SME financing is much more than money

I have not published anything here for quite a while, because all my effort is working in the Thomson Reuters Islamic Finance Gateway community and it will continue, so you should sign up for the newsletter at http://online.thomsonreuters.com/ifg/.  This is just as a teaser since I am just returned from Dubai and got the week off from the Weekly Briefing, so be sure to sign up there for when I return to my writing there. 

One of the key areas in the Global Islamic Economy Summit was the SME sector (it was one of the 7 pillars established for the Islamic Economy).  There is significant potential in that sector that has not been developed, particularly in the GCC, but also in the wider OIC (and there are some gaps too beyond the OIC in the developed world as well).  The UAE central bank governor speaking earlier this week mentioned the sector with an interesting comment:

"We are looking at various options to provide credit to this key segment of the economy outside the banking system. SME financing is very important in job creation and we need to pay special attention to this segment"

This is a clear indication that the banking system has failed to manage the SME sector's demands and it is understandable given their focus on size to mobilize the deposits they attract.  Ever growing deposits have to find a home and it is more cost-effective to put them to work in larger projects.  However, as the analysis I did in the Weekly a couple weeks ago showed, the conventional side of the banking system in the UAE is now dangerously over leveraged to the government-related entities and the new UAE central bank directive will force them to divest in GREs for risk purposes.  The Islamic banks face less of an overconcentration, but are still quite leveraged towards the GREs.

This deleveraging is likely to not be accompanied by growth in financing for SMEs on either the conventional or Islamic sides, or else the governor could have pointed to one or the other as a source of financing for SMEs.

So, with the banking sector unable to service this sector, where should we look?  If you asked me a week ago, I would probably not had a good answer, but I was reminded of one source of services that does serve the SME sector well: payment processing.

I was not honestly rushing to see the country representative of Mastercard at the event, but he was one of the more illuminating as he explained the role that they play beyond debit and credit cards in small business development.  In an ever globalizing world, there is a lot more market there for small businesses besides the 10 miles around their shop, but if they can't get paid, there is not likely to be much development.  But it also doesn't necessarily provide much financing; it is much more payment processing activity.

For these companies to really provide a good boost to entrepreneurship in the UAE (or elsewhere) there will need to be a better bankruptcy law and more acceptance of business failure regionally to encourage more people to try it.  This was a consistent theme of this panel, but there is more.  The person (who I assume was not speaking on behalf of his employer at this point) explained that his wife was interested in starting a cupcake business.  He asked her "What's the PnL?" and got a blank stare back.

This is probably not an uncommon response for small business owners (if I weren't a finance guy, I would have probably given the same look when I started my business).  Banks always ask for the PnL and most small businesses can't provide it because they don't know how to make a business plan, let alone the pro forma financials that a bank would require.  There will be some leeway on this type of information (or at least more hand holding) from non-bank institutions, but the key for opening up finance for SMEs is helping on this aspect.

And that gets to the real issue: an SME is not a small business, nor an entrepreneur. SMEs have over a million dollars of turnover annually.  And they still cannot get bank financing.  What is needed is something outside the banking system that gives them financing and is available for the sub-SME level too.  And that will come with education needs that probably will also apply for SMEs.  It is much more than just finding money, it is about SME development.  If you can crack that nut, you will be much better than I at solving the issue of 60 million new jobs that the Arab world will need created by 2030.  The important thing now is that there are policymakers listening, waiting for help finding the answer, as fast as possible please.

Limiting property market speculation without disadvantaging Islamic banks

Now that the Dubai property market bubble and bust is largely in the rear view mirror, there have been institutional changes to limit the prospects of a bubble from reoccurring.  These include banks increasing their review process, increased government regulation of the share of assets any bank can have exposure to and also a thus-far mooted effort to limit the maximum loan-to-value limits for real estate. 

In a recent interview, Faisal Aqil, deputy CEO of Emirates Islamic Bank said bluntly that a short-term profit tax was required in order to curb excessive speculation in the property markets.  This isn’t the first such call to use taxes to quell speculation in markets, but his position in an Islamic banks raises the question of why there hasn’t been more of a call from Islamic bankers to limit speculative activity in property markets, because they are supposed to avoid financing speculative investments like short-term ‘flipping’ of property. 

