State Street report on Islamic finance

The State Street report on Islamic finance that was recently announced (see previous blog post) provides a good overview of where the industry is now and what the primary risks and issues challenges that face it. I would recommend that those interested in the full report request it from State Street at vision@statestreet.com. A few quotes and comments from me are below.

"While Shariah’s faith-based principles continue to hold strong appeal for Muslims, the pragmatic benefits arising from its application are becoming increasingly attractive to non-Muslims as well, particularly during the current economic crisis and the intense focus on risk management we are witnessing."

This is a particular interest to me as a non-Muslim that sees the potential benefit from Islamic finance to the ethical finance industry. The latter has been very good at screening investments (and using positive in addition to negative screens which Islamic finance is just beginning to consider). However, the move from investing to finance more generally has been slow in other areas of ethical finance and the tools developed within Islamic finance could provide a good path for ethical finance to move into new areas.

"These [Shari'ah] boards are viewed as both an auditor for the company offering the financial service or product, and a consumer advocate for the company’s clients."

I think the idea of Shari'ah boards as 'auditors' and 'consumer advocates' is understated. However, the way the Shari'ah review process is currently structured where Islamic financial institutions pay scholars directly compromises this role in perception if not in reality. The idea of standardization has been widely promoted (including by me) but the easier and just as important area that is coming into its own is external companies that provide Shari'ah review services. The development of this service is a positive development for the industry, but just as with the problems at credit ratings agencies has spurred criticism about their independence (and a similar critique of accountants and auditors in the early 2000s) the Islamic finance industry needs to continue to develop standards to ensure that Shari'ah boards are truly independent and unbiased. This is beginning to develop with IFSB standards on Shari'ah review (ED10, pdf).

"Financial institutions in the Gulf are experiencing widening mismatches between longer-term maturities on the loans they extend and the shorter-term financing that backs them, creating demand for access to longer-term funding."

The asset-liability maturity mismatch is one of the greatest problems facing the Islamic finance industry. Secondary markets will help, but as conventional financial institutions are realizing, the mere existence of secondary markets does not ensure that they function efficiently.

"The perception of whether a product or service is Shariah compliant, or whether an institution is engaged in activities that are deemed unlawful under Shariah, leads to reputation risk. Again, the Shariah supervisory board plays a crucial role in conducting due diligence and helping to ensure compliance to mitigate this risk."

Reputation risk is one of the areas where Islamic finance is more risky, but also one of the factors that constrains excesses. If institutions are subject to rigorous Shari'ah audits and require this for their continued recognition by consumers as an Islamic financial institution, it should constrain their activities that could lead to a negative audit result.

"Collateral coverage at Islamic financial institutions is often higher for conventional banks since they have an obligation to back any transaction with a tangible, underlying asset. Still, certain transactions carried out by Islamic banks can bear above-average credit risk, namely musharaka (venture capital financing) and mudaraba (trust financing), which can increase the risks carried by the banks. In addition, in murabaha (mark-up financing) and ijara, the existence of full collateral could lead Islamic banks to be less vigilant when assessing the creditworthiness of their borrowers.

Funding and liquidity risk is one of the most critical issues for Islamic financial institutions since only a small secondary market exists to enable them to manage liquidity. Their assets are generally not sellable on a secondary market, and they aren’t able to invest in fixed-income instruments for treasury management purposes.

Liquidity risk is of particular concern with regard to PSIAs, should PSIA holders decide to withdraw their deposits at maturity. Islamic institutions have developed some layers of protection to deal with this, namely profit equalization reserves, mudarib fees and investment risk reserves."

This outline of the risks (credit, funding and liquidity risks) is very well outlined and really hammers home the issues facing the industry.

"Opening the door to additional alternative forms of investing, particularly ones that emphasize the sharing of risk and reward, will certainly help to facilitate our goal. Despite an impending market recovery, we are likely to see a continued trend toward risk-averse investments and intense scrutiny of investment practices across the board, which will give Islamic finance a boost for years to come."

I wonder whether a recovery will lead to enough introspection for long enough to lead to more sustained attention to Islamic finance, but for the near term, it should provide an opportunity for the industry.

