Islamic finance development and the competition with conventional banking

I ran across two articles recently that provided two different ways of thinking about how Islamic finance can compete with conventional finance.  The first, which comes from an interesting article about the development and launch of the Al Hilal Bank in Kazakhstan, describes how one challenge with attracting interest in Islamic finance among businesses:

"It has taken our corporate staff and legal team a long time to convince our customers that even though Islamic finance is approached in a different way, the final results are the same"

The second comes from Malaysia, where an article contrasts the primary selling point used elsewhere as being a financial institution's Shari'ah-compliance, in Malaysia, they have to not only provide a Shari'ah-compliant product but compete (in a competitive market) on the value proposition, which is helped by a number of tax incentives for Islamic finance products (link to story behind the Zawya paywall). 

Besides these two approaches, there is a third one used mostly in countries where Islamic finance is new and relies upon its relative scarcity to target Muslims who avoid using conventional banks at all because they want to avoid riba.  In these markets, even if Islamic finance is not cost competitive with conventional financial institutions, they will find a market for their products among some segment of the Muslim population, even if they are more expensive. 

The three approaches roughly correspond to different stages on the development of Islamic finance in markets, from first introduction to maturation.  In new markets, there will be a push along the lines of Kazakhstan on the corporate side, and along the small market (focused on customers who are relatively cost insensitive who will only use Islamic finance). 

The newness of the product and business model will attract 'first adopters' who are actively searching for Islamic finance products, and will choose them even if it is at a higher cost than they could find financing alternatives from conventional financial institutions. The size of this market will likely determine whether or not the market is large enough to support Islamic finance, and in some cases it is not large enough to support Islamic financial institutions that are focused on the domestic market. 

On the corporate side, however, it is likely not enough to try and attract businesses motivated by Shari'ah-compliance alone (or not just this factor), and most businesses will want to compare the cost of Islamic with conventional finance, and an unusual structure and perhaps the Arabic terminology in countries where Arabic is not the primary language may deter some businesses.  However, the development of Islamic finance has in large part come from developing products that are economically very similar to conventional financial products (in part due to the need to fit within regulations that were not designed for finance that is not based on interest).  The similarity in the product economics between Islamic and conventional finance can serve as a source of comfort against their unfamiliarity with the particular structures used. 

However, once the market becomes developed enough, the ability to attract more customers will become limited as the early adopters have largely shifted to Islamic finance, or become skeptical because of its similarity with conventional finance and Islamic financial institutions will have to go in search of a share of the broader market.  This is the point where the value of the product and its cost competitiveness with conventional finance becomes an issue. 

In Malaysia, Islamic finance has become cost competitive, in part due to government incentives (which may be a double-edged sword).  But, this is not the answer for the long-run, or even the short-run in markets where the government may not be able to provide explicit subsidies for Islamci finance, and the industry will have to find another way of becoming cost competitive with conventional finance. 

To date, a lot of focus on this area has been placed on increasing the scale of Islamic financial institutions, building mega-banks.  And this is a way that Islamic finance can become more costs competitive.  A larger bank has more assets over which it can spread its fixed costs, and will be able to provide lower cost products while maintaining a margin competitive with conventional banks.  But with the global financial institutions increasingly active in Islamic finance, with assets far in excess of what any wholly Islamic mega bank can achieve, this will be an increasingly difficult path for the industry to travel. 

Yet there is another alternative, which is less traveled, and which I will admit is likely to be vague compared to the more concrete examples described above.  Can Islamic finance offer a product that has 'other' value besides just dollars and sense?  Can, for example, it offer more flexible terms that provide a benefit for the financial institutions' clients that a conventional bank--due to convention or regulation--not be able to offer?  I struggle to offer concrete examples here, and it may be that none exist, but if Islamic finance wants tbeo avoid becoming just a niche market subsumed into the global financial industry, it should find a way to ask the question and maybe try it and see what happens. 