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Dubai wants to be trading center for sukuk

Dubai aims to become the trading center for Islamic finance, focusing first on banking and sukuk.  There are a number of reasons why Dubai is well positioned for this role in a recent Reuters article, as well as some reasons why it faces an uphill struggle.  

One reason (and the most difficult to change if it were a disadvantage) is the physical location of Dubai.  The article notes: “Located at the centre of the Gulf, it is the main transit point for air traffic between Europe, Asia and Africa and is a more international city than most of the other centres. “  This is more important than it probably gets credit for.  Not only is it more international than many other cities in the GCC (which makes it more attractive for foreign banks sending their staff to work), it is situated in a favorable location geographically relative to the other big financial centers.  It is four hours ahead of London (three of Western  Europe) and four hours behind Hong Kong (five behind Tokyo).  

With the exception of New York, its business hours overlap with all of the world’s major financial centers.  This financial centers important in Islamic finance outside of the GCC (London, Luxembourg, Kuala Lumpur, Singapore and Hong Kong).  This is important particularly in Dubai’s aspiration to become a center for sukuk listing and trading.  Of the five recent sukuk issuance that published data on the source of investors geographically (ADIB, QIIB, QIB, Emaar and EIB), on average 28% of the investors were Asian and 19% were European with the remainder from the Middle East (US and UK investors only represented a marginal share). 

However, Dubai has not had success attracting listings from many sukuk following the debt crisis which has been put in the rear view mirror by many investors, but which has not entirely been resolved.  As a result, there are currently only five sukuk listed on the Dubai Financial Market (DFM).  There are issuers that have equity listed on the DFM who have issued sukuk, although the sukuk were not listed on the DFM.  Paul McViety, legal director at DLA Piper is quoted in the article explaining that “the majority of issuance has gone through European exchanges".

The article describes further how “Several United Arab Emirates-based firms have listed their shares in Dubai but gone to the London Stock Exchange to list their sukuk because of London's superior reputation for liquidity and regulation.”  The second factor—regulation—that may make Dubai’s task harder, particularly for investors who are limited in the amount of their portfolio that can be invested in sukuk not listed on a European exchange.  There is an easy solution for this—a dual listing on both DFM and the DFM—but it adds cost and, in the absence of an advantage in terms of liquidity for the DFM, many issuers will instead choose to list only on a European exchange (most commonly the Irish SE, London SE or Luxembourg SE).

The regulatory clarity for investors is also an issue, but for issuers in the GCC region, the choice of listing exchange probably has little marginal impact if the assets-backing the sukuk (if it is an asset-backed sukuk) are located in the GCC.  These types of sukuk will, for the time being, be viewed as having significant legal risk because if the issuer defaults on the sukuk, investors will have difficulty taking possession of the underlying assets located in GCC countries.

In this area, Dubai could provide something that would benefit investors that would be harder for a competing financial center like London or Luxembourg: an arbitration system that takes into account the Shari’ah-compliance factor.  Malaysia has already put in place the rules for an Islamic arbitration system for financial products, which puts it a few steps ahead of Dubai.  However, the Malaysian arbitration system is based on Shari’ah standards developed by one of the two national Shariah Advisory Councils in Malaysia, and may allow some interpretations of Shari’ah that GCC-based investors object to.  It does have an exception for another Shari’ah specialist, but that requires mutual agreement of the parties in the dispute.

This flexibility (for example, allowing bay’ al-ina and transactions like bai bithamin ajil that are based on it) does not hamper the market in terms of attracting issuers to list because more conservatively based structures are still permissible, but there are not rules that would limit less widely accepted structures (like BBA).  In terms of providing a transparent arbitration standard in terms of what is viewed as Shari’ah-compliant, development of more GCC-focused Shari’ah standards by Dubai may create additional clarity in more conservative Shari’ah standards that could become the base for a competing arbitration system for Islamic financial products.  

