Dubai courts void ijara agreement for property that was not completed on schedule

A Dubai court voided an ijara agreement on the basis that it represented not a lease, but a sale contract and the asset being sold was not completed when the developer started collecting payments.  Prior to the Dubai real estate crash, many investors signed agreements that forced them to pay rent upon the anticipated completion date of their property.  However, when the debt crisis hit and projects were mothballed, developers charged rent for uncompleted units.  The court’s ruling—although it does not create precedent—follows criticism by Dubai’s Grand Mufti in 2011 and should lead to changes in ijara contracts used in sales of new residential units.  

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ICD head gives interview to Arab News

Arab News had an interview with the CEO of the Islamic Corporation for the Development of the Private Sector, Khaled Al-Aboodi.  The ICD is the private sector arm of the Islamic Development Bank (similar to the relationship between the International Finance Corporation and the World Bank).  Here are a few sections that I thought were interesting: 

"While lack of access to finance by the private sector has opened new opportunities for ICD to support private sector development in a number of member-countries, a combination of factors such as social unrest in some member-countries, increased cost of funding and lingering effects of financial crisis has made it very difficult for ICD to operate as planned."

 ....

"ICD managed to approve 18 new projects and capital incease for three existing equity projects totaling 372.26 million in 1432H/2011. This was 58 percent higher than the previous year (2010), which reflects ICD's continuing robust support to private sector development in the member-countries. Equity investments accounted for the bulk of ICD's 1432H/2011 approvals, representing 38 percent of the total, followed by the line of finance (35 percent), long-term financing (22 percent), and short-term murabaha (5 percent). In terms of sectoral distribution, the three main beneficiary sectors were finance, industry and real estate, jointly attracting 85 percent of the total approvals. The financial sector accounted for the biggest allocation, totaling 201.26 million, or 54 percent of the 1432H/2011 approvals. In terms of regional composition, 31 percent of ICD's approved projects during 1432H were allocated to the Middle East North Africa (MENA) region, followed by South Asia (23 percent), Sub-Saharan Africa (16 percent), East Asia and Pacific (14 percent), and Europe and Central Asia (10 percent). In terms of recipient countries, ICD approvals were extended to 13-member countries, including three new countries - Algeria, Gabon and Turkmenistan. "

...

"In the past year, ICD successfully closed the fund-raising for Tunisia and Saudi Arabia SME funds, and also for the Central Asia Renewable Energy Fund. Furthermore, ICD has approved establishment of a Food & Agriculture Fund and Fixed Income Fund, and successfully secured some mandates in Tunisia and Cameroon for capacity building and creation of Islamic windows within conventional banks."

...

"To fulfill our mandate, we support the private sector through the following ways: First, we assist them alone or in collaboration with other financing institutions the establishment and expansion of enterprises. Second, we can make direct investment, through Islamic instruments, in the subscription and purchase of their share capital. We also promote with participation of other sources of financing, including the structuring of syndication deals, underwriting of securities, joint ventures and other forms of association. Moreover, we can get involved in issuing mudharba, leasing and istisna'a bonds and other financial instruments. At the top of these, private sector firms may benefit from our advisory services and technical assistance programs."

 ...

"ICD's accumulated approvals since it began operation reached 2.17 billion by the end of 1432H/2011, which has been allocated to 218 projects. The corporation approved about 60 percent of its investments through two main modes of finance - equity and murabaha. The cumulative gross approvals of ICD by mode of finance include 766.07 million of equity, 535.77 million of murabaha, 526.5 million of ijara, 223.13 million of installment sale, and 119.14 million of istisna'a. "

"The financial sector accounted for the largest share, amounting to 783.7 million, or 36 percent of the accumulated gross approvals since inception. The industrial sector had the second largest share with a total approved amount of 596.1 million, representing 27 percent of the gross approvals. This was followed by real estate, with a total approval of 276.2 million (13 percent)."