Haidar Hamoudi, who offers excellent commentary on his blog, touched on the subject recently and suggests that the Islamic finance industry may have been oversold as both a more efficient and ethical form of finance, and one that can offer the same risk-return profile as conventional finance.  He suggests an alternative, which I think may be an accurate presumption of the choice facing the industry:

A more honest approach would be to inform the Muslim consumer that at some level and to some extent, there is a zero sum game at work here.  Some methods of financings might prove more efficient than others, who knows, but at the end of the day, there's a tradeoff to be made.  Either the industry mimics conventional finance, as it does now, and offers the same return and subjects itself to the same risk exposure in the process, using only differences in form to achieve the result, or it actually does do something different, something actually concerned with social justice, or the development of a moral economy, or the redistribution of wealth. But if it does that, then the money has to come from somewhere, and that somewhere are going to be the depositors, who will have to live with lower returns.

It may be true that depositors will just have to live with lower returns, or else have their deposits held by and invested by an Islamic bank that looks like a conventional bank with different structures used to receive the Shari'ah-compliant label.  But, maybe the post-financial crisis world will be one where overfinancialization, which led to a collapse in financial institutions' profits after decades of rising as a share of total profits will be one where this unsustainable growth begins to reverse, where the 'financialization' of the economy becomes less of a factor in juicing the returns of conventional banks, so Islamic banks don't have to replicate their business model as a way of keeping up with their returns.

If the 'new normal' in global financial markets comes with less use of leverage (which enhances returns both on the way up and the way down) and uses lower leverage, perhaps Islamic banks will be able to more easily be competitive on price without having to force their businesses to resemble so completely the business model of conventional banks, and can focus more on the other aspects of value to compete with conventional finance. 

Kazakhstan's first sukuk and the potential public benefit from government sukuk issuance

The Development Bank of Kazakhstan (DBK) issued its first sukuk, the first for the country.  The sukuk, for MYR240 million ($76.6 million) was issued in Malaysia (where 82% of subscribers were pension funds who are facing a shortage in sukuk).  For a market new to Islamic finance, the issuance by a development bank may provide a good starting point for opening the market for other sukuk issuers because of the development bank's connection to the government. 

The DBK is part of the government, but will still have to navigate the country's rules for fixed income offerings, and the associated challenges (but likely not any difficulties with taxation).  This should focus the government's attention on making changes to its laws that would otherwise block sukuk, which will benefit private issuers, who would otherwise have to find ways to convince the government to change on their behalf, which is likely a challenging proposition in any country. 

In addition, there are few forms of intellectual property protection for financial instruments, so the sukuk structures used by the government should be able to be adopted by private issuers, benefiting from the extra cost the development bank will have to commit to issuing its own sukuk.  There is also likely to be additional information available for pricing a corporate sukuk if a government entity has already issued a sukuk: investors can use both the corporate issuer's conventional debt, the government's conventional debt and the government's sukuk pricing as guides and the more sources for this pricing are available, the greater the potential for corporate issuers to lower the additional spread it will have to pay for sukuk versus conventional debt.

This does create additional costs for the government when it issues its sukuk, but if the government is committed to increasing the opportunities for sukuk issuance in the country, as Kazakhstan's is based on its public statements, having the additional cost be borne by the government could be a boon for the development of both a sukuk market, as well as Islamic banks who are otherwise going to have to look abroad for government-issued assets to use to fill a portion of their balance sheet. 

Kazakhstan Islamic finance hits speed bump

Kazakhstan's Islamic finance ambitions appear to hit a speedbump according to an article by Alastair Marsh in FT Tilt.  The article reports that Al Hilal Bank, the country's only Islamic bank (owned by the government of Abu Dhabi) had its license suspended for having too little equity capital, which the Abu Dhabi government says has been fixed and was due to large losses in its first year.  In addition, progress on a sovereign sukuk is slow, partly because of concerns that a sukuk would be significantly more expensive than a conventional bond.

