity management
In what potentially could be a significant development, the UAE central bank is planning to offer daily auctions of commodity murabaha with one week to one year maturity to help Islamic banks manage liquidity. The Islamic certificates of deposit would fill an important gap in the Islamic finance industry where short-term liquidity management tools are rarely offered by central banks. The daily auctions would provide an important datapoint for investors and Islamic bankers. The central bank also anticipates using these CDs to manage liquidity through repurchase (repo) agreements, along the lines of the short-term ijara sukuk issued by the Central Bank of Bahrain. The difference between an ijara sukuk and a commodity murabaha is that one represents ownership of an asset while the other creates a debt stream that may raise Shari'ah issues over its use in a repurchase agreement. However, these issues have probably already been reviewed by Shari'ah scholars. The need for liquidity management tools for Islamic banks and central bankers, however, may be so important that their presence, even where this is viewed with some skepticism, may outweigh the cost associated with a controversial application.

Other News

• Moody's showed up a little late with a report that the Investment Dar case against Blom Bank where TID was allowed to proceed to trial claiming that a wakala agreement should be voided on the basis of non-Shari'ah-compliance presented an "operational risk" to Islamic finance.
  
• Malaysia's central bank and Securities Commission are working on a plan to make Malaysia a center for non-ringgit-denominated sukuk, as well as other areas within Islamic finance. Previously, there has been a lot of development in sukuk markets denominated in ringgit with fewer non-ringgit issues. This is in contrast to the GCC where issuers have brought both local currency and US Dollar sukuk to market.
  
• Saudi Electric Company, which has issued several domestic sukuk, plans to tap the international sukuk markets in 2011.
  
• The Australian government is reviewing its tax laws to put Islamic finance on equal footing with conventional finance and the assistant treasurer Nick Sherry points out that Islamic finance can have a broader appeal besides just Muslims as a form of socially-responsible investment (SRI). If it wants to attract the SRI consumer base, however, I believe Islamic finance will have to move beyond just 'negative' screens and incorporate 'positive' screens for companies that contribute to the social good.
  
• The latest summary of the Dow Jones Islamic Indexes is available through the end of May.
  
• Jordan Dubai Islamic Bank began trading on the Amman stock exchange.
  
• Malta continues to examine how regulations need to be adapted to incorporate Islamic finance.
  
• S&P put Kuwait Finance House's long-term counterparty credit rating on Credit Watch Negative.
  
• The first Islamic bank in Tunisia, Azzitouna Bank, was launched on Friday.
  
• The Gulf Bond and Sukuk Association signed a memorandum of understanding with the Trade Association for the Emerging Markets (EMTA).
  
• There is a summary of tax legislation on Islamic finance in South Africa.
  

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.
  

Sovereign sukuk issues, other news

There have been no benchmark sovereign sukuk issues this year, according to Reuters. Malaysia is considering issuing a global sukuk to provide a benchmark for local sukuk issuance. A benchmark issue is usually over $500 million. The lack of sovereign sukuk comes despite the intentions of a number of countries including the UK, Jordan, Kazakhstan, the Philippines, Indonesia that have stated that they plan to issue sovereign sukuk. Three months into the year, I am not too worried that there will be no sovereign sukuk issues for the year, especially with a smaller (~$100 million) Indonesian sukuk issuance planned for March 30. However, there are still risks. Greece and Dubai were the flash points of the fall and both could shake emerging market credit markets if there are further problems and Portugal's downggrade could also make it harder for emerging market countries to tap the international credit markets. However, the scale of the issuance by countries across the emerging markets, not to mention the developed world like the UK, dwarf the size of a benchmark sukuk issue. The more important point is that many emerging markets (where most of the sukuk pipeline is coming from) are consumed with dealing with the economic recession and do not have the time to deal with the legal and regulatory issues to make a sukuk issue possible. Reuters has a factbox about possible and planned sovereign sukuk issues.