One thing I think is notable is that the ICD is becoming involved with both SME financing and renewable energy financing, which I have mentioned as important areas for Islamic finance several times.  One question that arose for me when comparing the inception-to-date statistics with the 2011 data was what the breakdown in terms of structure used by the ICD.  The inception-to-date numbers break down by equity, murabaha, ijara, installment sale and istisna'a, but the 2011 data show equity, line of finance, long-term finance, short-term murabaha. The data are not comparable without making some perhaps heroic assumptions about what structure is used for "line of finance" and "long-term finance" (which may be murabaha and ijara, respectively, but could combine a number of different structures in each category). 

Click through to the full article to read the rest of the interview. 

KFH's Alafco to consider listing on international exchange

Kuwait Finance House is considering a proposal from its shareholders that it list Alafco, its aircraft listing unit, on an international exchange.  This is an interesting idea for a number of reasons. First, the international listing would provide an investment opportunity that is relatively rare in the markets outside of the GCC/Malaysia in a Shari'ah-compliant financial institution. 

However, I think there are other reasons why it would be a good development.  It would facilitate the issuance of more sukuk backed by airplane leases and provide a different type of sukuk that is not widely available in the sukuk markets.  The only similar sukuk I am aware of (one specifically set up as an ijara for airplanes) was the GE Capital sukuk, which I wrote about in a post several years ago. 

GE Capital has said they would return to the sukuk market, but so far have not.  Boeing Capital Corporation's Middle East division has also mentioned the potential for airplane leasing sukuk, but as far as I know has not announced any airplane sukuk. In lieu of other issuers, KFH's Alafco could benefit from a listing on an international exchange if it plans a sukuk offering by becoming more well known among the institutional investors who would be the source of most of the capital for any future ijara sukuk. 

Egypt finishes draft sukuk laws

The Egyptian Ministry of Finance and Financial Supervisory Authority have finalized laws governing sovereign and corporate sukuk, respectively, although they have not yet been released, and will have to be combined into one law, according to the Daily News Egypt newspaper.

While it would appear at first glance that the Egyptian government, with a large (and growing) budget deficit, would be the sector most in need of the sukuk law, I would argue that it is the corporate sector that needs the law more.  As a result, it will be interesting to see whether the regulations of each will have to remain tied together, as the article suggests, at the risk of delaying both if there are objections to either one. 

With the caveaet that I am not an expert on the current situation in Egypt, I would offer the following thoughts.  First, while the idea of a sovereign sukuk sounds like a good way to finance the budget deficit, it may add costly delay to the financing of the deficit, and as the EGP depreciates and foreign exchange reserves move closer towards exhaustion, the cost of issuing a sukuk in several months versus a conventional bond (or finalizing the agreement with the IMF that would provide much needed funds) may be dramatically higher if investors lose confidence in the government's finances. 

Put another way, assume there is a 20bps discount (purely hypothetical) for Egypt to issue a sukuk, but where they could issue a bond today, it will take 3 months to pass the law and arrange the sukuk (it may take longer than that).  Days ago, Qatar doubled the deposits it holds with the Egyptian Central Bank to $4 billion and provided an extra $500 million as a grant to provide additional foreign exchange reserves while the IMF loan is negotiated, and the central bank is rationing the supply of dollars as the foreign exchange reserves have already fallen by $20 billion.  Even if the cost of a conventional bond today is higher than a hypothetical sukuk, there may be a far greater cost if there is a full blown currency crisis, which would dramatically increase the cost of both bonds and sukuk by the time the government is ready to issue a sukuk. 

Meanwhile, opening the way for corporate sukuk would probably yield few new issues given the turmoil with the currency (by either raising dramatically the cost of local currency issuance to foreign investors, or raising the probability of default for domestically focused companies that issue non-local-currency denominated sukuk).  However, with the prospects for an agreement between the government and the IMF that would (hopefully) bring some stability in the exchange rate, it would behoove the government to get the regulations passed and implemented as soon as possible for corporate sukuk.  When greater stability comes, the companies will then have more options for financing to bridge working capital shortfalls or to expand their businesses, which will increase employment.