Islamic finance: think global, act local

Kazakhstan is one of the recent entrants into the Islamic finance market. The country, which is 47% Muslim according to the CIA World Factbook, has only saw the opening of the first Islamic bank in the country, Al Hilal Islamic Bank, owned by the UAE government owned Al Hilal Bank. Since then there are a number of other Islamic banks including Amana Raya from Malaysia and Qatar Islamic Bank, which has a number of subsidiaries outside the GCC, most notably being QIB (UK) plc, its UK subsidiary formerly known as the European Finance House.

The latest development in Kazakhstan is the announcement (or more appropriately restatement) of a desire to launch a $500 million sukuk, which was announced at an Islamic finance conference in the country. According to a recent release by the Kazakh embassy in the US, the country plans on bringing $10 billion in Islamic financial transactions to market in the next 5 to 7 years.

At the conference, Prime Minister Asset Issekeshev said that "We are confident that Islamic finance will lead the way to attract funds, especially from the Gulf countries and other Muslim countries to develop all these sectors". In my opinion, this signals a problem in some of the expansion of Islamic finance. According to the World Bank, Kazakhstan is largely dependent on natural resources (oil, gas and minerals), which represent 39% of its GDP and 73% of exports, compared to agriculture and manufacturing, which generate 5% and 11% of GDP.

This is problematic if the government sees the sukuk as a way to tap funds from the GCC. The GCC itself is trying to diversify itself away from dependence on natural resources as well and therefore the economic cycles of the GCC and Kazakhstan are likely to be relatively synchronized. If the government is seeking funds from a region whose economic cycles are aligned with its own, it is likely that the funds it is tapping will not be there when it most needs it. If natural resource prices fall significantly, the region it is tapping for funds in sukuk will be facing their own troubles and will not be available to roll over maturing sukuk.

For the GCC and the investors from that region who subscribe to any Kazakh sukuk, they will face an equal problem. Their investment in the sukuk of Kazakh will be viewed as "troubled" if resource prices fall significantly at the point where the local economies in the GCC will be struggling from the lower revenues from natural resources. Expansion of sukuk with a focus on the GCC will be highly cyclical with issuance (and uptake from investors) highest in the economic peaks and problems emerging if resource prices falter.

For Kazakhstan, it should focus on sukuk with an eye to the local market and towards investors whose economic fate is less tied up by the price of natural resources. As the World Bank report notes, the country has been working to reduce the salinity of the Aral Sea, which has created fishing jobs, and on "drylands management", which has increased the agricultural sector (cattle and hay are mentioned specifically).

My knowledge of the Kazakh economy is limited, so I cannot offer much on that front, but from the perspective of Islamic finance, there should be a different focus (not only in Kazakhstan). Kazakhstan and other non-GCC countries aspiring to tap the Islamic finance market (particularly those with natural resource biases in their economies) should welcome investment in the sukuk from the GCC, but should focus on raising funds domestically and from countries with different economies whose investors may be more willing to continuing investment if resource prices fall.

They should also focus on the use of the funds from the sukuk into areas of government services that help to diversify the economy away from the natural resource sector to reduce their own reliance on resources to both create employment as well as de-link their economies from the same resource prices that provide the funding to their investors (if those investors are primarily located in the GCC).

Islamic finance in general, and sukuk in particular, are fashionable ways to attract money from the GCC because of its large wealth and also large Muslim population, but Islamic finance should not be viewed as just a way to get at the oil money in the region. It should be viewed as an alternative structure of finance (and bonds) and with nearly half of the population in Kazakhstan being Muslim, there should also be some focus on the local market. A domestic, local currency sukuk alongside the global sukuk would benefit the domestic market more than a sukuk focused on the GCC market.

Islamic finance lagging in private equity; sukuk for the Saudi mortgage market

An article cites Hussein Hassan, the head of Middle east structuring at Deutsche Bank pointing out that Islamic banks avoid private equity despite its similarity with the partnership approach in Islamic finance contracts like mudaraba. This is attributed to the use of high levels of debt in private equity, the financing of haram industries and the asset-liability mismatch in Islamic banks which limits their ability to invest in longer-term projects. Lahem Al-Nasser covers a similar topic when he chides Islamic banks for financing more "traditional" projects over projects which are new and untested. He says this bias is based on the management having experience in conventional banking who believe that "Islamic banking is nothing more than a marketing instrument to make profit" and they "lack the incentive to push for creativity and innovation".