Yasaar Media launched the first issue of "So Far? The Journal of Strategic Thinking in Islamic Finance". I was one of the think tank members contributing my views on the sukuk market and I would recommend it as a source of critical and strategic thinking into the Islamic finance. The current issue delves into the problems of the sukuk market recently. The first issue is available from Yasaar Media's website as a pdf

Malaysia strengthened its rules for Shari'ah board's review process to implement more transparency and documentation in the process. Not having read the rules, I cannot say for sure, but it appears that the rules would be at least in part in harmony with the call for greater Shari'ah transparency by Dr. Mohamed Elgari, which I linked to on Monday.

An article discusses the prospects of Islamic finance becoming involved with rainforest preservation in Indonesia.

A couple articles. discuss the prospects for a Dubai World restructuring proposal expected soon.

The managing director for Islamic finance at Global Commodity Finance says that the central banks in the Gulf region should develop an Islamic 'repo' transaction using sukuk for liquidity management purposes.

Other News

• More central banks in Africa may join the Islamic Financial Services Board (IFSB), the Malaysian-based standards-setting body.
  
• Assets in Islamic banks grew by 13.3% in 2009 compared with 7% growth in conventional banks within Pakistan. This growth rate is encouraging, but with conventional finance representing a much larger proportion of total assets, I would have expected Islamic finance to see growth rates be more significantly different, even given the general economic difficulties in the past year.
  
• An article proposes using the 'space value of money', which I do not completely understand.
  
• The short-term Sukuk al-Ijara issue from the Central Bank of Bahrain was oversubscribed by 330% (BD33 million for BD10 million in securities issued).
  
• Gulf Finance House says it is returning to a "back to basics strategy".
  
• Islamic banking continues to struggle to enter the Indian market.
  
• Despite all of the negative events including Nakheel, Bernama highlights some of the positives for Islamic capital market from 2009.
  
• Indonesia will offer sukuk on March 30 in an auction. There have been a few failed auctions recently with investors asking for too high yields for the government to accept.
  

Can Islamic banks be too big to fail? Dr. Elgari proposes Shari'ah governance standards, Nakheel sukuk options

A poll conducted by FinanceAsia magazine found that over 40% of voters in the poll said that Islamic finance had been damaged in the financial crisis. I agree with them, although it is more relevant whether Islamic finance was more or less damaged than the conventional financial industry in the countries where it is predominant. A direct comparison with the large banks in the U.S. and Europe is not very appropriate because Islamic banks had far less time to create toxic products (although those would have been more difficult under Shari'ah guidelines). The real lesson from the financial crisis was that there are insufficiently clear legal experience for bankruptcy and default compared to conventional finance. U.S. Treasury Secretary Timothy Geithner suggested today that too big to fail institutions should have a

"bankruptcy-like regime for large financial institutions that mismanage themselves into failure and can no longer survive without special government support. In that process, equity holders would be wiped out and the firm will be placed in a form of receivership so it can be broken apart, sold over time, with no exposure to the taxpayer."

While this has no specific bearing on Islamic financial institutions, it does highlight a similar problem facing Western regulators with regards to too-big-to-fail (TBTF) institutions as is facing the government of Dubai as it deals with Dubai World (whose subsidiaries were active in the Islamic capital markets). The problems with the Dubai World resolution mirrors the problem of TBTF institutions: there is no legal history to fall back on for guidance about how to deal with situations of crisis. With an Islamic bank being launched with $3 billion in capital, which could support total assets of between $30 billion and $60 billion assuming a 10-20x leverage ratio, it will be important for Islamic finance to consider whether this creates a systemic risk that even new bankruptcy laws developed for smaller Islamic financial institutions and players in the Islamic capital markets cannot deal with.