Returning to the article, the final section (which relates also to the discussion above of potential delays caused by political argument around the sovereign sukuk that has the potential to delay the corporate sukuk regulations) describes:  

"The jurisprudential studies committee in the Islamic studies congregation affiliated to Al-Azhar has twice opposed a law drafted by the Ministry Of Finance on sovereign sukuk compliant with Islamic Shari’a because it was deemed harmful to the economy and the country’s national security. It was also considered detrimental to the rights of future generations as it would allow the ownership of sukuk by foreigners and would open the door for the manipulation of fixed assets without real regulation."

This is a unique argument that I have not heard before, but Abdel Monem Said, the director of the Cairo-based Al-Ahram Center for Political and Strategic Studies, writing in Asharq Alawsat, explains that it may be based more on an objection to potential foreign ownership of sukuk: 

"Al-Azhar’s objection came in an unexpected way, for it was based on two Islamic rules: firstly, that it is not permitted, according to authorized Islamic schools of thought, to sell public Islamic assets in the form of bonds; and secondly, that foreigners might be able to buy public Egyptian assets of extreme strategic importance, such as the Suez Canal, for which generations of Egyptians sacrificed their lives."

Meanwhile, another writer described the objection as: 

"The [Islamic Research Academy at Al Azhar] mostly objected to the bill based on the potential loss of sovereignty for Egypt. It allows foreigners to own Egyptian land based on the fact that non-Egyptians will be able to purchase government sukuk. Therefore, they will have partial ownership in Egyptian state projects and properties."

From my perspective, these fears are remote since the sovereign sukuk could be structured to be equivalent to an unsecured bond, which would remove any claim from the sukuk holders on the underlying asset.  The typical way this is done would be to use sovereign assets (buildings, land, etc.) as the underlying asset.  These would be sold to an SPV that would pay for the asset using the proceeds of the sukuk sale.  The government would grant a purchase undertaking committing to buy back the assets at maturity or in the case of default.  The SPV would lease back the assets to the government and the lease payments would be passed along to sukuk holders.  At maturity, the government would buy back the asset for its face value (this is, at least for now, still permitted where it is not in mudaraba or musharaka).

This structure replicates an unsecured bond, because it would likely only transfer beneficial ownership (the right to enjoy the economic benefits of the asset), not full legal title to the SPV.  I am not a lawyer, of course, and nor am I an Egyptian (to whom in the end it is up to to decide how to manage the government's assets).  But the argument that the government would be putting the country's sovereign assets at risk doesn't sound like it holds true.  At worst, it would end up functioning too much like a conventional bond where the government is forced to repurchase the sovereign assets at face value even if their value has depreciated. 

World Council on Credit Unions may take lessons from Afghanistan to Libya

The World Council of Credit Unions has spent the past 8 years building 34 Islamic Investment and Finance Cooperatives across Afghanistan providing murabaha, ijara and a murabaha-ijara hybrid product to its 92,456 member-owned cooperatives (here's the WOCCU's page on the IIFCs).  Now it is shifting its attention to Libya where there CEO of San Francisco Federal Credit Union said "As the country reconstructs, it is an opportunity for credit unions to participate in rebuilding the economy."

It would be useful to see the development of more Islamic credit unions, particularly in countries where access to finance (of any kind, conventional or Islamic) is low because the credit union model has a seeming overlap with Islamic banking.  Depositors of the credit union are members (i.e. owners) of the credit union and the return they get on the use of their deposits are returned to them as profit.  While there are still aspects where the credit union will replicate how banks work (for example, losses are unlikely to be passed through to depositors unless the credit union fails), there are fewer areas where there are difficult contradictions inherent in the model.

For example, if an Islamic bank goes out and tries to attract deposits using the mudaraba structure, they would be theoretically at risk of loss if the investments made with the deposits lose money.  Yet, how is that different from the equity owners of the bank, who should in theory have the same risk-return profile.  One difference between the mudaraba depositors and the equity investors is that the investors would have the right to participate in some ways in the management of the bank where the depositors wouldn't. 

However, that would make the structure of an Islamic bank more beset with conflicts of interest than a credit union (where members provide deposits and also act as the owners of the bank, which is typically a non-profit).  The equity investors (musharaka partners, essentially, have a right to a portion of the bank's earnings, much of which is made using the funds provided by depositors (the mudarib fee in the mudaraba arrangement).  The depositors are liable for the loss of their deposits if the investments are poorly chosen, and are entitled to the share of the profits accruing to them as the rabb al-maal but have no rights to direct the management of the bank. 