The VP and MENA business manager for corporate trust at BNY Mellon Corporate Trust in Dubai suggests that "sukuk would be the best way to mortgage homes in a Shari'ah-compliant fashion" using an asset-backed structure. I would tend to agree because so long as most of the mortgages are tradable (i.e. not based on murabaha), they could be securitized in a way similar to the Islamic Development Bank's sukuk al-istithmar. In the istithmar sukuk, the underlying assets are other financing contracts (in the case of the IDB sukuk, they are murabaha, istisna'a and ijara). The sukuk is tradable so long as the proportion of ijara contracts (by value) is more than one-half of the total assets. The reason for this is that murabaha and istisna'a contracts create a debt obligation (the financier holds a receivable for future payment), whereas an ijara contract provides the financier with ownership of an asset.

Kazakhstan is planning to issue $500 million in sovereign sukuk, in part to try and make the country the "Islamic finance hub" for the former Soviet Union. The government of Abu Dhabi-owned Al Hilal Bank opened the first Islamic bank in the country earlier this year. The CEO of the Kazakhstan branch of Al Hilal Bank, Prasad Abraham, tempers the expectation saying that issuance could start at just $200 million this year but rising to as much as $3 billion per year by 2015. The sukuk is replacing a cancelled $750 million Eurobond, which Bruce Gaston, the CEO of Skybridge Finance, says will cost the government up to 150 basis points m more compared to the Eurobond.

Other News

• Kuwait Finance House Research estimates that global sukuk issuance in 2010 will reach $30 billion. The first half issuance was $16.5 billion.
  
• Al Baraka Banking Group plans to raise $200 million through its first sukuk issuance by the end of 2010. Al Baraka also signed a non-exclusive memorandum of understanding with the Islamic Corporation for the Development of the Private Sector (ICD). ICD is part of the Islamic Development Bank group.
  
• Gulf Finance House is planning to increase its capital by $300 million but did not specify how it plans to raise that capital.
  
• Dubai may issue debt in 2010, but it is "not under pressure to do anything".
  
• Bahrain Financial Harbour raised $240 million through a 7-year ijara facility to repay debt.
  
• The Al Rajhi Bank-Cagamas cooperation may only be the first effort to bridge the divide--particularly in Shari'ah standards--between the GCC and Malaysia. While much of the news concerns the Shari'ah standards, there are other areas where harmonization of standards becomes difficult. Megat Hizaini Hassan, the head of Islamic banking & finance at Zaid Ibrahim, is quoted saying: "In the Middle East, in certain jurisdictions [Islamic finance] is not even regulated so how can you harmonise?".
  

Thursday bullets

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

Islamic retail banking in the West: Can the US provide an example?

There are a number of articles about the challenges facing the Islamic finance industry that caught my eye in the last couple days but none challenge the conventional wisdom as much as an article from Bloomberg that Islamic banks or conventional banks Islamic windows in the UK have been set back substantially by the recession. Further, there may be too many banks (22) chasing too small a market ($19 billion versus $93 billion in Malaysia). Another article in the Independent focuses on the withdrawal or shrinkage of retail Islamic finance at large banks in the UK. One of the areas where the Bloomberg article flies in the face of conventional wisdom is that the UK government has not supported the Islamic financial industry sufficiently. This contradicts the widely held view that the UK is preeminent among non-Muslim-majority regions in both its level of development and the scope of government support. As much as this challenges these ideas, there is a caveat that is not mentioned in the article: it is mostly focused on the domestic market, not the participation of UK-based banks in the global Islamic finance industry. However, it does set back the idea that Islamic banking can become a widely accepted subset of the domestic financial industry in non-Muslim-majority countries with sizeable Muslim minorities.

