Why does Islamic finance ignore agriculture and SMEs?

An article about the new, as of yet undefined, strategic plan for Islamic banking in Pakistan interested me with a few statistics about Islamic banking in the country: "Islamic banks held 644 billion rupees ($6.8 billion) or 7.7 per cent of total banking assets in March this year, central bank data shows. [...] Financing by Islamic banks is currently dominated by the mainstream corporate sector at 73.9 per cent of total financing, with agricultural financing representing just 0.1 per cent and SMEs 5.1 per cent, central bank data shows." 

The article then went on to describe: "A campaign will also be launched to increase awareness of Islamic banking and boost growth momentum in Pakistan."  This is an important thing for Islamic finance to do; it must appeal to not only the segment of the Muslim population that will not interact with any interest-based financial institution. 

I am not intending to suggest that the plan in Pakistan is to 'increase awareness' among only those Muslims who avoid interest (they are going to search out alternatives on their own), but often efforts to increase awareness of Islamic finance focus on the religious aspects of riba and gharar, which are undoubtedly important, but the pitch seems to be one of 'Islam prohibits interest and Islamic financial institutions offer a way to be in compliance with this prohibition' rather than a positive message that Islamic finance can offer benefits on its own, that it can compete head-to-head with conventional finance. 

As I am sure the readers of this blog understand, there is a specific reason why Islamic finance has trouble making the positive argument.  The trajectory of Islamic finance has been one focused on recreating interest-based products that can be certified as being Shari'ah-compliant, by changing from a loan to a lease or a sale with a markup.  I read back to a blog post I wrote on the struggle between pragmatism and idealism in how Islamic finance operates (which comes down on the side of pragmatism) and I agree with the arguments I made in the post. 

However, it is not a satisfying answer for me to see Islamic finance replace interest-based financing with murabaha or tawarruq and say it can save the world.  There are difficult issues to be sure in adapting Islamic financial products to the regulatory environments that were built around interest-based financing, and this provides a real reason for why Islamic finance operates the way it does.  But from my own non-Muslim perspective, it is unsatisfying that Islamic finance must be constrained to trying to reach out across the diverse population of Muslims in the world with such an undifferentiated product.  Not to mention trying to reach non-Muslims who in many cases would be open to an alternative to the conventional mega-banks that have a large share of the financial services industry. 

The push for Islamic finance on its current path will proceed regardless of whether it is intellectually and personally satisfying for me in its current form, but it will always be relegated to 'niche market' status unless it can find a more compelling story to tell than just an appeal to consumers' piety, which is where most Islamic finance resides.  There are, of course, very pragmatic reasons for it to be sold as such, but this makes it much harder to get excited about than if the practice of Islamic finance were more unique and could elicit the same emotional enthusiasm as I have seen talking to people over the years (6 years at this point) about idea of an 'Islamic' financial system detached from the actual way it works in practice. 

For the most part, these discussions (mostly but not exclusively) with Muslims have relied much less on appeals to piety (although many of the people I have spoken with are motivated themselves by their faith) than conventional Islamic finance.  They are more often start with an appeal to a problem that the current financial system has created (for example, excessive indebtedness leading to debtors losing power over their own future because of an unexpected event). The discussions search for a way to change the power dynamic between debtors and creditors by relaxing the assumption that the creditor should be the last to take losses due to the unexpected event. 

These types of discussions don't have the simple conclusions of Islamic banking as it operates now. Where Islamic banks have reached a consensus that instead of interest-based financing, let's have the bank buy an asset and resell it to the customer with deferred repayment, the discussions I described above want a more sweeping change from Islamic finance than just replacing a loan with a murabaha.  However, more sweeping change is difficult and will be more slow to grow than the way Islamic finance works today, which is why the latter became the way Islamic finance operates. 

As I mentioned in the post linked earlier about the pragmatism versus idealism debate, I often tend to side on the pragmatic solution because if the industry is to grow in the near-term, it will have to develop in a way that is uncomfortable for the idealists about how Islamic finance should work.  At this point, you are probably wondering what this has to do with the statistics about Islamic banking in Pakistan that I began the post with. 