DFM is developing sukuk standards (currently in draft form [PDF]) that cover both listing and trading, which are described in the article  as being “more detailed than other centres' standards, potentially resolving some of the controversies and giving traders and investors more certainty.”  Whether these new standards becomes accepted within the market, and whether an arbitration system that incorporates these standards is developed will likely be key in determining the ability of Dubai to attract both listings and greater trading volume in sukuk. 

Dana Gas restructures sukuk

Dana Gas released the final terms on its restructuring of the $1 billion sukuk that matured on October 31st, and they were within the terms expected.  The $1 billion sukuk (of which $80 million was bought back, and will be cancelled) had $70 million in cash paid to sukuk holders with the remainder split between a convertible and non-convertible sukuk, with an average coupon of 8%, due in 5 years.  This is not much higher than the 7.5% coupon the original sukuk had, but the conversion price which is not fixed as I understand it, but will come in at between Dh0.75 and 1.00 (the stock is currently trading in the low Dh0.40 range).

Using a back of the envelope calculation with a 20% discount rate, that amounts to about a 30% haircut in present value terms for sukuk holders (excluding the value of the conversion feature for the convertible tranche of the sukuk), which is probably a good deal for sukuk holders if the company can collect on its receivables from Egypt and Iraq (a small portion of which from the latter were received by Dana Gas shortly before the restructuring agreement was made public). 

Sukuk holders could have enforced the guarantee on the assets that were put up to secure the sukuk which amounted to the company's assets in Egypt (the company asserted that these gas concessions could be cancelled if sukuk holders enforced on the collateral) and a built but not yet operational natural gas import terminal and processing plant in Sharjah.  The latter asset was probably not of much value since it would be time consuming and costly to go through the UAE court system (not to mention not guaranteed to be successful) to take possession of the asset.  Not to mention that it has been entangled in a dispute with Iran's national oil company over the agreement to import gas .

There are likely other terms included in the final restructuring agreement that are not yet known, which may include rights (just speculating here) to Dana Gas' 3% interest in MOL, the Hungarian company with which it is operating its assets in Kurdistan, which were not a part of the collateral of the original sukuk (or perhaps a covenant that Dana Gas cannot sell that asset without using a portion of the proceeds to repay creditors).  But that is just a guess on my part and I don't have any information about whether it was included (if you know, please email me).

The bigger story here is that there is now precedent set for a restructuring of a UAE-based private sector sukuk.  That doesn't carry any weight in the local court system, but it might for future cases where a private sector corporate sukuk issuer runs into trouble.  There is now at least one situation that can be used as a point of reference. 

The legal environment in the UAE and the limitations on foreign ownership, not to mention the lack of a bankruptcy regime will continue to introduce uncertainty for creditors (even where the sukuk is subject to English law, since English law judgments are not enforceable in the UAE).  However, the bankruptcy law being developed has continued to face delays.  That is not necessarily problematic if the delays are done in a way that produces something something that is able to translate from law to practice.  One can only hope that the delays are due to a desire to 'get it right' and not just dragging of feet or bureaucratic intertia that favors the status quo. 

Whither Islamic finance dispute resolution?

The issue of how to resolve disputes in Islamic finance is complicated.  Currently, the most common way is to make most large Islamic finance products subject to English law (or more rarely New York law) to capitalize on those regions' long history in finance and strong legal systems.  The legal systems in many countries where Islamic finance is prevalent are not viewed as sufficiently predictable should a dispute, insolvency or restructuring happen.  I addressed the issue in my last newsletter (sign up on the right side of my blog) with respects to new laws being considered in the UAE to develop a new insolvency and restructuring regime that will be Shari'ah-compliant. 

The issue of Shari'ah-compliance particularly in insolvency and restructurings, but also in commercial dispute is important for Islamic finance.  When using English and New York law, the need for certainty outweighs Shari'ah considerations (and those can be considered, but only consensually; these courts will not consider Shari'ah in their decisions, nor should they be expected to being a part of secular legal systems).  However, for Islamic financial institutions, there will come a day when the consensual system of finding solutions that are Shari'ah-compliant will not be sufficient and there will be disputes that involve important issues of Islamic jurisprudence at the heart of the contracts, and a secular legal system will not be able to handle it. 

