Sharing lessons between Islamic finance and ESG-based finance

There have been several interesting articles by Funds-at-Work about Islamic finance, which use a network analysis to highlight aspects of the industry that may not be as clear from other forms of analysis (I wrote a few blog posts about their analysis on Shari'ah scholars in 2010).

Their latest is a short article (PDF) that compares the factors used in conventional finance, Islamic finance and conventional finance with ESG (environmental, social and governance) consideration.  They find that there is very little overlap between finance incorporating ESG considerations and Islamic finance, specifically that both use a set of negative screens to exclude certain sectors, for which there is overlap between the two in terms of what is excluded. 

However, there is a much more robust set of other criteria for ESG-centered conventional finance, including positive screening (adding positive weights for best-of-class companies), active engagement with the companies in which they are invested including voting their proxy votes in line with the ESG criteria they use, as well as incorporating far more non-financial factors in their financing decisions. 

Islamic finance, as described in the report, focuses on negative screening, incorporating zakat and other forms of distributions to the needy, avoiding excessive debt, and linking to real assets.  I would put an asterisk on avoiding excessive debt and linking to real assets.  On the debt issue, most Islamic financial institutions do use less debt than some conventional financial institutions, but there are other Islamic financial institutions that employ significant leverage in their financing, so long as it can be structured to be Shari'ah-compliant. 

I put less of an asterisk on the point of linking products to real assets.  There are fewer products that build on other financial products (rather than serving as financing to another business directly), although the most talked about exception is commodity murabaha, which is used to synthesize as much as possible a conventional loan.  There are situations where that is appropriate (where there are no good alternatives) but there are others where it is probably applied in situations where another structure could function equally as well, but which is more connected with the financing of a specific activity (rather than creating an unsecured loan). 

The main point, however, is that there is much that ESG and Islamic finance can gain from greater appreciation of the goals of each.  For example, in almost every place where finance of any kind operates, there are members of society who are in need of assistance, and so perhaps companies that extend financing that includes ESG consideration can set aside a portion of their profits for specific financial assistance within the communities they operate (and many probably already do, but maybe not with as much connection between the level of profit and the level of giving). 

Islamic finance can incorporate greater consideration to ESG criteria in their financing decisions, to incorporate not just the financial and sectoral screens, but consider whether companies have good relations with their workers, with the environment and the best-in-class systems of governance to protect the 'stakeholders'.  Where these analysis come up short (or where the company proposes changes that would impact the ESG criteria, or the criteria specific to Islamic finance, like proposing taking on additional debt), Islamic financial institutions can become more engaged with management to suggest alternatives, or at least use their ability to participate in proxy voting to encourage changes. 

It's beyond my pay-grade to suggest the specific ways these are implemented, and most of the changes would probably be set with a discussion between the management and Shari'ah board at the individual Islamic financial institution.  They can adapt their implementation of selecting the aspects of the ESG criteria, and how they are applied, to fit within their Shari'ah board's idea of what will encourage positive outcomes and avoid creating any issues with the existing Shari'ah rules. 

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.
  

The Economist on GCC sukuk, first Canadian Shari'ah-compliant ETF planned

Canadian Islamic finance compaany UM Financial is partnering with Jovian Capital Corporation to explore the launch of a Shari'ah-compliant ETF. North America currently has a lack of investment products for Muslim investors. Although there are a few mutual funds, the landscape is currently dominated by Amana Funds which offers only two Islamic mutual funds. The greater development of Shari'ah-compliant ETFs would serve to expand the investment options available to Shari'ah-sensitive investors.

The Economist discusses the prospects for the Gulf bond and sukuk markets following the credit crisis and the first GCC-based sukuk default (The Investment Dar).

In a report for LSE's Kuwait Proramme on Development, Governance and Globalization in the Gulf States, Rodney Wilson points out the "the search for alternative means that Islamic banks are likely to receive more attention" in the wake of the credit crisis that originated in conventional financial institutions in the US.

Other News

• The Islamic Development Bank may raise its planned sukuk issuance from $5 billion over 5 years to $6 billion over the same period.
  
• NCB Capital commented on the prospects for GCC sukuk issuance, while Malaysian-based Aminvestment provided a rosy outlook for the Malaysian sukuk market.
  
• Islamic banks are levying 'maintenance fees on small accounts and are treating them as current accounts and not providing them with the profit-sharing features common for accounts at many Islamic banks.
  
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• Standard & Poor's has launched an Shari'ah-compliant version of the S&P/TSX 60 Index.
  
• The Investment Dar continues the process of restructuring, forming a steering committee to communicate with investors.
  
• Salama, a takaful and re-takaful company has partnered with Credit Agricole Asset Management to launch a series of Islamic funds.
  
• An article describes the methods by which trusts can be created to be Shari'ah-compliant.
  
• Malaysia's Securities Commission revised its list of Shari'ah-compliant securities to add 13 and remove 1. Unlike most other countries, Malaysia centralizes many Shari'ah-compliance functions.
  
• Terry Lacey describes the ASEAN annual meeting of Shari'ah scholars held in Indonesia and warns the industry of 'flying to close to the sun'.
  
• Hawkamah issued a declaration calling for the development of isolvency and creditor rights systems for the Middle East and North Africa "Noting the importance of Islamic finance institutions in the region and beyond".
  

Western corporate sukuk; Indonesia retail sukuk

Western companies, especially U.K. and French companies, are considering using sukuk to raise funds. The head of BMB Group Adnan Aziz is quotes as saying, "There is a lot of interest from corporates to issue sukuk. My feeling is that as liquidity in the West gets scarce, they will look into the Middle East".

Indonesia's retail sukuk offering is currently open to new investors through a number of domestic companies. The proceeds from the sukuk will be used to fill a budget deficit. The sukuk, structured as an ijara, will pay 12 percent per year and will have a maturity of 3 years. The finance ministry will not disclose the total issue size, which it says will depend on demand, but Standard Chartered said that IDR 969 billion ($82.365 million), 57 percent of the target issue size of IDR 1.7 trillion ($144 million).

Dubai Islamic Bank, the oldest Islamic bank in the world that recently became embroiled in a corruption scandal, has become a founding member of Hawkamah Institute, a corporate governance organization in the Middle East.

In a press release announcing its rating of Bahrain Islamic Bank, Moody's Investors Service, describes some of the factors that are unique to Islamic banks and affect the rating agencies' ratings of Islamic banks: "The D+ BFSR also captures the restrictions that Islamic banks face in managing their liquidity, growing competition in the domestic, regional and international Shari'ah-compliant banking markets, as well as the reputation risks to which Islamic banks tend to be subject."