In the actual operation of Islamic banks, depositors are treated as being senior to the equity holders (they will have their deposits paid first if the bank were wound up, with any residual accruing to the equity holders).  That introduces an additional potential conflict of interest where the bank's equity owners would benefit from gains but would not have as much at risk to loss if the bank failed (since they would be investing with their equity capital plus the deposits).  This conflict of interest, of course, is the reason why banks (including Islamic banks) are so highly regulated. 

However, from the perspective of choosing whether an Islamic banking entity would work better using musharaka equity investments alongside mudaraba deposits as a privately held bank or a member-owned credit union, I think there is a lot to be said that the credit union would be better because the potential conflict of interest between the depositors and the equity owners would be eliminated by making the depositors the owners of the credit union.  There remains still, of course, the governance challenge of aligning management and depositor/member interests in a credit union, but using a structure with fewer conflicts to manage seems like a better way to go. 

Dr. Zeti speaks on the shift towards equity-based Islamic financing

Dr. Zeti Akhtar Aziz, the governor of Bank Negara Malaysia, spoke today at the Islamic Development Bank's Regional Lecture Series in Indonesia, and while there was nothing groundbreaking contained in her speech, there were a few parts that I think are important to remember (and I would recommend again that when Dr. Zeti speaks it is wise to be listening). A few quotes:

The recent global financial crisis provides a distinct example of how excessive leverage and exponential growth in financial activities that are detached from the growth trajectory of the real economy can become a source of instability. Leverage increased sharply in the years leading to the crisis, buoyed by years of strong economic growth. In the advanced economies, bank balance sheets exploded, growing to multiples of annual GDP.
[...]

The sheer size, complexity and leverage in the banking system increased the fragility of financial institutions and limited their ability to absorb even small losses, thereby resulting in widespread and deep economic dislocations.

[...] 

There is also strong discouragement against excessive risk undertakings and a prohibition against speculative elements. These rulings also serve to insulate the Islamic financial system from excessive leverage, which in turn contributes towards promoting financial stability and its long-term sustainability. These fundamental elements resonate with the call for banking to focus on its core function of providing financial services that add value to the real economy.

[...]

Whilst Islamic finance has all the ingredients and the potential to meet the needs of the global economy, the channelling of funds to productive activities in Islamic finance today is still largely being carried out through non-participatory contracts, that includes the mark-up sale (Murabahah) and the lease-based (ijarah) structures, which continue to remain essential to cater for financing trade and the purchase of assets. Such contracts are similar to lending instruments which expose the Islamic financial institutions mostly to credit risk elements. Whilst non-risk-sharing contracts will continue to contribute to the future growth of Islamic finance, the wider use of risk-sharing transactions and undertakings under participatory finance models have significant scope in evolving a broader representation of Islamic financial products that will spur the next phase of industry growth and development. This includes participatory or equity-based contracts such as Mudarabah and Musharakah that support ventures involving entrepreneurship endeavours. Greater use of equity-based models in Islamic financial solutions has been observed in the more recent period. This has been most evident in the sukuk segment, with Shariah structures evolving from predominantly ijarah and murabahah structures to musharakah partnerships as well as convertible and exchangeable trusts. 

The further development of participatory Islamic finance contracts on a broader scale offers particular potential in efforts to reinforce links between finance and the real economy. Several elements of risk- and profit-sharing participatory contracts support this. As profit-sharing and loss-bearing are clearly identified and agreed based on the contractual agreements between the financier and the entrepreneur, strong emphasis is placed on the value creation and economic viability of productive efforts that create new wealth. In equity-based contracts, the financial intermediation is thus also directed towards promoting entrepreneurship, in that the clearly defined risk- and profit-sharing characteristics of the Islamic financial transaction provides strong incentives for both parties to contribute to the success of the investment. This also provides the foundation for a long-term trust-based relationship, and a clear interest for the financial institutions to undertake the appropriate due diligence to ensure that the returns are commensurate with the risks being assumed. Aspects of governance and risk management thus strongly underpin these contracts. In particular, such contracts demand higher standards of disclosure and transparency to be observed, which in turn act to strengthen market discipline.