There is not anything wrong with a global Islamic bank with assets of upwards of $50 billion: this is far smaller than the TBTF institutions that Secretary Geithner is speaking about. However, with $50 billion in assets, this could account for 5% of total Islamic finance assets in one institutions and would be a significant size relative to many of the economies in the Gulf (ex-Saudi Arabia). For example, it is more than three times the GDP of Bahrain, which could house the bank. That rivals the ratio of RBS, Barclays and HSBC combined as a percent of UK GDP (337%). Creating a resolution regime for large Islamic banks should be a big focus for the Islamic banking industry and it would create a bad image for Islamic finance if it had to wait for an equally large crisis as the one that conventional finance faced in the fall of 2008.

It is hard to provide a good summary of Mohamed Elgari's call for greater Shari'ah governance in the Islamic financial industry and it the article from Arab News deserves a full real. His views cover the many areas including transparency in Shari'ah governance as well as creating greater public dialogue among Shari'ah scholars about the Shari'ah standards under which Islamic products are judged. He rightly notes that there will not be a consensus nor can (or should) there be total standardization of Shari'ah standards. That would remove the ability to adapt the interpretation by Shari'ah scholars to changing environments and lessons learned from how Islamic finance develops.

The first Nakheel sukuk since the one that matured in December will mature on May 13 and there are a number of options being considered according to Reuters reports. The sukuk is likely to be part of the Dubai World debt restructuring plan and the Nakheel sukuk, unlike its predecessor, does not have a guarantee from Dubai World. The most likely option according to Reuters is an extension of the maturity, although this would depend on whether the creditors would be forced to take a haircut and the size of that haircut.

Other News

• Dr. Abdel Fattah M Farah, the Economic Advisor to the Ajman Chamber of Commerce and Industry, proposes a model for a Shari'ah-compliant charitable investment bank that is very interesting.
  
• An Islamic advisory in the Dubai International Financial Centre, Tabarak Partners, will become the first such firm to be wound up under DIFC laws. With a peak valuation of AED1 billion ($272 million, mis-stated in the article as $27.2 million), it would be relatively small compared to Dubai World, but could provide an example for future (larger) cases.
  
• Al Hilal Bank received a license to open the first Islamic bank in Kazakhstan.
  
• Al Rajhi Bank has received approval to offer banking services in Jordan. The Oxford Business Group has an article on building Islamic finance in Jordan.
  
• Turkey's Islamic banks made profits of $470 million. This represents a 9% growth over 2008. Total assets grew 30% to $22.4 billion.
  
• Japan's Tokio Marine may expand its Islamic insurance operations.
  
• The new ETFs allowed by the Saudi Arabian regulators can include sukuk and commodities.
  

Dubai World, Islamic hedge funds

Dubai World negotiations continue to be released in bits and pieces to the media, and they may or may not be totally accurate. However, the latest release is that Dubai World will be split into 'good' and 'bad' companies and dealt with in separate ways. Nakheel and Limitless the domestic and international property companies within Dubai World, respectively, will be put into the 'bad' company as their prospects are more bleak with a collapse in real estate markets globally in the past two years. The 'good' company would include DP World, Ports Customs and Free Zones and Dry Docks. Statements in the past have separated these two groups of companies and it appears that that will be formalized in the proposal.

This could help move the restructuring on for the 'good' companies if they are separated and their debts are repaid in time while the 'bad' companies are worked out. However, I would imagine that the many large banks have exposure to both 'good' and 'bad' companies. This could provide more flexibility in the negotiations if they can know ahead of time that the debts of the 'good' companies will not have any haircuts requested. However, it does not address whether there will be a government guarantee on some, but not all, companies. Some proposals being floated in the media involve a delayed repayment (in some cases for the 'bad' companies with a haircut of 20%) with repayment guaranteed by the government of Dubai. This will increase some certainty, but there are still questions about whether Dubai would be able to make good on this guarantee without additional support from Abu Dhabi. The restructuring is proceeding, but is likely to continue for months if not years.