If Islamic finance is likely to continue its current trajectory of product development that it has in the last 35 years, it needs to have a source of differentiation to create excitement and to serve an underserved area of the economy.  A paper (pdf) by the CEO of the Small and Medium-sized Enterprise Development Authority (SMEDA) in Pakistan described: "The Economic Census of Pakistan-2005 lists 3.2 million business enterprises nation-wide and SMEs constitute over 99 percent of all.  Their share in industrial employment according to an estimate is 78 percent and in value addition approximately 35 percent."  Additionally 45% of Pakistani workers are employed in agriculture generating 20.9% of GDP.

These are clearly areas where Islamic finance should focus just because of the size of the population involved in agriculture or SMEs and their contribution to the economy.  Yet, Pakistan's Islamic banks focus on the corporate sector with "agricultural financing representing just 0.1 per cent and SMEs 5.1 per cent".  That is not an indictment of Islamic banking in Pakistan.  I would not be surprised to see the same disparity between contribution to GDP from agriculture and SME and the amount of financing from Islamic banks in many other majority Muslim countries.  

However, it is a place that Islamic banks can focus their efforts to provide financing in proportion to the share of the labor force and the GDP that is generated in agriculture and SMEs.  If the products that are used are not quite as easy to generate excitement about Islamic finance, then at least its impact on the real economy should be.  Doing that will require far fewer 'awareness' campaigns than the current course.

Is Islamic finance beneficial for non-Muslims?

Reviewing a little bit of the backlog of articles I have that I passed over in the past few weeks, I found two that I think get at an important but difficult topic with Islamic finance: how open Islamic finance is to non-Muslims.  The first article was one from Rushdi Siddiqui discussing somewhat controversial comments from Badlisyah Abdul Ghani, CEO of CIMB Islamic, that conventional banks should not be allowed to issue sukuk (except for multilateral development banks). 

Rushdi counters with a number of good articles about why scholars have allowed conventional banks to issue sukuk and for Islamic banks to use conventional banks as counterparties for their commodity murabaha. Another article comes from Faizy Syed, who focuses his article on India, with reference to other countries where Muslims are in the minority, is more concerned with the role Islamic finance can play within non-Muslim majority countries. 

I have a slightly different view from either, but that does not mean it is necessarily contradictory of their perspectives.  Islamic finance is in fact present in many countries whose Muslim minorities may be too small to support an indigenous Islamic finance industry, and in many of these countries the Islamic finance industry is not focused on the local market.  For example, Ireland and Luxembourg, are often held up as Western nations trying to attract Islamic finance.  However, they are no more interested in attracting Islamic finance for a domestic purpose except to bolster their status as offshore locations to facilitate international finance. 

These countries all see Islamic finance as no threat, and really no different in purpose in the economy from conventional finance and see the potential to expand their market share compared to the Cayman Islands, Guernsey or Bermuda as low-tax-rate countries that are also used to faciliate international transactions.  Both Ireland and Luxembourg are viewed as attractive because of their experience serving as domiciles for UCITS directive compliant funds offered across the European Union. 

While in that sense, Islamic finance has integrated itself in the international financial market, which is good for its development (something that Rushdi mentioned as well).  However, the other idea that is often expressed is that Islamic banks because they are guided by Islamic principles are therefore beneficial for all people, including non-Muslims.  I think the connection is more tenuous there.  Most Islamic (retail) banks operate to provide Muslims with Shari'ah-complaint financial services, which is good on its own by promoting greater financial market integration for Muslims. 

There are also widely cited examples, such as the high penetration of Islamic banks in the non-Muslim population in Malaysia.  In many cases this has arisen because Islamic banks can offer cost-competitive products and may also include some provisions (such as non-recourse mortgages in some countries) that conventional banks choose not to.  This is the best way I think for Islamic banks to expand their take-up by non-Muslims. 

One of the least effective, in my opinion, is to say that Islamic banks were insulated from the financial crisis by virtue of their inherent 'better-ness', or by repeating claims that Islamic banks are just 'better' than conventional banks (even while the Islamic banks are replicating the conventional banks' business models with higher fees).  There are many intriguing possibilities for Islamic finance that are appealing to many non-Muslims (like me), but they are based on specific cases, not broad generalizations. 

One of the things that allowed the financial sector to take over the American (and to some degree global) economy before the financial crisis (as measured by the share of total profits generated by financial institutions compared to the economy as a whole) was that it believed it was (to borrow from Goldman Sachs' CEO Lloyd Blank phrase) "doing God's work".  That it was inherently productive to the economy as a whole.  Instead, the correct description is that finance has a purpose which is productive for society as a whole (allocating capital to productive enterprises).  When it strays from this role (for example, by encouraging subprime mortgage lending to fill securitizations and re-securitizations, or by contributing to a real estate bubble topped off with newly created islands shaped like palm trees), it is not acting productively.