On the scale that Bloomberg is looking, there probably is not a large enough market that can easily be penetrated by large institutions and the one solely retail focused and Shari'ah-compliant institution, the Islamic Bank of Britain represents too small a sample to generalize about the prospects for smaller institutions. In this regard, the United States may provide an example of how Islamic banking can be feasible without participation from large conventional banks. The US market--for reasons of regulation and geographical concentration of the Muslim population--has no product availability among the large banks, but under the radar exist community banks, credit unions and non-bank financial companies that provide Islamic financial services. This may be the maximum size that is profitable currently in countries without sizable Muslim populations and that should be recognized as a success. Although the headlines are drawn by the largest and the newest products and institutions, having financial institutions that recognize the value of remaining small enough to serve their customers and avoid overexpansion is a virtue in itself. Not all areas in the U.S. have remained under the radar. For example, the Amana mutual funds have grown over the past decade and two of the funds are the largest Islamic equity funds in the world, in large part because they have transcended their natural market and attracted non-Muslims based on their performance.

Areas of the Islamic financial industry that are not yet able to attract significant non-Muslim participation but are able to avoid growth-at-any cost may not make the headlines, but the experience of the Amana Funds shows that this is not necessarily a failure. The Amana Funds remained small for many years before starting their rapid growth at the beginning of the last decade. Their growth was "supply-driven"; it was "demand-driven" based on their ability to provide a service demanded by consumers both Muslim and non-Muslim based on its performance. There cannot be a direct analogy that could work elsewhere in non-Muslim majority countries, but the contrast could provide lessons for other non-Muslim-majority countries with aspirations to develop a domestic Islamic finance market. Maybe the next decade will be the decade for retail banking.

Other News

• Rushdi Siddiqui has two great articles in Gulf News. In one article he suggests: "For Islamic finance, a lack of Muslim inclusion should be a greater concern than lack of standardisation. When we speak of convergence, it may well entail technology (mobile phone) and banking for the non-bankable Muslims. Hello, is Islamic finance listening at the other end?". In the other, he interviews Dr. Mohammad Nedal Al Chaar, the Secretary-General of AAOIFI.
  
• As the Islamic finance industry grows in Canada, the Rotman School of Management at the University of Toronto is the first to offer a course on the subject for MBA students.
  
• Saudi Binladin Group sold a short-term sukuk with a maturity of 9 months for $187 million (SAR700 million). Most sukuk have a tenor between 3 and 7 years.
  
• Sukuk sales in 2010 are expected to be $23-$25 billion according to a poll by Reuters. This was close to the $23.3 billion issued last year and lower than a poll conducted in April which forecasted $28 billion in sukuk sales. Asa Fitch wrote a good article in The National about the growth of the sukuk market and the rapid decline during and after the financial crisis.
  
• Even after a four-month rally, the yields on Nakheel's sukuk are twice as high as 2007. A credit analyst at S&P in Paris, Mohamed Damak who also is co-chair of the Islamic finance working group for S&P points to this as evidence that the market is still hard to access for real-estate-based companies.
  
• Kazakhstan has resumed planning for its first sukuk, which is not expected soon and will likely be an ijara sukuk of roughly $300 million. There are a number of regulatory issues that need to be dealt with.
  
• Russian bank Vneshtorgbank (VTB) has also resumed work on a sukuk issuance and "a range of other Islamic financial products". The Association of Regional Banks of Russia established a task force on Islamic financial institutions.
  
• An article in Arab News describes the backlash facing Islamic banks in South Africa over high fees. However, the criticism of the high fees are not limited to Islamic banks.
  
• A report about Islamic banking in Indonesia was released recently.
  
• The Saudi Electric Company is planning a fourth sukuk. The timing, size and pricing are yet to be determined.
  
• Abu Dhabi Ports Company is considering a bond or sukuk of up to $1 billion in early 2011.
  