Islamic hedge funds have been slow to develop because there is not agreement on the contract, arbun, used by Shariah Capital to synthesize a short sale. Muddassir Siddiqui, a Shari'ah scholar criticized the use of arbun telling Reuters that "The payment of arbun does not transfer title to the buyer. The principle of the sharia is that you are not allowed to sell something that you don't own". There will be an uncertain for the future of Islamic hedge funds if such important aspects are disagreed on among scholars. However, it is likely that if there is broader approval of the arbun short selling contract, then the first mover advantage could be substantial.

Other News

• Sukuk issuance grew from $14.13 billion in 2008 to $20.15 billion in 2009, with half of the 2009 issuance coming from Malaysia according to the Malaysian ambassador to the UAE.
  
• Kuwait's special circuit court has granted The Investment Dar's request for protection under the financial stability law.
  
• Quarterly changes to the Dow Jones Islamic Market Indexes were released.
  
• The Jordanian government is considering ways to make sukuk issuance possible in the country.
  

Dubai World; Islamic 'lender of last resort'

News about possible options for Dubai World continue to surface in media reports and the latest is that Dubai World may seek to simply rollover its debts and lower the interest payments and repay over an eight to ten year period. The outcome for sukuk holders was not discussed specifically in the reports and I am still not sure whether the Dubai World restructuring will include specific accommodations to account for Shari'ah-compliance concerns. In my opinion, and I am not a scholar so I can't speak definitively about this, that any extension of maturity with continued lease or profit payments could be difficult because it would effectively exchange a delay in repayment for a higher level or repayment, which would probably raise some issues. However, I recall that the Nakheel sukuk incorporated defaults by extending the lease term and continuing the lease payments until repayment (analogous to what is being proposed), while retaining the lease as the source of the payments. This would probably be viewed more favorably because it would not include a delay in repayment in exchange for increasing the principal (by making periodic payments for a longer period). However, not all of the Dubai World Islamic debt is structured as ijara. One source in the FT article said that creditors could receive a share of future profits, which could be a way to extend the maturity by turning a murabaha or other facility into a mudaraba or musharaka. However, the lack of clarity on this issue in the media report suggests that there is either a minority of debt that is Shari'ah-compliant or the issue of Shari'ah-compliance is not at the forefront and is being viewed as a later issue when the general terms are agreed for something to be engineered to work around any issues. The National newspaper also offers its slightly different analysis. The Nakheel sukuk are discussed in another article as JP Morgan indicated in a note that sukuk holders could receive repayment at par.

The Union of Arab Banks says it is finalizing a way to allow Islamic banks to approach the central banks of the region for support. This is an important issue because without 'lender-of-last-resort' protection, Islamic banks are more vulnerable to runs. The lack of this support potentially can turn a liquidity crisis at Islamic banks into a solvency crisis if they are forced to unload assets at fire sale prices to meet depositors' withdrawals. This vulnerability should overshadow the more conservative lending standards in the pronouncements of Islamic banks' supposed immunity to crisis. The interbank market is important for banks to be able to have lower reliance on high levels of liquid assets that can reduce their profitability and thus the competitiveness with conventional banks. Following the launch of larger banks like Istikhlaf, which appears only to be an investment bank at the time being, there will need to be more attention paid to the systemic risk posed by larger Islamic banks. Without liquidity facilities at the central banks, investment banks and retail banks in the Islamic financial industry are extremely vulnerably. Beyond the fleeing of depositors in a 'classic' bank run, the demise of Lehman Brothers and Bear Stearns show how a run can start even without depositors if the wholesale funding partners of a bank withhold credit all at once. Both 'classic' and 'Lehman' runs should be considered in judging the urgency of establishing a 'lender of last resort' facility. When there is a new bank with $3 billion in capital expected, this could translate into $60 billion in assets (assuming a leverage ratio of 20:1). That would be a huge institution that would pose systemic risk to the Islamic financial system. It is an issue that deserves a lot of attention.

Other News

• The Dubai Financial Services Authority issued five Islamic finance handbooks for firms operating in the DIFC.
  