There is nothing inherently better about Islamic finance than conventional finance, and asserting its superiority compared to conventional finance as if the two could be compared each as a single monolith, is a fruitless discussion (and one that is unlikely to expand its appeal for non-Muslims who may not really understand what Islamic finance even means).  There are good products and bad products and the former can offer something to everyone that will help finance return to its productive roots and perhaps also improve it.  The latter, however, are not any better than the bad conventional products, or really any worse.  It is just that the conventional financial industry has a much greater reach so the bad products in conventional finance spread faster and more widely and thus have a much greater impact on the global economy. 

Instead, the path forward, if creating finance that is good and beneficial for all, is to ask "can Islamic finance offer a product that is cost competitive with conventional finance, and which offers something of value to consumers that conventional finance does not?".  If so, let's proceed post-haste.  If not, there may still be value (e.g. integrating Muslims into the financial system), but just recognize that the potential for the product to get widespread appeal among non-Muslims.  It is not necessarily a bad thing to develop a product that may only appeal to Muslims, if it can bring them into the financial system in a way that benefits them.  But this is a far cry from the idea that Islamic finance in its entirety is inherently better than conventional finance and therefore should appeal to all people. 

Combining Islamic finance and sustainable finance

I've been going through the Malaysian Financial Services Blueprint (2011-2020) and there are a number of interesting ideas in there about Islamic finance.  Hopefully, I'll get to some of the others in later posts; the first one is on the connection between the Socially Responsible Investing industry and the Islamic finance industry.  The report writes:

The demand for Islamic finance is expected to emanate not only from the Muslim population but also from those with affinity for socially responsible objectives and those seeking ethical financial solutions where the central theme is a more equitable model that would foster sustainable growth, whilst preserving the environment and improving the overall socio-economic landscape. This is spurred by the growing significance of global ethical consumer movement where Socially Responsible Investment (SRI) is expected to be an important mainstream asset class by 2015. With this development, Islamic finance has an enhanced growth prospect given its close synergy with ethical finance.

The idea here is worthy and there is definitely a possibility for Islamic finance to attract non-Muslim consumers based on the ethical ideas that underpin Islamic finance.  Malaysia is noteworthy in this respect and estimates place the share of Islamic bank accounts held by non-Muslims at around 25%. 

The often attributed reason for the take-up of Islamic finance by non-Muslims in Malaysia is that the products are cost-effective or even cost-advantageous, in part due to the government's efforts to promote Islamic finance.  This is something which could work in some other regions, but in many countries--particularly those with small Muslim minorities--the idea of favoring Islamic finance over conventional finance is going to be a non-starter. 

Without a government-aided cost advantage, Islamic finance will have to offer something new that conventional finance ignores.  The most frequently offered suggestion is to move Islamic finance more towards profit-sharing contracts (e.g. mudaraba and musharaka).  While this may make Islamic finance more attractive (it is not necessarily certain that this is the case), it is unlikely that, outside of some areas of finance like stock markets, this will be possible in current regulatory environments. 

Therefore the suggestion from the report to focus more on activities that "foster sustainable growth, whilst preserving the environment and improving the overall socio-economic landscape" makes sense.  This is probably most likely way to tap the "enhanced growth prospect given its close synergy with ethical finance".  So far, Islamic finance has concentrated much effort in laying the groundwork and setting up Islamic finance to meet the financial needs in a way that is Shari'ah-compliant.  

Now, it should take the next step from expanding the breadth of product offering and focus on differentiation.  This need not be an industry-wide shift.  There are likely to be plenty of people who just want a Shari'ah-compliant alternative to conventional banking, so not adding complexity will make these services more competitive with conventional financial institutions.  

However, there is likely a market opportunity--among both Muslims and non-Mulims--by offering Islamic financial products with a focus on low-income communities, avoiding investments that are not environmentally sustainable, and to add other so-called ESG (environmental, social, governance) criteria to the investment decisions.  These may or may not be required to be Shari'ah-compliant, but there is nothing stopping Islamic financial institutions from adding more ethical criteria to their decision-making process. 

Is Islamic Finance Ethical?