[...]

Business risks of equity positions and ownership risks of underlying assets are, for example, embedded in these arrangements arising from the contractual relationships between the investors and entrepreneurs as well as the Islamic banking institutions as the intermediary of funds. Further in-depth applied research is also needed to develop more innovative financial products using risk and profit sharing structures with the corresponding development of risk management techniques. This also needs to be reinforced by enhanced consumer protection and education initiatives to deepen the understanding and awareness of consumers on the associated risks and rewards in the Islamic financial contracts, in particular for equity-based instruments.

Equally important in ensuring the institutional soundness of Islamic financial institutions is the need for robust liquidity management. Today, Islamic financial institutions operating in the different jurisdictions are still confronted with the challenge of managing their liquidity positions effectively, given the limited supply of high quality Shariah-compliant liquid instruments being the reason most commonly cited. The lack of high quality liquidity instruments for Islamic finance is not only constraining effective liquidity management, but it is also affecting the efficient cross-border diversification of financial flows. It is therefore our hope that through the mandate of the International Islamic Liquidity Management Corporation (IILM) in issuing high-quality liquid sukuks, it will contribute to promoting more efficient cross-border liquidity management by Islamic financial institutions whilst facilitating Islamic financial institutions in meeting the international requirements on liquidity.

A theme during the speech is a focus on keeping the Islamic finance industry focused on a connection with underlying economic activity, avoiding excessive leverage and maintaining as much diligence in the underlying businesses being financed.  This is, again, not anything groundbreaking, but it is interesting how she ties it in with the contractual form used in Islamic finance products (ijara/murabaha versus mudaraba/musharaka). 

The primary criticism I would offer of the Islamic finance industry's structure is that it is not only focused on replicating the same contracts as are used in conventional finance, it is replicating to a degree the same business models, with a skew towards the more leveraged business models (investment banking and private equity) at the expense of some that would fit in well with the ideal of risk sharing that Islamic finance is often described as being focused on

There is of course a need for Islamic finance to offer products with similar economics as conventional products for some needs (trade finance using murabaha, for example, or ijara as a substitute for conventional financial leases) but the danger comes when these contracts are used within the context of institutions that accumulate significant degrees of leverage on their own balance sheets. 

In this regard, Islamic commercial banks receive good marks since they have higher levels of capital for the most part and are not heavily leveraged, even though their balance sheets do include some leverage.  Islamic investment banks and Islamic private equity companies, however, which were the main casualties of the financial crisis, on the other hand, used high degrees of leverage in their business and paid the price when financial markets turned and they were unable to roll over their debts as the value of their assets fell. 

In the case of many of these, the institutions themselves were leveraged and their investments were also leveraged, amplifying the effect of a fall in the value of the assets they owned.  To use one company as an example (Arcapita), it had a $1 billion murabaha syndicated loan that the parent company took out to fund part of the investments it made in portfolio companies.  These companies were acquired as leveraged buy-outs, and Arcapita's equity interest was sold to investors, with a portion of the equity retained by Arcapita. 

While Arcapita would argue that it was the actions of an agressive minority of murabaha holders that led to their bankruptcy, these holders acquired the debt at a steep discount to par value because there was a fall in the value of their portfolio companies (many of which were acquired near the peak in 2006 and 2007) and the effect on Arcapita's balance sheet was magnified by the leverage employed on each buy out deal, which led to doubts that Arcapita had sufficient assets to pay its inter-bank liabilities, balances to unrestricted investment account holders and the murabaha holders.  Had the structure been less leveraged, it would have had a greater chance of avoiding bankruptcy. 

And this brings me back to Dr. Zeti's conclusion that the use of risk sharing contracts will force greater connection to the prospects of the businesses the Islamic financial institutions are financing.  While it will force some greater diligence because the risk assumed is more than just credit risk, there will be an important caveat that the market discipline from equity-based contracts will only be effective if the Islamic financial institutions themselves are not leveraged up and thus susceptible to the same types of risks that ended up bringing down many conventional financial institutions.