Islamic finance complexity (Part IIf)

One of the ideas of Islamic banking that is most often repeated is that the Islamic banking system is based on profit-and-loss sharing products.  However, the theory and practice diverge significantly on this at least on the asset side of the balance sheet.  The liability side (e.g. deposits and equity) are done more along the lines of the theoretical model of mudaraba.  However, a recent working paper published by the IMF (pdf) found that the profit-and-loss sharing of Islamic banks did not translate into a significant difference in the profit rates paid on deposits.  

The study examined Malaysia and Turkey from 1997 to 2010, which included 2 crises (1997/98 for Malaysia, 2000/01 for Turkey, and 2008/09 for both).  This should provide some evidence that Islamic banks operate differently from conventional banks by not focusing exclusively on a smoother period, or a crisis period.  However, the results of the econometric tests showed that the deposit rates on Islamic and conventional deposits moved together and tests for causality showed a significant causality from conventional deposit rates to Islamic deposit rates, but did not find evidence of causality in the other direction.  The data used in the study were for 1-year deposits, although the authors indicate that tests using 1-month and 3-month deposit rates gave similar results. 

The authors of the study do not test to see why this relationship exists, but they do hypothesize on a few possible explanations.  One is that Islamic banks have to compete for deposits with conventional banks and therefore have to pay depositors competitive returns on their money in order to attract deposits.  This is accomplished in most Islamic banks by using Profit Equalization Reserve accounts that allow the bank to save up excess profits to cover shortfalls from the market rate of deposit interest/profits. 

Another explanation is that the profitability of an Islamic bank is determined, in large part, by the assets on its balance sheets.  Given that the products used by most Islamic banks are debt-based products like murabaha, ijara, and istisna’a, which generate returns that are benchmarked to LIBOR or another conventional interest rate benchmark, the profitability of the bank will be in large part based on interest rate movements.  

This explanation does make sense, but is less obvious an explanation because, while deposit rates do move in line with other interest rates, like LIBOR, there is not necessarily an automatic relationship between one and the other.  If the changes in Islamic bank deposit rates were driven by changes in rates on assets (e.g. LIBOR), the causality flowing from conventional  bank deposit interest rates to Islamic bank deposit profit rates would probably not be there.  Islamic banks as they work today should not have significant differences in the breakdown of their assets compared with conventional banks, so the transmission of changes in LIBOR to changes in deposit profit rates should not occur with a lag compared with conventional banks (there should not be causality from conventional rates to Islamic rates on deposits).  

The evidence, at least from this one study looking at just two countries, suggests that the more probable explanation is that Islamic banks manage their deposit profit rates using Profit Equalization Reserve accounts to follow conventional deposit interest rates.  The reason for this is relatively simple: if they offer lower rates, they will have trouble attracting deposits.  Alternatively, if the rates are highly variable, with some period where Islamic deposit account returns are significantly higher than conventional deposit rates, but also periods of significant underperformance, it will also discourage depositors from moving to Islamic banks because depositors are not likely concerned with the average deposit rate over a period of time alone, but want this return to be of lower variability.  

What are the lessons from this?  First, Islamic banks are not independent of conventional banks and (based on the data in this study) compete directly with conventional banks.  Second, Islamic banks do not operate based solely on the theoretical construct of profit-and-loss sharing, even on their liability side.  As long as this relationship continues to hold--and there are valid consumer demands that Islamic banks must meet, and regulatory environments which make Islamic banks look like "banks"--the idea that Islamic banks are more resilient or even somehow unique in their response to economic changes should be dismissed.  There may be areas where they could be, but even on the side of the balance sheet where profit-and-loss sharing is at least theoretically entrenched, the data shows a strong relationship between Islamic banks and their conventional competitors.  

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

UFANA, Rusdhi Siddiqui on UK Islamic banking, inter-bank money markets, Indonesia sukuk

The Usury Free Association of North America (UFANA) held an event concurrent with the G-20 meetings in Toronto which was well covered in the local media. Investment Executive has an article. In addition, several speakers were interviewed by BNN: Shahzad Siddiqui (UFANA Executive Director), Guy David (Partner, Gowling Lafleur Henderson) and Stephen Ranzini (President & CEO, University Bank)

Rushdi Siddiqui provides what I think is the best analysis of the article that called Islamic banking in the UK a flop (although an article by Mushtak Parker in Arab News does also make some good points). I provided my analysis of the article in earlier blog posts and offered my oown suggestions in my latest newsletter (subscribe on the blog or email me at blake@sharingrisk.org). Rushdi Siddiqui, with his long and prominent experience in the Islamic finance industry, provides his usual clarity to the issue.