Islamic finance is ethical in the sense that it conforms with the commonly accepted understanding among Shari'ah scholars of what is ethical.  However, the industry markets itself in a different idea of what is ethical.  Islamic finance is supposed to be a superior alternative to the current financial system, one which appeals to Muslims as well as non-Muslims and one which takes as a minimum a standard that is more stringent than the 'industry average'. 

On this metric, I think Islamic finance has much more work to do.  If one thinks that Islamic finance is supposed to meet the baseline standards of financial ethics with an additional set of constraints specific to the dictates of the Shari'ah, than Islamic finance meets the definition of 'ethical'.  However, the way Islamic finance is presented, and I would argue also how it views itself, this standard is not sufficient to be 'ethical'. 

For example, take socially responsibly investing.  It is an 'ethical' framework for investing and it has broad appeal (although there is nothing 'unethical' about disagreeing with the standards under which it operates).  However, it operates in an environment with conventional finance is a competitor and where it has to offer something valuable to consumers.  Islamic finance, on the other hand, is largely concerned with serving a market where it is not in direct competition with conventional finance. 

For Islamic finance to gain consumers--at least until that market is saturated--all it has to offer is the same types of products that conventional finance, but in a way that passes muster of a Shari'ah board.  This type of Islamic finance industry does not directly compete with conventional finance because it is targeted towards a consumer who is not deciding between Islamic and conventional financing, but instead is deciding between working with an Islamic bank or keeping his or her money under the mattress.  This market is almost entirely Muslim, although not all Muslims use Islamic finance. 

There has been a trend in recent years for non-Muslims to use Islamic finance, whether this is Islamic banks in Malaysia or Islamic mutual funds in the United States.  This decision is primarily financial: if an Islamic bank or mutual fund offers a better deal than conventional financial institutions, then non-Muslims will use it regardless of the "ethical-ness" of the product.  However, being price competitive alone does not make the product "ethical", even if it happens to be designed to fit within an ethical system like the one derived from Islam. 

Islamic finance talks a lot about being superior to conventional finance and being an alternative that is attractive to conventional finance to non-Muslims as well as Muslims.  While this is admirable, there still remains a disconnect between creating an "ethical" alternative based on the precepts of Islam.  Returning to the socially responsible investing example, that industry started (like Islamic finance) by avoiding things that were viewed as "unethical", whether that was weapons or tobacco makers or producers of alcohol or companies that produced other harmful or toxic products.  But, the evolution of socially responsible investing did not become an "ethical" alternative until it started offering a product that was defined by what it did, not by what it did not do. 

Today, Islamic finance is approaching the point where it too will have to define what it is, not what it is not.  This ties back into my earlier post on the debate between the idealists and pragmatists in Islamic finance with the former saying that creating financial products that Shari'ah scholars approve using financial engineering in some cases which fit into the current regulatory environment is sufficient.  The latter say, "no", and argue that only profit-and-loss sharing (PLS) products are true to the roots of Islamic finance. 

When viewed through the ethical lens, the idealists have the edge because they are offering an idea about what they want, not how they have not done X, Y or Z.  However, they promote an idea that I think is incompatible with financial services today because of regulatory barriers, as well as consumer preference.  Not every financial consumer's needs can be met with a PLS-based financial product.  For example, how would one structure a student loan to pay for college using PLS?

But, I do think their focus on what Islamic finance does that other types of finance do not is useful for the Islamic finance industry.  To create an ethical product in Islamic finance, financial institutions should consider not only avoiding what is haram, but also on incorporating ideas of what is encouraged within Islam into financial products.  This will make it easier to explain to non-Muslims why they should consider Islamic finance, without either resorting to platitudes about fairness and justice or hoping that the economics of the transaction are more beneficial than a conventional financial product.

Until Islamic finance moves towards this idea, it will be stuck selling its products to the segment of Muslims who will not deal with conventional banks, or those who prefer to deal with Islamic banks, if the cost is similar.  There will remain examples that can be tossed out to refute my argment based on the large non-Muslim customer base, but in large part, those will be isolated examples where the economics work out better for the consumer.  There will be little progress in making inroads on the non-Muslim market (and also among many Muslims) if there is not something being offered that is not solely based on superior performance. 

Broadening the appeal of Islamic finance

I was reading an article on Indonesia providing advice on Islamic banking regulations and I was struck by one quote from Grace Stuart Ndyareeba, the deputy director of commercial banking at Bank of Uganda, the country's central bank. He said, "We in Uganda know that Islamic banking is not only for Muslims. It is another financial product. [And conventional banks charge] very high interest rates expensive for consumers".