• Bermuda is trying to attract the Islamic finance industry following a trip by the CEO of the Bermuda Stock Exchange to Bahrain.
  
• An opinion piece in China Daily by the program director of the University of Hong Kong SPACE on the development of Islamic finance in Hong Kong, including the areas where it is being held back, particularly in human capital.
  

Islamic pricing benchmark, Khazanah sukuk

The International Shariah Research Academy for Islamic Finance (ISRA) in Malaysia is planning to release a study on a proposed Islamic benchmark pricing rate in 2011. The proposal received criticism about the practicality of having two different pricing benchmarks within Malaysia. The criticism has merits and the development of a separate Islamic yield curve would provide limited benefit compared to other areas that the effort required could be directed towards like strengthening Islamic financial institutions' liquidity management. However, if Islamic financial products move beyond replication of conventional financial products and take on different risk characteristics than conventional products, a separate pricing benchmark could be useful for new issuers because the pricing would reflect the balance between supply and demand for Islamic financial products in the secondary markets.

Malaysian state-owned Khazanah Holdings may issue S$500 million ($354 million) in sukuk to finance its purchase of Parkway Holdings, a hospital operator. The sukuk would be the largest issued in Singaporean dollars passing a S$200 million issue from the Islamic Development Bank.

Other News

• The final decision on Tamweel and Amlak, two troubled Dubai-based Islamic mortgage companies could come this month. It is reported that Dubai Islamic Bank is seeking to increase its share of Tamweel to over 50%. Tamweel's statement on its restructuring did not confirm or deny Dubai Islamic Bank's reported plans.
  
• Saturna Capital, the fund manager of the Amana Funds received a fund license in Malaysia.
  
• A credit union in the US is offering Islamic financial services.
  
• Gulf African Bank, one of the first Islamic banks in Kenya, reported a profit in the first quarter of 2010 and expects its first full-year profit this year.
  
• Pakistan hopes to double the share of Islamic banks in the country over the next 3 years, to 12% of total assets. For comparison, Malaysia is set to reach the 20% mark this year.
  
• An article discusses the idea that Dubai World attracted more attention than its overall impact in the financial markets and points out that the reason for the near-default was the financial and economic conditions as well as company-specific factors that were not related to Nakheel using a sukuk rather than a conventional bond to raise financing.
  
• Nakheel has begun paying contractors and may resume construction on some projects "within weeks".
  
• A Malaysian bai bithaman ajil (BBA) sukuk was placed on negative ratings watch. The BBA structure is used extensively in Malaysia, but not accepted in most other countries.
  
• The government of Kazakhstan is supporting Islamic finance in the country with the assistance of Abu Dhabi, whose government owned bank Al Hilal opened an Islamic bank in Kazakhstan.
  

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.
  

Sukuk in default, Amlak and Tamweel resolved?, Islamic law firm

Malaysian ratings agency RAM Ratings Service has a very detailed overview of how sukuk function in cases of default comparing both the asset-based and asset-backed sukuk, as well as the differences between the Gulf and Malaysia. In asset-based sukuk, the asset is used to structure the transaction, but is not actually transferred to investors. The sukuk investors therefore become unsecured creditors of the issuer through a purchase undertaking that compels the issuer to repurchase the assets in cases of default. In asset-backed sukuk, the assets are sold to the SPV used to structure the transaction and the investors have recourse to this asset, which the sale to the SPV protects from the claims of the issuer's other creditors.

The problems at Amlak and Tamweel, two Dubai-based Islamic finance companies could be close to a resolution that sees them merged together into an Islamic bank that is partially government-owned. The two companies have not been providing any financing as their fate has been determined largely by the government of Dubai and the United Arab Emirates. The resolution proposed in some way resembles the conservatorship that was the end result of Freddie Mac and Fannie Mae in the U.S. with partial government ownership of the combined companies that would support the two companies' debt load.

An article provides greater detail about the workings of a Shari'ah-compliant law firm. In a time when law firms along with their financial clients are tightening it is interesting that there is a law firm that is beginning with a self-imposed limitation on the types of clients it will accept.