• Having announced last year investments in Chicago and a joint-venture with a publicly traded REIT, Kuwait Finance House is planning further expansion in the US, China and Canada. Other Islamic banks have urged China to consider Islamic banking as a way to attract capital from the Middle East.
  
• Indonesia raised 999 billion rupiah ($108.9 million) in its latest sukuk auction with a maturity range of 5 to 15 years sukuk. It had no winning bids for an 11-year sukuk auction. There have been several recent failed auctions for sukuk with investors demanding too high a yield to be accepted by the Ministry of Finance.
  
• Forbes has an article (written by Oxford Analytica) on the moves towards standardization in Islamic finance.
  
• The Islamic Development Bank will soon launch a roadshow to raise money for Istikhlaf, the 'Islamic Goldman Sachs' expected to begin operations later this year.
  
• Dar Al-Arkan redeemed a $600 million sukuk.
  
• The Jordanian government borrowed $100 million from Jordan Islamic Bank to finance a stockpile of wheat and barley.
  
• Centennial College in Toronto will offer an Islamic finance course starting in May.
  
• Has Islamic finance helped cushion Bahrain from the blow of the global recession? The finance minister thinks so.
  
• The Investment Dar continues to struggle on its restructuring and may seek protection under the country's financial stability law.
  
• Amana Takaful, a Sri Lankan takaful provider received an insurance license in the Maldives. The takaful industry continues to struggle over the lack of sufficient supply of appropriate investments, like sukuk, and a shortage of talent.
  

More commentary on TID's wakala

The Investment Dar's defense in a lawsuit filed by Blom Bank over a wakala agreement is receiving significant attention throughout the industry. The contract, in which TID acted as the investment agent for Blom Bank and was responsible for returning principal plus an agreed profit margin if the investments were profitable, was signed off by its Shari'ah board three years ago. In court case, TID argued that the contract was not Shari'ah-compliant and therefore is void. The court sided with TID and ordered that TID repay only the principal. This has attracted attention to the impact the ruling could have on Islamic finance as a whole by increasing Shari'ah risk. One unnamed lawwyer suggested that TID "is clearly in financial difficulties and clutching at straws to get out of paying but [this] may cause concern for conventional institutions considering entering into a sharia transaction."

Other News

• Reuters sums up a recent Islamic finance conference in Jordan.
  
• Belgium is marketing itself to Brunei (in addition to countries in the GCC) as a destination for Islamic venture capital funds.
  
• A Malaysian company Binariang GSM has partially redeemed $1.1 billion of its senior sukuk.
  
• The recent debt exchange by Gulf Finance House led Standard & Poor's to raise the rating from selective default to CCC- with outlook negative.
  
• Bullion Management Group, a Canadian company offering two bullion funds, received Shari'ah approval from the Islamic Finance Advisory Board.
  
• France is still expected to make changes to its legal and regulatory framework to accommodate Islamic finance.
  
• The establishment of an Islamic finance company in Kerala, India is still uncertain because of the involvement of the government and the limits of government involvement with a religiously-based financial institution. It may be changed to be an 'interest-free', rather than Islamic institution.
  
• New tax changes that would implement a goods and services tax in Malaysia will be done so that it has an equal impact on conventional and Islamic financial services.
  
• Business Week provides a list of the upcoming sukuk issues.
  

Dubai issues $1.93 billion in sukuk

Dubai announced the results of its 5-year sukuk issuance today. There were two tranches, one for $1.25 million of USD-denominated sukuk and the other was $680 million in AED denominated sukuk. The sukuk were priced at 375 basis points over mid-swaps. Bloomberg reports that the USD sukuk were priced to yield 6.39%. The AED tranche are floating-rate notes based on a spread over EIBOR, priced to yield 5.65% according to the same Bloomberg article.