Although Uganda has a significant Muslim population--12% or 4 million people--it still is better viewed as an example of a non-Muslim majority country creating opportunities for Islamic banks to provide their services. It is unlikely to develop a large Islamic banking industry that a country like Indonesia might based on its larger population and higher proportion of the population that are Muslim.

In this context, Islamic banks are best suited to focusing on the Muslim population, particularly in the early stages of development. It will thrive in the end if it is able to serve these people's needs well and will attract non-Muslims if it is able to provide quality efficient banking services. What it will not do is replace the very high interest rate products with products that are cheaper, at least not at first.

It is likely based on the small population of Muslim consumers and probability that there will remain additional costs and inefficiencies to Islamic banks in the country that the Islamic banking products will be more expensive than conventional alternatives. An analogy that should provide some forewarning about the benefits from a cost perspective alone in non-Muslim majority countries is the difference between the US and Canada, which both have Islamic finance companies offering products. Reports I have seen suggest that the Islamic financial products in Canada are more expensive than in the US. Canada is at an earlier stage in the development of its Islamic finance industry than the US and has a smaller population as well (both in total population and Muslim population, about 1/10th for total population and 1/7th for Muslim population).

This doesn't mean that Islamic banking cannot work in Uganda (or Canada), but it seems preferable that it be targeted first to Muslims and then, once it has matured and been able to better compete with conventional banks, the products should be marketed on their own merits to non-Muslims. They will not have any natural preference towards Islamic banking products unless they are cost-competitive and offer a tangible benefit compared with conventional products. A good example of a market where non-Muslims participate broadly in Islamic finance based on the cost of the product is Malaysia.

The cost aspect is easy to understand; if a product offers a better value for consumers (lower cost for equal or higher quality service), then consumers will be inclined to choose it. The "merits" of the Islamic banking products is a little more complicated.

There may be some consumers who, for whatever reason, want to avoid explicit interest in their financial dealings. There are others who want to ensure that their deposits are not being used for socially detrimental activities like selling alcohol or tobacco, producing weapons, or gambling and pornography. These consumers may be indifferent between Islamic and conventional products or even be willing to pay a premium for the more 'ethical' product.

However, many consumers will look at an Islamic banking product and see additional cost, limited 'ethical' screening (compared to socially responsible investments which use a broader set of screens) for a similar product to conventional financial products. This is particularly true for murabaha and ijara. Each are analogous to conventional financial products (loans and leases) and the benefits may not be apparent. They are often not apparent to many Muslims based on this similarity.

There are no easy answers for how to make Islamic banking products more appealing to consumers, Muslim or not. It is not even clear that the products abstracted from the benefit of Shari'ah-compliance, are better than conventional financial products. This is the largest challenge to making Islamic financial products more acceptable to non-Muslims absent a cost reduction (which is often not present because the products are benchmarked to interest rates and they are generally more costly to create). It also highlights the challenge to Islamic finance to attract a new set of Muslim consumers. How can Islamic banks operate in a way that differentiates their products from conventional financial products without confusing consumers, running into regulatory issues, raising costs further or creating stability concerns for the Islamic financial institution.

Canadian company sukuk, Islamic finance in China, faith-based ETFs in the U.S.

The wave of sukuk defaults will test the industry as well as the prospect for investors to receive judgements in English courts that govern the sukuk SPVs. The next step will be to try and enforce these judgements in the GCC, according to an article in Euromoney.

Bear Market Resorts is planning a $380 million sukuk that will be issued in August. It would be the first sukuk in Canada and one of few by North American issuers. Siraj Capital is working with the company on the sukuk having previously worked on the East Cameron sukuk which is currently being affected by the issuer's bankruptcy. Following the East Cameron sukuk issue, Siraj Capital announced it was nearing a commitment to work on a sukuk for a NYSE-listed oil and gas company that was never issued.

A research economist at the Qatar Central Bank, Syed A. Basher, writes in an article published in Gulf News that despite the growth of Islamic finance throughout the GCC, the level of government support for the industry has varied widely with Bahrain and Kuwait being the most supportive and Oman and Saudi Arabia lagging behind.

Following the launch of the first U.S.-based Islamic ETF, The Dow Jones Islamic Market International Index Fund (NYSE: JVS), another companies, FaithShares, there is an article about FaithShares which requested approval in April to launch its own ETFs to meet screening criteria of other faith groups including Baptist, Catholic, Christian, Lutheran and Methodist.