The UAE route of changing their laws to put in place a system that is both based on well established legal systems but also tailored to the needs of that country (including incorporating Shari'ah).  An alternative is being considered in Qatar through the Qatar International Court and Dispute Resolution Centre (QICDRC), which would operate within Qatar but with a more global focus.  Both systems would be a welcome change from the situation today where Shari'ah disputes that are part of conflicts between parties or are involved within insolvency and restructuring situations cannot be directly addressed.  It will undoubtedly be a long time before any new system through either the QICDRC or the new UAE laws will develop the credibility and predictability required to challenge London or New York as the legal homes for cross-border products, but to get to that point requires a first step, which the UAE and Qatar appear to be taking. 

Would national Shari'ah boards help Islamic finance?

According to Saif al-Samshi, the assistant governor for monetary policy and financial stability is that the "Despite the advanced state of the UAE in issuing Islamic sukuk, we believe that we still need to do more [including] finding a unified body for the main fatwas (decrees) in the Islamic financial services domain, as is the case in Malaysia".

Anyone who reads my blog with regularity over the past several years, will probably remember times where I have expressed support for national Shari'ah boards, and other times when I have questioned whether the establishment of national boards would limit the potential of the industry to innovate beyond the current state of replicating conventional products.  So, to start the discussion, I will admit to not holding a consistent view on the issue because there are many different factors that would lead a national Shari'ah board to be successful or unsuccessful in providing consistency in Shari'ah rulings, with enough leeway for institutions to develop new products.

However, the question remains about whether developing a national Shari'ah board for the UAE to complement those that exist in Indonesia and Malaysia, with potentially more national Shari'ah boards popping up across the GCC, South Asia and Africa.  On the once hand, national Shari'ah boards could provide clearer guidance on what the base Shari'ah standards are for individual countries, which would provide some certainty to institutions considering whether to launch cross-border services or products.  But it would also risk crystallizing the status quo, and dividing the industry and limiting the ability of successful products to be adopted more widely, because they would likely have to be reviewed by the national Shari'ah board of every country, something which is unlikely to be as rapid as it could be if the Shari'ah-compliance decision were left to each institution (and its customers). 

A recent article on the difficulties of introducing more arbitration proceedings in the place of court hearings to adjudicate disagreements in Islamic finance contracts leans to some regard in favor of greater centralization of Shari'ah standards.  One difficulty, which the article convincingly argues could limit the use of arbitrations in Islamic finance, is that the Shari'ah standards applicable in the Islamic finance industry are determined more by individual Shari'ah boards, and not based on an industry-wide, or even country-wide set of standards.  From this perspective, the establishment of national Shari'ah board could set the ground rules (on Shari'ah issues) for an arbitration panel and in cross-border deals, the contracts could specify then a certain national set of Shari'ah rules in case of disputes. 

Perhaps a more specific plan for a national Shari'ah board in the UAE would give me more conviction on whether it would likely be a positive or negative development for the Islamic finance institution, because today I remain as conflicted as I was before on the issue.

What could go wrong?

When I saw the headline "Emirates Islamic offers 100% financing for UAE homes", I thought I had traveled back in time to a bygone era (specifically 6-10 years ago in the United States).  I looked at the date on the article, April 14, 2012, and it surprised me that an Islamic bank would have stumbled upon a product that had so recently led to havoc in the conventional financial markets.  Sure, the US housing boom was fueled by other factors (securitization and re-securitization of mortgages into complex securities), but one of the reasons the problem spread into the real economy was that a fall in home prices pushed many homeowners into a position of negative equity (owing more on their homes than it was worth). 

The way that Islamic home finance works today would not insulate an Islamic bank offering this type of product from problems down the road, and since the product offered here is only for 5 years, it creates a potential refinancing risk, since most people cannot afford to pay for a house in just 5 years.  A 5 year loan requires that either refinancing will be a available five years from now, or a rise in home prices (and thus a buyer expects to sell within 5 years).   Both assume that the home will either remain the same price or increase, which the financial crisis and recession following it has demonstrated is a dangerous assumption. 