Mutual fund screening and the path to Islamic finance by a Japanese bank

Mutual funds designed to meet the criteria of a faith are not limited just to Muslim investors and some funds are moving beyond the Islamic funds in incorporating more proactive actions that do more than just using exclusionary screening. These including becoming activist shareholders and including 'positive' screens that support companies with the highest ethical conduct. I think it is the next step for Islamic mutual funds to become focused on more than just prohibition-based screens.

The path of Tokyo-Mitsubishi UFJ Bank from initially considering becoming active in Islamic finance becoming active in Malaysia with expansion plans elsewhere are described in a short article.

As usual, the sukuk al-salam issued by the Central Bank of Bahrain was oversubscribed, highlighting a continued need for short term investments for investors including Islamic banks.

A Shari'ah-compliant health insurance plan was introduced in Dubai.

New sukuk are smaller than last year; profits hold up for Islamic banks although challenges remain

A blog post at PBS, the U.S. public broadcasting organization, provides a brief description of Islamic banking seen through the prohibition of usury in the three large monotheistic religions: Judaism, Christianity and Islam. The U.K. may be providing the greatest example of how to allow Islamic banking to operate on a level playing field with conventional financial products.

A panel at a conference in the Dubai International Financial Centre (DIFC) tackles difficult subjects like the effect of the credit crisis on Islamic finance and the potential for 'greater good' efforts to expand Islamic financial principles to financial products without the 'Islamic' label (e.g. 'ethical' and 'green').

In another report, data show that the sukuk market has fallen off in 2008 compared with 2007. Issuance in the GCC fell from $14.15 billion in the first nine months of 2007 to $8 billion in the same period in 2008. The number of sukuk issued in the GCC only from 36 to 34 which means that the average size of sukuk has fallen (from $393 million to $235 million). There were some sukuk significantly larger than average issued by real estate companies: eight accounting for $4.85 billion (compared with seven in the same period in 2007 valued at $3.42 billion). This means the remaining 26 sukuk issued this year only averaged $121 million compared with the non-real estate issues in 2007 which averaged $370 million.

Business Week had a story that I missed a few weeks ago about Islamic finance weathering the credit crisis, but which was mentioned in another article on Islamic finance, because of its additional screens which help Shari'ah-compliant investors avoid some of the pitfalls that have been hurt the most in the credit crisis. Some non-Muslim investors may even be attracted to the industry by its relatively simple screens used to exclude companies that, while conforming with the Shari'ah screens, may also perform better in bad markets for several reasons including a lower reliance on debt financing.

Although Islamic finance is less susceptible to the credit crisis, Moody's warns that it is not completely isolated from global economic trends and are overexposed to real estate markets, particularly in the GCC, which have only recently began slowing. Despite this, the profits of Islamic banks remained strong in the last year.

The Islamic Development is planning a sukuk to raise money to assist member countries suffering in the wake of the credit crisis.

AAOIFI head criticizes the chairman of AAOIFI Shari'ah board; Islamic Development Bank launches work team to monitor credit crisis

The Islamic Development Bank is establishing a work team of experts to monitor the effect of the current financial crisis on the Islamic financial crisis. I think it is a good move and recognizes that, although the ethical requirements on the Islamic finance industry can help mitigate the effects, the industry is not completely unscathed from spill-over effects of the financial crisis. The spill-over flows through the conventional credit markets (many if not most sukuk are priced in connection with the LIBOR) and the effects of the crisis on the underlying global economy. While there is little that the work group can do to reduce the effects of the crisis on the Islamic finance industry, monitoring it closely can allow early moves to head off serious repercussions.

The head of AAOIFI, the global standard-setting body, lashed out at the head of the Shari'ah board, Sheikh Taqi Usmani, at the International Islamic Finance Forum for comments about the Shari'ah-compliance of sukuk that were followed by a drop in issuance in sukuk. Mohamad Nedal Alchaar said "The statements that were made by our sharia chairman about the sharia compliance of sukuk wrecked the market". While the timing of the comments were inauspicious, there is little doubt that the financial crisis wracking credit markets worldwide had far more to do with the fall off in sukuk issuance. Sheikh Usmani's comments, to be fair, were not followed quickly by a statement from the full AAOIFI Shari'ah board (that followed several months later). However, the comments in and of themselves, will probably benefit the industry in the long run by pushing the sukuk market, and hopefully Islamic finance in general, towards more differentiation with the conventional financial markets. Until now, most Islamic financial products have emerged from a process of 'Islamicising' of conventional products and have largely the same structure. What Sheikh Usmani was advocating (which was confirmed in the follow-on statement from the AAOIFI Shari'ah board) was removing fixed redemption of sukuk at maturity. This was instituted initially so that it resembled conventional bonds. Forcing instead on repurchase at market prices creates more risk-sharing because sukuk holders share in the appreciation or depreciation of the underlying assets used to back sukuk.