The Bank of Ningxia plans a pilot project to test the offering of Islamic financial products in the region which would be the first within China.

Other News

• Islamic microfinance industry is being encouraged in Pakistan by a group, the Alhuda Centre of Islamic Banking and Economics which has launched a helpdesk to help microfinance institutions that want to shift form coonventional to Islamic finance.
  
• Moody's says that Islamic banks in the GCC should 'change their business model' to adapt to the post-financial crisis world.
  
• The joint-Islamic Development Bank/Asian Development Bank Islamic Infrastructure Fund announced that it had raised $266 million towards the $500 million it expects to begin with, most of which came from the Islamic Development Bank and the Asian Development Bank.
  
• As part of its regulatory reforms, France plans on changing laws to ensure that Islamic financial products can be offered in the country which has one of the largest Muslim population in Europe.
  
• The Central Bank of Bahrain redeemed its $250 million ijara sukuk that was issued in 2004 following its maturity.
  
• Islamic banking could grow in Africa following Al Baraka's listing on the Johannesburg Stock Exchange according to an article in African Banker.
  
• Malaysia and Singapore have both been making regulatory changes to encourage inflows of capital from the Middle East, including through Islamic finance.
  

Nakheel may try to tender its sukuk, interview with Anouar Hassoune, opinion piece by Rushdi Siddiqui

Nakheel may make a tender offer for its $3.52 billion sukuk that comes due in December at a discount. However, many investors are likely to reject the tender offer in the hope of receiving full repayment at maturity, in part because Nakheel may receive government support from the Dubai government if it is unable to make payment on its own, as Phillip Lotter, a vice president at Moody's Investors Services said June 10. The prices in the secondary market fell to 63.5 cents on the dollar before rebounding to 87 cents yesterday. I wrote a summary of the Nakheel sukuk on my Zawya blog back in May.

Emirates Business 24/7 has a great interview with Anouar Hassoune, the Vice President and Senior Credit Officer at Moody's Investors Service about the Islamic finance, in particular, the resiliency of the industry at a time when several stand-alone Islamic investment banks have defaulted on their obligations.

Rushdi Siddiqui, head of Islamic finance for Thomson Reuters has an opinion piece saying that Islamic financial institutions should undergo stress tests like the major banks in the U.S. did earlier this year to increase confidence in the industry.

European banks, including a German bank but no French banks, have expressed interest in financing and running the $3 billion IPO planned for Istikhlaf, the planned $10 billion mega-Islamic bank. Sheikh Saleh Kamel and Adnan Yousef who have been the driving force for the bank's launch are not going to take management roles in the banks following the IPO.

Other News

• The Islamic Development Bank is planning to issue the first $500 million sukuk over the next few weeks as part of its planned 5-year, $6 billion sukuk offering.
  
• Indonesia's exchange-backed bond pricing agency will begin publishing daily prices of bonds and sukuk to facilitate greater liquidity in the secondary markets and help issuers price new issues.
  
• The Dubai government is providing AED 5 billion ($1.36 billion) in financing to merge two banks together into the Emirates Development Bank. However, despite the expectation that Amlak and Tamweel, the troubled Islamic mortgage lenders, would be included in the new entity they were not part of the announced plan.
  
• The flood of new sovereign sukuk issues continues as the Ras Al Khaimah Investment Authority (RAKIA) is planning to issue a $500 million sukuk in July.
  
• A Bahraini Islamic investment bank is financing construction of a $50 million mall in the country.
  
• Gulf news has two articles about Islamic banking and in particular the use of Islamic financial institutions by non-Muslims in the Gulf.
  

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.

Non-Muslims not sought out by GCC Islamic banks; Tier II capital sukuk issued; More data on Dubai's real estate market collapse

Most non-Muslims in the GCC do not seek out Islamic banking products at the retail level, instead opting for conventional banking products. However, some seek out Islamic banking products because, in the words of one Malaysian expat: "Malaysians have a sense of what Islamic banking is about. Maybe the returns are not that high, but it feels more secure and safe." In other cases, non-Muslims receive financing from an Islamic bank because that is what is available, for example, at a car dealership. Jawad Ali, a partner at King & Spalding, believes that retail Islamic banking products are not "geared towards retail customers" and receive more attention from high net worth clients who care not only about the cost, but are interested in how the financial product "works" to ensure it is Shari'ah-compliant. There is also very little need for Islamic banks to attract non-Muslim clients because the demand from Muslims has not yet been saturated.