The difference between a 100% financing product and an 80% financing (e.g. 20% down payment) is that the former incentivizes greater speculation on home price rises because it doesn't require they buyer to have 'skin in the game'.  The incentive problem is made more complicated by the potential for buyers who default to be threatened with arrest. However, while this might limit the number of defaulters (in an non-optimal way), the incentive problem remains.  It is a frequent refrain that Islamic finance was spared some damage during the credit because it is different from conventional finance, but if Islamic banks start moving into the same types of products that caused problems in the financial crisis, will this hold true in the future, or are we on the road to Islamic CDOs?

Islamic finance complexity (Part IIg)

I have covered the structure of the liabilities section of the Islamic bank's balance sheet in earlier posts, and I plan to return to the liabilities in the context of its interaction with the income statement and the maturity mismatch that is a function of banking.  However, that is best done with reference to the asset side of a bank's balance sheet because the income statement deals both with the income earned on assets and the costs of funding the assets.  Therefore, I am going to move onto the asset side to describe the 'stocks' of the asset (the maturity mismatch and the income/expense are included in the 'flows' arising from the 'stocks' of assets and liabilities).

Before going into the asset side of the balance sheet, I want to reiterate that this whole Islamic finance complexity series (maybe I should have come up with a better title for the series) of blog posts is a thought exercise to come up with interesting areas of how Islamic finacne works that are not always part of the day-to-day discussion of how Islamic finance works in practice.  Most of what is out there is either new products offered by Islamic finance institutions, the financial results of their activities or theoretical discussions of how Islamic finance should operate, or why it is 'superior' to conventional finance.  There is definitely a place for new developments and discussions of how the industry should operate, but I have found that the latter is done in generalities (including within a lot of my own writing).

Apologies in advance if my in depth discussion becomes dull or is too simplistic, but I think that if a discussion of the Islamic finance industry (and an analysis of how it has diverged from what it is 'supposed to be') is to be undertaken in a comprehensive way, it has to be a bit dull at points and include a simplistic analysis of the data that is put out about Islamic banks, which are largely contained in financial statements.  However, I hope that there is some value in the insights that come out of this analysis.  As always, I welcome comments on the blog posts or by email at blake@sharingrisk.org.

Moving into the balance sheet, there are a number of categories of assets held by Islamic banks and for a sampling, I delved into the balance sheet of a large UAE-based Islamic bank to provide a set of assets to go through.  It's not important which Islamic bank was selected, because the focus should be on the types of the assets on the balance sheet.

The assets can be divided into a few categories:

• Cash
• Inter-bank lending
• Islamic financing and investment
• Investments
• Receivables
• Property, plant & equipment
• Goodwill

Cash

Islamic banks, like all other financial institutions want to have a liquid supply of cash available to meet depositor withdrawals, payments to their vendors, money held with their central bank to meet reserve accounts, and any other needs that arise in the course of their business.  One thing that I have seen repeated widely (including in my blog) is that banks hold higher cash balances than conventional banks.  As a rough test of this idea, I compared the Islamic bank with one in the US that has similar total assets (I picked the US bank because it was easier for me to find a bank with comparable assets in the US).  

The US bank had 2.7% of its assets in cash (either in non-interest-bearing or interest-bearing instruments) while the Islamic bank held 6.4% of its assets in cash.  I accept that this is a highly unscientific analysis, but with a cash-to-assets ratio of the Islamic bank more than twice the conventional US bank, it seems probably that Islamic banks do hold more cash than conventional banks. 

The problem for Islamic banks when dealing with their cash balances is that it is harder for them to make a return on the balances sufficient to offset the cost associated with their funding and so higher cash balances should all other things equal lower the return on the bank's assets.  A mitigating factor is that the Islamic bank was able to place a large proportion of its cash balances in profit-paying instruments with the central bank (the UAE has an Islamic CD available starting in 2010 for Islamic banks in the country).  However, the remainder is either cash on hand, held in a current account at the central bank or held against the bank's reserve requirement with the central bank.  