The shortage of qualified professionals, trained in Islamic finance rather than structured finance, could reduce the future growth rate in the Islamic financial industry, according to INCIEF CEO Agil Natt. Ahlibank deputy CEO Yehia Elbatrawi believes that, although the Islamic finance industry has been relatively unscathed by the credit crisis, it is at risk from an overexposure to real estate and private equity: "some of these markets are overpriced, which increases the exposure of many Islamic banks". Shari'ah-compliant investments, although shielded from a lot of the damage have seen indexes screened for Shari'ah-compliance lose $5.6 trillion in value, according to Standard & Poors.

Islam (and other religions) bring ethics back to the financial industry...and to Bosnia. Other countries are also changing regulation to attract capital from the Middle East by encouraging Islamic finance. The U.S. is even getting involved at a governmental level. U.S. deputy secretary of the Treasury Robert M. Kimmitt is in the Middle East learning more about Islamic finance. He noted that Treasury Department officials are increasing their familiarity with the industry and although he was "not sure that Islamic banking will also be itemized in the agenda, but it is a subject that is often dwelt in the public and private sector".

Another sukuk, planned by Deyaar, has been delayed. It's CEO, Markus Giebel says, "There is very little liquidity in the market right now and to launch a sukuk would be foolish. We have to obey market conditions and so we have delayed it but not cancelled our plan for it,"

Islamic finance at risk from commodity price volatility

Although Islamic finance has grown rapidly over the past 8 years, it still is not widely accepted by high net worth individuals in Asia, some of whom are concerned that it does not have a long enough track record. One of the concerns is whether Islamic finance will be able to endure after oil prices fall back to lower prices. After reaching nearly $150 per barrel, they are now trading around $80 per barrel. A Forbes article describes in further detail the risks of falling real estate and commodity prices for Islamic finance. In addition to falling commodity prices, which lowers wealth growth in the GCC compounded by slowing real estate price growth, there is another hazard: commodity price volatility. The reason that commodity price volatility is harmful is that, whether you agree with it or not, there is widespread use of products like commodity murabaha. In transactions like commodity murabaha transactions to synthesize conventional loans are structured using trades in commodities (e.g. metals). Greater volatility in the prices of these metals introduces trading risk if the prices at which these metals can be bought and sold (often on the London Metal Exchange).

The second soverign sukuk planned by the Malaysian government will reset the risk-free pricing benchmark for ringgit denominated issues and facilitate price discovery of ringgit-denominated sukuk during the current market turmoil. The last Malaysian sovereign sukuk was issued over six years ago.

Japan Bank for International Cooperation (JBIC) may be forced to delay its sukuk issue because of the credit crisis.

I disagree with the comments from Sheikh Qaradawi about the 'collapse' of the western financial system and the presumption that Islamic finance provides a unique alternative that can stand on its own right out of the gate. Islamic finance provides a good model for how to expand ethical finance beyond just screening investments, but there are still several products that are warts on the Islamic finance industry like commodity murabaha and tawarruq. In these two cases, products are structured to mimic conventional interest-based loans to meet financial demands of Islamic banks and consumers where alternatives that are unique from conventional products have not yet been developed. Islamic finance should not be focused on standing alone apart from other ethically-based financial systems. Other ethical systems share similar concerns as Islamic finance about interest-based finance, funding weapons and other products which have a socially detrimental effect like alcohol and tobacco. The similarities should be praised and used as a way to promote a more just financial system not just one for Muslims.

Forbes Special Report, etc.