Saudi Hollandi Bank issued a SAR 775 million ($207 million) sukuk as the first tranche of SAR 1.5 billion in Tier II capital. Tier II capital includes debt that is subordinated to the bank's depositors. The sukuk is callable after 5 years and returns Saudi Interbank Offer Rate (SIBOR) plus 200 basis points and is a mudaraba sukuk. This sukuk is an example of one in which additional transparency from the bank and the Shari'ah board about its Shari'ah-compliance would be helpful. It appears to be the equivalent of a floating rate bond benchmarked to an interest rate. It would be useful to see how the return on the investment is related to the underlying profits of the bank, rather than just based on a market-derived interest rate disconnected from the bank's operations.

AIM-listed Tejoori, a Shari'ah-compliant investment trust, released preliminary earnings for 2008 that showed a significant loss and very little remaining cash following a full change in their board in April 2008. The preliminary report for 2008 also mentioned that the new board would reduce its "high exposure to the Dubai real estate market".

I normally do not concentrate on individual company's results (and do not make any recommendations of any investments), but this company has investments primarily concentrated in real estate in Dubai and its difficulties, I believe, are indicative of a collapsing bubble in real estate in parts of the GCC, most noticeably in Dubai. The largest Tejoori investment is in the Lagoons, a project in Dubai managed by Omniyat Properties. Another company working on the Lagoons recently announced layoffs from staff working on other projects. The article described the real estate market in Dubai: "In just two months, Dubai has moved from being a safe haven to a market where virtually no major project is left unaffected by the credit crunch". The difficulties in the real estate market in Dubai may not have anything to do with Islamic finance, but as I have said before in this blog, Islamic finance is affected by global economic conditions and investment companies and banks in the GCC with a lot of exposure to the real estate market may see the greatest declines as the credit crisis sweeps across the globe. This is merely one example.

University Bancorp, the parent company of University Islamic Financial Corp, decided to voluntarily delist itself from the NASDAQ to save money on legal and accounting costs associated with being a publicly traded company.

Islamic finance may face challenges from economic slowdown; another call for focus on the ethical basis of Islamic finance

Although there has been a lot of suggestion that Islamic finance is immune to the credit crisis (although it may be hurt by the follow on economic slowdown), the Islamic financial industry has not yet gone through a period where the legal structure has been tested if the issuers of sukuk, for example, default. For example, there has not been a challenge of whether sukuk holders have a claim on the asset used to back sukuk. According to an article in Asian Banker, the IFSB says that they should, but the fallout from the economic slowdown may result in an actual test of whether or not sukuk holders get ownership of the underlying asset in the case of default.

A EFG-Hermes report on the UAE says that the merger of Islamic finance companies Amlak and Tamweel will be a balancing act and that "one thing we can be reasonably confident is that while Amlak and Tamweel may make it to the beginning of the year, they are unlikely to make it to the end".

Farmida Bi argues that focusing too narrowly on specific rules as opposed to the intent of Shari'ah guidelines hampers growth and that "If Islamic finance is seen in its true guise as a form of ethical financing, of interest to all rather than only as a faith-based activity of interest to the Muslim population, it is likely to find favour with a different type of conventional investor who would be potentially willing to consider different types of risk-reward stuctures." I wholeheartedly agree that Islamic finance should focus on the objectives (maqasid) of the Shari'ah and should work to attract non-Muslims. This will ensure that the industry does not just become an exercise in structured finance, but promotes a greater ethical cause that is shared among peoples of all faiths.

Japan's largest bank, the Bank of Tokyo-Mitsubishi UFJ is planning to offer Islamic financial services in the Middle East and Asia. Japanese companies have been exploring growth into Islamic finance and some have started to become involved in the industry.

Islamic finance in India is finally beginning to develop some momentum.

New website on Islamic finance from Al Arabiya; More doubts about the ability of Islamic finance to insulate itself from the credit crisis

The Middle East TV news channel is launching a website devoted to Islamic finance and economics, which will add another source for news on the Islamic finance industry in addition to the few leaders in the GCC region, Zawya and Sukuk.net. The Times (U.K.) describes Islamic finance and the recent developments, particularly the growing opportunities for people to study Islamic finance at some universities in the U.K.