The nearly $2 billion issuance is the first issuance of bonds by Dubai since April 2008, before the real estate markets in Dubai began to tumble in the wake of the global credit crisis. There are a number of maturing debt issues--some $6.8 billion in the fourth quarter of 2009--none more crucial to Dubai's reputation than the $3.52 billion Nakheel sukuk. The Nakheel sukuk is not officially sovereign debt, but it is a government-related entity guaranteed by Dubai World, the government-linked holding company.

Nakheel, the developer of the palm-shaped islands off the coast of the Emirate, has run into severe difficulty following the property crash in Dubai, and has confirmed it has received money from Dubai's Financial Support Fund, although the amount has not been disclosed. Although the funds raised in this sukuk issuance will go to the government, in part to pay maturing sovereign sukuk, there will soon be another $10 billion bond issuance, a part of the $20 billion bond program that was started with a $10 billion bond issued to the UAE central bank.

Nakheel has been reported to be in restructuring talks over the $3.52 billion sukuk, which could include a tender offer involving equity. However, a number of investors have publicly criticized the possibility of recieving equity for their investment. Due to the deferred lease payments throughout the sukuk, the total amount payable on maturity is around $4 billion. Were the Nakheel sukuk to not be fully redeemed upon maturity, it would send a bad signal to the bond markets about the credit-worthiness of other highly-indebted government-related entities and could affect the Dubai government's ability to raise future debt.

However, the ability of Dubai to access the international capital markets, as well as the support from the UAE central bank through the earlier bond, sends a positive signal that Dubai will not allow Nakheel to default on its debt. The outcome is still uncertain, although the secondary market trading in Nakheel suggests that there will be a favorable outcome. The latest pricing is 107 - 108.5 as of October 28th. The final maturity value of the Nakheel sukuk is near 115.

Other News

• Indonesia plans its next sukuk in mid-November. The first two auctions have seen investors demanding higher yields. The first auction had all bids rejected and the second auction saw less than 5% of the total bids accepted.
  
• Jordan continues to consider issuing a sukuk, although the discussions are in an early stage.
  
• Next year may see $20 billion in sukuk issuance according to a poll. The issuance was $9.3 billion in the first seven months of 2009. The total sukuk issuance this year could be around $15-17 billion. However, with a pipeline estimated at $45 billion, this would be less than some expect.
  

Dubai wades back into international capital markets, sukuk coming back or are defaults too strong a headwind for the next year

Dubai Civil Aviation may issue sukuk and conventional bonds to refinance $1 billion in debt maturing in November, in signs that Dubai may be re-approaching the sukuk and bond markets despite uncertainty about the level of debt in government-related entities like Dubai World and Nakheel, which has a $3.52 billion sukuk maturing in December. The ability of Dubai to tap capital markets has been buoyed by the return of risk appetite among investors as well as the repayment a month early by Nakheel of over $1 billion in bank debt extended earlier this year. However, there is still skepticism about Dubai's ability to restructure its debt and government-related entities.

A senior executive at Nomura believes that there will be a further uptick in the issuance of new sukuk by corporate and sovereign issuers in the next 18 months. The issuance through the end of September was $13.5 billion, primarily out of Saudi Arabia, which accounted for 44% of issuance and included sukuk from Saudi Electric Company and the Islamic Development Bank. Other more recent data shows that $18 billion in sukuk have been issued so far this year.

The sukuk market remains in a state of flux because of the unresolved issues about asset-based and asset-backed sukuk, which is discussed in an article in the Financial Times. The important point brought up in the FT article is that not all sukuk transfer ownership of the underlying asset to the investors. In many cases of asset-based sukuk, the asset is transferred to the SPV that issued the sukuk but with a repurchase agreement that requires the issuer to repurchase the asset in the case of default. This means that the asset ownership transfers back to the company and the sukuk holders are given essentially an IOU that the company will redeem the principal of the sukuk in a default. This is different from an asset-backed sukuk where ownership is transferred to the sukuk holders, who then have legal right to the asset. This was the case in the East Cameron sukuk, which was based on an overriding royalty interest that entitles the sukuk holders to a share of production in the underlying lease. Other sukuk transfer ownership of a tangible asset (the ORRI is legally recognized as real property in Louisiana, but is not a transfer of the underlying properties being drilled, which are leased from the US government).