Forbes released a Special Report on Islamic finance. Although the U.S. has not shown much interest in changing regulations to put Islamic finance on a level playing field with conventional finance, other countries like the U.K., Malaysia, Singapore, Japan, Dubai and Bahrain are vying to be the largest hubs of Islamic finance. The growth in Islamic investing is one area in which ethical investing has begun to grow out of being a niche market within the global financial system, although it is still small compared with the system as a whole. The growth, however, has come with challenges. One of the greatest is the shortage of Shari'ah scholars who know both the Shari'ah, financial services and with enough knowledge of English "to wade through hundreds of pages of a prospectus or legal documents".

Forbes also provides a historical analogy to the development of Islamic finance in the conventional finance market. This was the gradual move away from prohibitions of interest (usuria) in Catholicism. Although there is nothing that suggests that the prohibition of interest in Islamic finance will be circumvented, the historical analogy provides a warning against focusing on the form, rather than the spirit, of the prohibition of riba. The tension between the letter and spirit of Islamic law is the subject of a piece by Haider Ala Hamoudi, a professor at the University of Pittsburgh.

One of the areas in which the U.S. has seen significant growth in Islamic finance is in equity mutual funds, the subject of one article in Forbes.

Islamic banks in Pakistan report the need of short-term liquidity instruments, a need filled using short-term government bonds by conventional banks. The increased cost of products used by Islamic banks in the absence of liquidity management products may slow growth in demand because, as the CEO of Meezan Bank Irfan Siddiqui noted, people's demand for Islamic banking depends on the service and price, in addition to its Shari'ah-compliance. The government of Pakistan announced on April 25th that it has appointed manager of the first rupee-denominated government sukuk, expected to be Rs. 20 billion ($309 million).

The fifth Islamic bank in the U.K., Gatehouse Bank, is now open. The takaful industry, now at $3.5 billion, is expected to grow to $10 billion by 2012. Despite unsolved regulatory and tax issues, Indonesia plans to issue up to $2 billion in sovereign sukuk this year to finance the country's large budget deficit. Islamic finance, while still at an early stage, is growing in Canada. The Kuwaiti exchange will allow the selling of Islamic options on stocks using the controversial arboun structure. Although very little has been done in Islamic finance in France, the government is setting up two round tables to assess the feasibility of Islamic finance in France, in part to attract funds from the Middle East caused by the significant increase in the price of oil.

The requirement of compulsory zakat recently enacted in the UAE has attracted criticism from a notable Shari'ah scholar, Sheikh Hussein Hamed Hassan, who says it is an individual, not institutional requirement.

Sukuk, UAE to head council on Islamic finance, Islamic finance in Canada & the U.K. and growing interest in Islamic microfinance

The Islamic Development Bank is planning a $150 million sukuk issue in Malaysia that it expects to use within two years to finance projects in Malaysia, mostly relating to education, healthcare and basic infrastructure. The IDB also plans on another sukuk to be issued elsewhere to fund the bank's operations. Moody's expects the global sukuk market will reach $200 billion by 2010 (Moody's also expects to see significant growth in the number of Shari'ah-compliant funds). The GCC sukuk market has focused on larger sukuk issuance (like the $3.5 billion sukuk from DP World used to fund the purchase of UK-based P&O Ports), while small and medium sized companies have more luck issuing in Malaysia.

2008 will see first sovereign sukuk issuance from the U.K., Indonesia and Hong Kong.

The UAE will head a council with representatives of the Islamic financial industry as well as finance ministers, central bankers, the IDB, accounting and audition agencies the Islamic Financial Services Council, the World Bank and the IMF.

Further response to the Archbishop of Canterbury's comments about allowing some Shari'ah courts in the U.K. uses the example of how Islamic finance has incorporated Shari'ah principles into modern finance.

Ethical investing guided by faith is growing rapidly in Canada, with mutual funds that select investment based on religious principles. The most common faith-based funds appeal to Christians or Muslims. A range of additional services are available to Muslims in the U.K. including banking and home finance that have only limited availability in Canada.

Islamic microfinance is succeeding in Afghanistan where non-profits like FINCA offer Shari'ah-compliant microfinance. The success of Islamic microfinance has led to people like Joyce Lehman, a microfinance program officer for the Gates Foundation, to say that there should be greater availability of Shari'ah-compliant products: "Out in the field, MFIs are losing clients to other organisations that provide Shariah loans and it’s that type of market competition that is making MFIs look into providing Shariah products," she says.

Recently, a microfinance institution in Nigeria converted to only offer Shari'ah-compliant microfinance products.