The Islamic CD offered by the UAE Central Bank was significant for the bank I looked at.  Between the end of 2009 and the end of 2010 (i.e. before and after the Islamic CDs were offered), almost all of the drop in cash on hand and current account deposits with the Central Bank were offset by deposits in the Islamic CD (representing about 30% of the total cash balances of the bank).  Banks are responding to the opportunity to place funds with the central bank and generate a return on these assets, even if it is low.

I will return to the Islamic bank's assets in a future post.  See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

Islamic finance complexity (Part IIe)

After thinking a lot about how products are structured, I am moving onto some real-world breakdown in the actual balance sheet balances of some Islamic banks to translate the ideas of how they design their products into how they are actually represented in terms of the bank's liquidity profile.  To do so, I picked one country (the UAE) to limit the differences between banks caused by different countries, different regulatory environments, etc, and focused just on the "Liabilities" items in the balance sheet at one point in time (December 31, 2010 for all except for Ajman Bank, which only had annual financial statements through the end of 2009).

The liabilities section is, in rough form, broken into three categories of liabilities: deposits, inter-bank borrowings and other liabilities (e.g. longer term liabilities like sukuk).  In general, deposits made up the vast majority of the Islamic banks' liabilities that I looked at, ranging from 76% to 85%.  Within the deposits, there were a few main types (current accounts, savings accounts and investment accounts).  Most of the banks had just one type of investment account, which I am guessing is almost universally mudaraba-based profit-sharing accounts.  Two banks (Al Hilal Bank and Emirates Islamic Bank) which had another category of deposits, wakala.  The banks in general used "investment accounts" as their primary funding source, representing around 60% of total liabilities (three-quarters of the deposits), although this wasn't universal.

The real difference between the banks (only two banks offered this detailed breakdown, unfortunately) came with the maturity of the deposits.  Dubai Islamic Bank had more (about two-thirds) of deposits in short-maturity or demand deposits, while Al Hilal Bank had more mid-range (3-6 month) deposits (about one-half) compared with the remainder split between longer-term (>1 year) and short-term funding (<3 months).  The split between short- and longer-term deposits is more of a business decision, than it is something that goes to the heart of how Islamic banking differentiates itself .

However, with the limitations on Islamic deposit insurance, the maturity of deposits can be a factor in how resilient an Islamic bank is to future banking system problems (longer maturity giving more protection against runs on the bank becoming destabilizing). The offsetting factor (for the bank) is that longer-term deposits are more expensive than short-term deposits, and that will be true whether the bank is Islamic or not because in practice, deposit accounts are not entirely pass-through, and also must offer rates of return that are competitive with conventional banks.

The other two areas of liabilities on Islamic banks' balance sheets varied bank to bank to fill the remaining 15-25% of the liabilities with some having more in inter-bank financing while others had longer-term liabilities like sukuk or the Central Bank wakala financing that was provided to banks during the Dubai debt crisis.  However, in general, the larger the bank the less reliant on inter-bank financing, although the three largest banks (DIB, ADIB and Emirates Islamic Bank) all had wakala financing from the UAE Central Bank, which skews the relative shares.

Removing the wakala financing from the Central Bank (assuming it was replaced with inter-bank financing) removes the previous relationship between longer- and shorter-term other (non-deposit) liabilities between larger and smaller banks (the smaller banks being Sharjah Islamic Bank, Al Hilal Bank and Ajman Bank; Noor Islamic Bank does not put financial statements on its website).  The ratio of short term to the sum of short- and long-term non-deposit liabilities is the metric I looked at (moving wakala financing from long- to short-term) ranged from a low of 29% to a high of 87%.

The sample I chose was purposefully non-representative to try and limit the fluctuations due to country-specific factors, but a few trends emerge.  First, most banks have deposits as the largest source of their funding, which is probably good because it is lower cost than sukuk and less volatile than inter-bank financing.  The one exception to the stability of bank deposits is in a banking crisis and the UAE Central Bank did what central banks are supposed to do in a crisis: they lent freely on more costly terms than they normally would (the wakala is convertible into equity).