Other News

• The Investment Dar announces that it has appointed a Chief Restructuring Officer following the Standstill Agreement with its creditors.
  
• DIFC and the World Bank's Multilateral Investment Guarantee Agency are working together to develop the GCC's bond and sukuk markets. A more detailed summary of the issue is available from Emirates Business 24-7.
  
• Malaysia continues to plan for a 20% market share for Islamic banking and takaful in 2010. The share for Islamic banks is currently about 17% and for takaful 7%.
  
• China could be the next large market for Islamic finance, although regulatory hurdles remain.
  
• The Islamic Bank of Britain is offering 2-year Islamic CD's yielding 4.5%, which will be fund the bank's Shari'ah-compliant financing. The bank recently revealed it had faced increases losses because of low interest rates that decreased the net interest margin on its financing activities.
  
• QFinance launched an online reference guide to finance, including Islamic finance.
  
• An Islamic cooperative bank has been opened in India. It marks another step on the slow development of the Islamic finance industry in India.
  
• Islamic banking has begun to grow in Kazakhstan eight months after it changed laws to accommodate the industry.
  
• The most recent issue of sukuk al-salam from the Central Bank of Bahrain were 100% oversubscribed with BD12m in subscriptions for the the BD6m issued.
  
• Dow Jones has released the performance for September of its Islamic indices.
  
• In an interview, the CEO of Hilal Bank is asked about the need for central regulation of Shari'ah-compliance, as well as the fallout from the credit crisis and the potential conflict of interest caused by Shari'ah boards being employed by the institutions they oversee.
  
• Abu Dhabi's Tourism Development and Investment Company issued a $1.45 billion sukuk al-ijara that will have a AA rating from S&P.
  

Weekend Update

• Islamic bank PT Bank Rakyat Indonesia Syariah (BRI Syariah) expects its assets to double to 3 trillion rupiah ($297.6 million). In 2008, the share of assets held by Islamic banks was 2% of total assets which is expected to increase to 3 percent in 2009.
  
• Following legal changes earlier this year, Kazakhstan expects to see three or four Islamic banks open this year according to central bank head Grigory Marchenko.
  
• Bahrain-based Gulf Finance House plans to continue its planned investments in North Africa despite the economic crisis.
  
• Following supportive comments from the Australian government, National Australian Bank plans to offer Islamic financial products on a trial basis.
  
• Al Salam Bank-Bahrain is investing in a building in London's financial district.
  

IDB working to introduce Islamic finance to Central Asia

The Islamic Development Bank is working with the Central Asian member states (Kazakhstan, Kyrgyzstan, Turkmenistan, Uzbekistan and Tajikistan) of the Organization of the Islamic Conference (OIC) to bring Islamic finance to these countries. Until now, there has been little if any access to Islamic financial services in these countries.

Khazakhstan, Ratings for takaful and the IDB and book review

Emirates Bank and Bank TuranAlem, the second largest bank in Kazakhstan, are moving forward towards opening an Islamic bank in the country. The process started back in May when the two firms signed a Memorandum of Understanding

Moody's , the ratings company, explained how takaful companies are rated. The report, "Moody's Approach to Analysing Takaful Companies" discusses the significant differences takaful companies have compared with conventional insurers and mutual insurers.

A review of a new book on Islamic Banking: "Islamic Banking, Finance and Insurance: A Global Overview," by Saluhuddin Ahmed.

The Islamic Development Bank received an Aaa/Prime-1 issuer rating from Moody's in its recent annual report.

IFSB Summit in Dubai

The UAE central bank governor Sultan bin Naser Al Suwaidi, speaking at the opening session of the Islamic Financial Services Board (IFSB) Summit in Dubai. In addition to finding more Shari'ah-compliant financial instruments to manage Islamic bank's short-term liquidity managment, he also urged Islamic banks "to find a more transparent way to differentiate between the dividend paid to shareholders and investors (or depositors)". He also reiterated the common call for more harmonization of Shari'ah boards' opinions on Islamic banking and financial products.