The need for interbank money markets for Islamic banks is put into context with a news story that almost one-third of all the UAE's central bank certificates of deposits are held by Islamic banks which cannot accept any return on the CDs because they pay interest. The central bank has been developing an Islamic CD to offer to Islamic banks. Out of the central bank's total outstanding CDs, AED20 billion (of AED68.5 billion) are held by Islamic banks. With such a substantial holding of non-interest bearing CDs, Islamic banks are missing an opportunity to generate a return on its capital, which is in part so large because they are not able to avail themselves of the liquidity facilities of the central bank because those are interest-based. The planned Islamic CDs would be based on murabaha (likely commodity murabaha) and, although an imperfect solution, would at least make an impact towards helping Islamic banks compete with conventional banks on price. In contrast to Islamic banks, the conventional banks holding CDs with the central bank earn interest (however meagre currently) on their capital. A great article in Arabian Business describes the situation, although it lists the deposits of Islamic banks at the UAE central bank at 19% (in contrast to the one-third in the previous article). It also points out the alternative to the additional capital held by many Islamic banks: hoping for the best. Instead of holding excess cash on the balance sheet, many Islamic banks may be maximizing their profitability at the expense of their stability by relying on short-term deposits to fund themselves while investing in longer-dated sukuk and other assets. Those institutions risk either a conventional run by depositors or a Lehman-style run by short-term investors who lose confidence in an institution.

A similar issue to the inter-bank money market is whether LIBOR should be replaced by an 'Islamic' metric. An article by Joseph DiVanna provides a good overview of the problem and some interesting potential solutions. However, in my opinion it is a waste of time. The Malaysian experience, where there is an Islamic and conventional yield curve determined by market forces from secondary market trading in debt instruments is largely similar. The difference in yields can be ascribed to the tax incentives provided by the Malaysian government for Islamic instruments. Pricing using LIBOR may be one more similarity to conventional finance that needs to be explained when it arises, but the cost of capital has much more to do with a specific company or market than it does with an Islamic versus conventional structure. When there are sukuk or other Islamic finance debt products that do not behave identically to debt, then the issue may need to be revisted. However, until then, there are more pressing problems like Islamic inter-bank money markets to be dealt with.

Indonesia's problems attracting investors to its sovereign sukuk continue as it rejected all bids for its latest $111 million sukuk offering. The total bids were only 474 billion rupiah compared with the target for 1 trillion rupiah in sukuk. The Reuters article that describes the failed auction correctly points out that previous failed auctions have been the result of investors demanding higher yields than for comparable maturity conventional bonds due to the lack of liquidity in the secondary market for sukuk compared to conventional debt. There is now 24.5 trillion rupiah in sukuk outstanding compared to 590 trillion rupiah in conventional bonds. The most recent failed auction may be somewhat disturbing because it failed to attract the planned issuance (although only one data point). This may suggest that investors are concerned that a viable secondary market may not develop in the sukuk where in the past investors only wanted a higher yield to offset this possibility. However, in the case of Indonesia, which has had success issuing conventional bonds, this should just serve as added impetus to develop its domestic sukuk secondary markets further, which a stronger Islamic banking sector could provide.

Other news

• Nakheel began to pay the cash portion due to trade creditors with the sukuk for the remaining balance coming later.
  
• Political concerns in Egypt, along with many fradulent companies in the 1980s that operated under the 'Islamic' label has slowed the growth in the country. Despite the headwinds, many GCC Islamic banks are eyeing Egypt as a possible growth area.
  
• Malaysia's banking system is now 19.6% Islamic with MYR303 billion ($93.6 billion) in assets.
  
• Gulf Finance House continues to work to extend the maturities of its debts after it ran into trouble following the financial crisis. The latest is a $100 million murabaha due in August.
  
• Malaysia may see a number of its cooperative banks convert to be Shari'ah-compliant.
  
• There was an article about the Northern New Jersey credit union that became the first credit union that I know of to to offer Islamic finance products.
  
• Kuwait Finance House was removed from CreditWatch Negative by S&P but with a negative outlook that reflects its "weakening asset quality" but with greater likelyhood of "extraordinary support" from the Kuwait government. A greater likelihood of government support amid weakening asset quality is not great news following the dismissal of a ratings agency that considered downgrading KFH Malaysia.
  
• Dow Jones offers its latest monthly commentary on the Dow Jones Islamic Market Indexes.
  
• The latest updated list from Bloomberg of upcoming sukuk issues.
  
• Some estimates target growth in the Islamic finance industry to $2 trillion in the next 3-5 years. By the most optimistic estimates, Islamic finance is currently nearing the $1 trillion mark.
  
• CIMB Islamic head Badlisyah Abdul Ghani says that Malaysia has developed Islamic alternatives to more products because of its' "effective product-development approval process". There has also been more government support for Islamic finance, a greater take-up by the non-Muslim population and also the benefit of a centralized Shari'ah board, which also has its own costs. CIMB recently lost its top spot as top underwriter of sukuk to HSBC, which either reflects a growing share taken by the banking giants or further globalization of Islamic finance based on HSBC's greater geographical reach.
  
• Among other things, the Islamic Development Bank expanded its capital from ID16 billion to ID18 billion. 1ID (Islamic Dinar) is equal to one Special Drawing Right (SDR) of the IMF.
  
• Reliance Capital is launching two Islamic funds in Malaysia by July and unveil other products at a later date. It is a sign of the underdevelopment of the Islamic finance market in India that the company has avoided its home market for Malaysia.
  
• Kenyan firm ApexAfrica Capital is considering expansion into Islamic investments.
  
• OSK-UOB Islamic Fund Management Bhd plans to launch equity-based ASEAN-centril Islamic financial products.
  
• Sri Lankan firm LB Finance is launching an Islamic unit.