Other News

• The World Bank's IFC sukuk price guidance is 35-40 basis points over 5-year US Treasuries.
  
• Jordan is considering offering sukuk to cover its growing budget deficit.
  
• A columnist in the Guardian discusses the role of regulation and religion in finance.
  
• Emirates Development Bank, the government funded bank that is anticipated to take over Islamic mortgage lenders Amlak and Tamweel is one step closer to launch, although the fate of Amlak and Tamweel remains uncertain.
  
• Saudi Electric may tap sukuk markets again to finance a new contract the firm signed.
  
• There is a nice article is in a Minnesota paper about local organization African Development Center, which offers Shari'ah-compliant home and business financing.
  
• An English paper has a good article about the growth of Islamic finance.
  
• Korea needs incentives for investments in sukuk, according to the head of Doha Bank's representative office in the country.
  
• Islamic Finance Resources links to a recent paper on the history of Islamic finance in France, a relevant article given the recent French law about Islamic finance that was struck down by the constitutional court on procedural grounds.
  
• Ithmaar is offering a rights issue as well as a 5-year mandatory convertible sukuk.
  
• Gatehouse Bank, based in the UK, joined Paris Europlace, a Paris-based organization that promotes the French financial industry and established an Islamic Finance Commission in December 2007.
  

Sukuk volume in 2009: opinions differ

An English online grocery store Ocado received £10 million in financing using Shari'ah-compliant leasing (ijara). Although the transaction is small and uses a relatively simple Islamic finance product, it has significance, I think, because it is the company's first use of Islamic finance and it chose this type of finance because of the "competitive offering" from the Bank of London and the Middle East, a Shari'ah-compliant wholesale bank in the U.K. There are relatively few instances where Western companies chose Islamic finance products based on their price competitiveness (e.g., the $166 million East Cameron Gas Co. sukuk), but there is potential for this to become more common if Shari'ah-compliant banks are able to tap sources of capital and have not been hurt themselves by the credit crisis through the slowing of global growth where health companies find that they can only receive finance from conventional banks at extremely high cost.

According to a poll conducted by Reuters, the amount of sukuk expected to come from Southeast Asia, a region with a large volume of sukuk in recent years, is around $5 billion, far below last year. Most of the issuance is expected to be issued by governments. A previous estimate for Malaysia put the volume from that country at $4 billion for 2009. The GCC region is also expected to see far smaller volume of sukuk with unnamed bankers telling Reuters they expect to see issuance between $4 and $8 billion. Standard & Poor's, however, believes there are $45 billion of sukuk in the pipeline and the number that reach the market in 2009 will depend on whether the market becomes more favorable than it is now.

Other News

• Gatehouse Bank announced a new $1 billion 'Milestone Sukuk' platform and a first issue on the platform that it claims makes the issue of sukuk easier.
  
• Islamic financial institution Arcapita Bank, based in Bahrain and Atlanta, Georgia was downgraded recently, in part because of its 'high leverage'. The high leverage aspect is surprising because Islamic finance is often characterized as putting significant limits on allowable leverage.
  
• Turkey's first sukuk, a revenue-linked bond, was a flop raising only about one-quarter of the planned amount.
  
• Organizers of the 2009 Asia Sukuk Summit, in contrast, believe that countries where Islamic finance is just beginning to become into significance like Jordan, Hong Kong, Singapore and Japan will issue sukuk this year.
  

CSR, takaful, Islamic indexes & wire transfers

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UAE-based Dana Gas decides to postpone its convertible sukuk it announced in June due to 'global credit market weakness'.

U.K. Muslims prefer takaful, but most specify that their demand is based not only on Shari'ah-compliance, but also cost and level of cover.

Western Union will offer wire transfer services in Jordan through the Jordan Islamic Bank.