• The IFSB press release on the conference is available from the IFSB website.

Shaikh Hamdan Bin Rashid Al Maktoum, deputy ruler of Dubai and Minister of Finance and Industry, said he believes the market demand for Islamic financial services will set the number of Islamic banks. While Tamweel and Amlak Finance have applications for approval to enter the Islamic banking market, the UAE central bank has said it will not issue any more licenses in the near term.

The Secretary General of the IFSB, Rifaat Ahmed Abdul Karim noted that:

"Institutions offering Islamic financial services are growing fast and are emerging as an integral part of the international financial system. Thus it is important to have a coordination of supervisory efforts in banking, the securities market and insurance to safeguard the stability of the global financial system."

This sentiment was supported the governor of the Central Bank of Bahrain

Al Salam Bank Bahrain officially opened its regional hub in Bahrain today.

Qatar Islamic Bank plans to open an Islamic bank in the U.K.

President Gayoom of the Maldives discussed the possibility of an Islamic bank in the country with the Islamic Development Bank

Another article about Islamic banking coming to Kazakhstan

U.K. Islamic bonds, Islamic banking in Kazakhstan, Malaysia and the GCC

Financial Times writer Farhan Bokhari editorializes on the benefit of a U.K. government sukuk. He argues:

"Muslim investors could use their newly found presence in a country such as Britain to promote the concept of Islamic finance to a more global audience. In spite of its spectacular growth, the concept remains misunderstood in many circles. Developing partnerships with academic institutions and mainstream professional bodies to promote sukuk and other Islamic finance concepts would help to address this lack of understanding."

This goal of creating understanding of Islamic finance is one of the primary goals of the Institute of Halal Investing.

There are a couple more details about the expansion of Islamic banking into Kazakhstan.

The second finance minister of Malaysia says that Bahrain, Qatar and the U.A.E. want to learn from Malaysia in implementing such a banking system.

Shari'ah Capital, an Islamic hedge fund, received a license to operate on the Dubai International Financial Centre (DIFC).

A conference will be held in Colombo, Sri Lanka on the "Fundamentals of Islamic Banking & Finance".

• This conference has been added to the IHI conference listing page.

IsDB Poverty Reduction Fund, Kazakh Islamic banking

IsDB to launch $10 billion Poverty Reduction Fund

The Islamic Development Bank will launch the Poverty Reduction Fund at the annual meeting of the board of governors of the IsDB in Dakar, Senegal on May 29-30, 2007.

• This conference is listed on the IHI conference listing page.

Emirates Islamic Bank to enter Kazakhstan

Emirates Islamic Bank, a subsidiary of Dubai-based Emirates Banking Group will cooperate with JSC Bank TuranAlem in developing Islamic financial products for the Kazakh market. Kazakhstan estimates that Islamic banking could make up 5 to 7 percent of the country's banking market. Kazakhstan is 47% Muslim.

Other News

Gulf Daily News: "Central Bank of Bahrain Governor Rasheed Al Maraj yesterday received a Philippines Central Bank delegation led by Corazon J Guerrero and briefed them on Bahrain's control mechanisms and Islamic banking supervisory procedures."

Arabian Business: "Al Seyassah, Kuwait: Islamic lender Kuwait Finance House plans to set up a unit in Algeria."

Khaleej Times: "Dubai-based Islamic mortgage lender Tamweel TAML.DU said on Tuesday its first-quarter net profit surged almost five-fold as its home loan business grew."

The Edge Daily: "ING Funds Bhd expects a 10% to 12% annualised average return from its newly launched fund, the ING Baraka Capital Protected, which provides investors with 100% capital protection and potential capital appreciation over a three-year period.">

A U.K. Regional Development Agency will offer £2 million of loans for small business and not-for-profit social enterprises to be matched by private funding. The fund will include Shari'ah-compliant funding for businesses in the Manchester area.