In the non-deposit liabilities, the wide range of splits between inter-bank financing (short-term) and longer-term financing like sukuk was mostly explained by the difference between banks that had sukuk outstanding and those that didn't.  The banks with sukuk outstanding had lower reliance on inter-bank financing than banks that did not issue sukuk.  This suggests that one way to mitigate the reliance of banks on short-term inter-bank financing is to further develop the sukuk market, especially finding structures that don't require physical assets, but can fund longer-term assets on the balance sheet with longer-term funding.

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

UAE sukuk market evolution

An article from the Business & Banking Review (via Zawya) describes the evolution of the UAE sukuk market.   One of the most interesting parts of the article (the whole thing is well worth a read) comes at the beginning:

In 2004, only three sukuks were issued in the UAE with an aggregate value of $1.165 billion. Two years later, the number of sukuk issues had increased to seven and the value grew eight-fold to $8.755 billion. The height of the sukuk market was certainly 2007 with eleven issues with a value of $10.8 billion.

What is interesting to me is not the growth (827% over four years), but the average size of the sukuk issued in the UAE, which grew from about $385 million in 2004 to $1.25 billion in 2006 and nearly $1 billion in 2007.  This size is significantly larger than many of the sukuk issued since the financial crisis (excluding some of the sovereign issues from Malaysia).

Many of these sukuk were for real estate-related projects, or for financial institutions which financed real estate investment.  While it is not unusual to see a large volume of sukuk (and conventional bonds) come from financial institutions and real estate companies, the large size of the projects in the UAE (particularly Dubai) were financing a real estate bubble, in many cases supported by the government (the issuers were often partly state-owned or quasi-government companies).

During the boom, these sukuk were snapped up quickly, as demand for nearly any sukuk overwhelming the supply, even in the mega sukuk (a significant amount came from the three Nakheel sukuk, $2.5 billion issued in 2006, $750 million in 2007 and $3.6 billion in 2008).  Now that the sukuk markets are recovering to some degree, the demand is still there, but it is not being met by mega-sukuk.  In many cases (for example, when GCC-based institutions have traveled to Malaysia to issue sukuk), the average size has shrunk significantly, although there are still a good share of "benchmark" sized sukuk.

This is not a bad thing for the market overall.  While a smaller issue may not generate the same secondary market liquidity (given the proclivity of many buyers to hold-to-maturity), they provide more diversity in issuers, currency, ratings, industry, etc.  This is positive because it provides more opportunities for sukuk investors to diversify, so long as they can get an allocation of new sukuk or find them in the secondary market, which is never a given.

Overall, however, I think the current situation is preferable because 1) there was little secondary market activity in the sukuk pre-crisis; 2) there were far too few diversification possibilities for investors away from real estate and related financial institutions; and, 3) the real estate on which the sukuk were based turned out to have been overvalued, leading to a near collapse of the primary market for sukuk.  Risks remain from a global economic slowdown and geographical diversification is still nearly impossible.  However, the market is on the right track.  Again, I would suggest reading the whole article because there is a lot more there. 

Int'l Islamic Liquidity Management Corp to issue $200 to $300 million product this year

Bernama released an article based on an interview with CEO Mahmoud AbuShamma of the International Islamic Liquidity Management Corporation (IILM), which was established in October 2010 (and launched at the beginning of 2011). The IILM was established to provide short-term sukuk to global Islamic financial institutions for use in their liquidity management. Currently most Islamic financial institutions hold excesses of cash and use inter-bank murabaha (mostly) to manage their liquidity needs. Some countries (e.g. Malaysia, Bahrain and the UAE) have set up their own local currency denominated short-term instruments and all have seen strong uptake. However, there has not been any short-term sukuk issued by any institutions that are denominated in the global reserve currencies like the US dollar and are backed by supranational institutions.