The Islamic Bank of Britain is looking to the Middle East for additional capital to fund its growth.

A number of practitioners in the Islamic finance industry discuss the industry's development moderated by Dr. Mohamad Nedal Alchaar, the Secretary General of AAOIFI.

In an article that should surprise no one familiar with the Islamic finance industry, future growth depends on increasing the number of Shari'ah scholars according to many including Sheikh Nizam Yaquby.

SEI, a large asset management firm, says that the Islamic finance industry has performed well compared with markets as a whole despite sharp falls in commodities and energy and a rise in the price of financial stocks. By virtue of the Shari'ah screens, Islamic investment funds tend to have very little exposure to financial stocks and more in energy and commodities than most of the indices. Despite doing better than the markets in general, Islamic finance does see repercussions from the credit crisis and global economic slowdown. An article in the Guardian casts doubt on the ability of the Islamic financial industry in the GCC to avoid a crisis similar to the one in conventional markets due to banks' asset-liability maturity mismatches and a falling real estate market accentuated by the illiquidity of credit markets worldwide. The regional head of Citi's Islamic finance in Malaysia discusses the effects of the economic slowdown on Islamic finance.

A Malaysian Shari'ah scholar says that the use of derivatives and options, which are allowed in Malaysia, could create a crisis similar to the one moving through the credit markets in the West.

Singaporean bank OCBC says that non-Muslims are becoming more interested in Islamic banking because it is more conservative than conventional banks which have been struggling because of over-aggressive investment in the real estate market and derivatives relating to mortgage-backed securities.

Malaysia's central bank is going to issue a 37-day sukuk for Ringgit 200 million ($55 million).

Sukuk and future growth in Islamic finance

In an interview, deputy minister of finance Nor Mohammad Yakcop, describes the efforts taken by Malaysia's government to expand its international presence. One comment, in particular, struck me as a valuable observation that is often lost in stories about the rush of different cities like Kuala Lumpur, Singapore, Dubai and London to become centers of Islamic finance.

"Malaysia welcomes the growing acceptance and popularity of Islamic finance, together with the emergence of other Islamic financial centres such as Dubai. We believe it is not a zero sum game. In fact, the increasing number of financial centres undertaking Islamic finance, is a necessary condition to provide critical mass and sustainability for the sector."

The Islamic Bank of Britain claims that it saw an uptick in the number of non-Muslims opening accounts in the wake of the credit crisis. It would be interesting if, in addition to vague suggestions about the popularity of Islamic finance by non-Muslims, there were numbers attached to track the growth or contraction in numbers of non-Muslim clients. I think that would provide a more useful measure of how much progress is made to attracting non-Muslim to Islamic finance, an important thing for the growth of the industry particularly in countries like the U.K. with relatively small Muslim populations.

The sukuk secondary markets have about $40 billion in sukuk that are 'actively traded', according to a GCC-based asset manager. The yield difference between conventional and Shari'ah-compliant debt have fallen. Relative to US Treasuries, conventional debt with issuers sharing similar characteristics with issuers of sukuk yield 314 basis points while the yield spread for sukuk is 320 basis points.

The minister of finance in Indonesia was recently asked about the plans to issue a sovereign, dollar-denominated sukuk in the wake of a fall off in sukuk issuance:

Gulf News: An HSBC report recently reported that sukuks have witnessed a $10-billion drop in sales since early 2008 and an average price fall of 1.51 per cent. Viewed against Indonesia's impending plans to sell dollar-denominated sukuk, how do you view the appetite for Islamic bonds in the Gulf markets next year?

Sri Mulyani Indrawati: We still believe that our plan to sell sukuk is relevant and will get positive responses from Gulf markets. Our skuk will attract the demands of Gulf's investors for several reasons:

The sukuk is fully guaranteed by the government; The government has a good track record in fulfilling bond obligations; many investors are waiting the issuance of sukuk; and Indonesia is the biggest Muslim country, and the Sukuk is a tool to enhance the brotherhood between investors in Gulf countries and Indonesia.

My optimism also relies on data released by Standard and Poor's on September 9 suggesting that the Sukuk market will rise again.

In this regard, I think the liquidity in the Gulf is still abundant and requires secured investment instruments such as our sukuk.

Why Islamic Banking?

The Motley Fool (UK) has a good article on why non-Muslims in the U.K. might prefer to switch from conventional banks to Islamic banks.