The IILM has been quite mum about its own product and it remains largely unspoken now, but there were a few new pieces included in the article. The IILM now is hoping ("if all the systems have been put in place and the infrastructure is ready and the market conditions are suitable for the issuance"--a lot of 'ifs') to issue the first short-term sukuk denominated in US dollars for $200-$300 million by year end 2011. After the inaugural issuance, further sukuk will be issued "when needed by the market" and the IILM will consider issuance in other (local) currencies "depending on the requirements of the market" according to Bernama. The local currencies would presumably be those currencies that are used in the countries whose central banks are members of the IILM: Indonesia, Iran, Kuwait, Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Saudi Arabia, Sudan, Turkey and the UAE.

While I describe the issuance as a "sukuk", the term is not used once in the entire article, instead describing it as "short-term liquidity products", which could mean the instruments will not be a tradable sukuk, but will instead be structured along the lines of other short-term products; Bahrain issues sukuk al-salam and sukuk al-ijara while the UAE Central Bank uses a commodity murabaha (as well as offering Islamic repo transactions using a commodity murabaha collateralized by the Islamic CDs that are themselves based on commodity murabaha).

There is still much work to be done and no certainty of issuance in 2011 given the careful hedging of the launch date by the IILM CEO (see the list of 'ifs' above). However, it is a step forward for the industry that this institution has come to form so quickly from its establishment (how long has an Islamic 'mega bank' been just over the horizon?) and the fact that the original idea for an institution similar to the IILM was "mooted by the Islamic Financial Services Board High Level Task Force" in the fall of 2008.

UAE central bank offering Islamic repo

The UAE central bank, which recently launched Islamic certificates of deposit to help Islamic banks manage their short-term excess liquidity needs is being expanded into a full repo (repurchase agreement) offering. I will discuss the structure in a little more depth (as much as I can based on the information now available), but the first point I find interesting is that it would be based on one model proposed in a paper by the International Isalmic Financial Market released last year, which I reviewed on my blog at the time it was released.

The structure that Reuters is reporting is being used is one based on murabaha. There is nothing new about commodity murabaha being used for liqudity management, but the repo product would use commodity murabaha with the central bank's Islamic CDs being offered by the bank as collateral for the loan. There are currently AED12 billion ($3.27 billion) in Islamic CDs held by Islamic banks in the UAE, giving a relatively large pool of assets for the repo transactions to use as collateral.

The need for a repo facility is clear for both central banks and Islamic banks, but the model that will be used is the most cynical possible outcome. When I read the IIFM report last year, I commented on the collateralized murabaha: "The addition of transfer of securities as collateral (without compensation) on top of the use of commodity murabaha would raise the most objections, I believe, on grounds that the product is cynical and does nothing to really help the industry develop new products." At that time, I saw the collateralized commodity murabaha as cynical because, although it tries to find a solution to a problem, it does so by further entrenching commodity murabaha into the Islamic financial industry.

The UAE repo facility goes one step further. Not only does it use the collateralized commodity murabaha between the Islamic banks and the central bank, it uses as collateral an Islamic CD which itself is based on commodity murabaha between the central bank and an Islamic bank. So, if an Islamic bank has surplus capital, it can loan it to the central bank by buying an Islamic CD, in which it buys a commodity and sells that commodity to the central bank and the central bank will repay the debt sometime within the next year (depending on the agreed upon maturity). However, if the Islamic bank needs liqudity before the CD matures, it can pledge that debt owed by the central bank to the central bank in exchange for a loan structured as a commodity murabaha.

If one takes this a step further and the central bank finds a way to have enable 'netting' of the commodity murabaha products, then it will have developed a way to trade debt (final payment for commodity murabaha represent a debt), which is mostly (outside of Malaysia at least) viewed as not permissible. As much as the short-term liquidity management tools are needed for Islamic banks (and for the central banks that want to engage in open market operations), creating a system where the central bank and Islamic banks are trading back and forth debts from commodity murabaha seems like the worst possible way to find a solution that has any lasting impact on the Islamic finance industry besides just solving the problem of the hour.

The UAE Central Bank has two PDFs describing:
-The Islamic CD; and,
-The collateralized commodity murabaha.