Islamic Development Bank wants G-20 to look at Islamic finance and inclusion in the IMF's Financial Stability Forum

The Islamic Development Bank says that the G-20 meeting in London should include a discussion on the opportunities offered by the Islamic finance industry. Ahmed Mohamed Ali also said that Islamic financial institutions should have representation within the G-20 and the Financial Stability Forum of the IMF. The article describes his comments:

"The major selling proposition of Islamic finance is its strong ethical foundation. Financial stability also requires to go back to basics under a new leadership, a special moral fiber and a character-and-integrity-based governance," he said.

However, it also entails recourse to "people values" and to "principles-oriented governance" and a strong linkage between financial services and real economic activities and transactions. It also requires a sense of responsibility and accountability. Islamic finance of course has an extra tier of compliance in the form of Shariah governance.

One of the important things discussed in the article is that the President of the IsDB remains confident about the Islamic financial industrty's resiliency but remains concerned about the effect of a slowdown in economic growth on the industry.

Bahrain based Al-Salam Bank and Bahrain Saudi Bank are planning to merge. Mergers between Islamic banks should continue through the next few years to reduce the number of Islamic banks and increase their average size. Regulators should be concerned about allowing Islamic banks to become 'too big to fail' especially without interbank lending markets and no lender of last resort. However, the risk of too big to fail is offset by the need for Islamic banks to be better diversified on the asset side of their balance sheets.
Other News

• There is an article about the Shari'ah screening process that includes a description of one of the most important developments the industry will need to make: the inclusion of positive (not just negative) screens.
  
• The sukuk market is expected to recover in 2009, although local currency sukuk will be more prevalent according to Islamic bankers like Badlishah Abdul Ghani, CEO of CIMB Islamic bank and Salman Younis of KFH Malaysia. The Islamic Development Bank is planning to issue local currency sukuk in Singapore, Indonesia, Kazakhstan and possibly Hong Kong.
  
• Bahrain's central bank is planning a $500 million sukuk to rollover a maturing $250 million sukuk as well as $250 million for a new issue.
  
• The Islamic Bank of Thailand is planning to issue its first sukuk this year.
  
• Indonesia plans to sell up to Rp 7.5 trillion ($650 million) in sukuk before June. The treasury director said that depending on changing valuations of the underlying asset could cause the issuance to change.
  
• Amana Bank Ltd will become the first Islamic bank in Sri Lanka when it opens. It recently received provisional approval from the country's central bank.
  

Ijara sukuk; Islamic finance hurt by falling asset prices; KFH-Turkey to open branch in Germany; GCC banks convert gov't deposits into capital

The announcement that ijara sukuk were the most common form of sukuk in 2008 came from a Moody's report that attributed its popularity to the AAOIFI ruling in February that criticized the Shari'ah-compliance of other forms of sukuk. Although I have argued that the AAOIFI ruling did not cause much of the overall reduction in sukuk issuance in 2008 (the evidence suggests it had more to do with the credit crisis), the shift in types of sukuk is more likely to be affected by AAOIFI rulings. Placing AAOIFI in the center of the decision around which types of sukuk are optimal is the right thing to do. There are many types of sukuk approved by AAOIFI and it benefits the industry for AAOIFI to direct which forms of sukuk are optimal from a Shari'ah-compliance perspective. However, more transparency from the organization reduce the uncertainty that contributed to significant confusion about which forms of sukuk were preferred by Shari'ah scholars that prevailed between Sheikh Usmani's comments in November 2007 and the AAOIFI clarification in February 2008.

An article that provides an introductory look at the Islamic financial industry provides a few good points that are not frequently expressed explicitly about the susceptibility of the Islamic finance industry to falling asset prices.

"However, in spite of these facts, following Islamic principles is not enough for banks to get the total protection from the financial crisis. Islamic finance is so intertwined with the global financial system that they also can’t avoid problems.

Many Islamic banks have invested their funds in equity. When the prices for real estate go down, their portfolios also go down. Countries involved in computer and electronics manufacturing (such as Malaysia) have been hit by competitive devaluation and reduce of export.

So even though Islamic countries have not suffered from the credit crunch, they have suffered from asset valuations and its financial effect.

Kuwait Turkish Participation Bank (KFH-Turkey) received approval to open a branch in Germany. The entrance into the European Union through Germany is a first. Prior to this announcement, Islamic banks wanting to enter into the EU started in the UK because of the FSA's accommodative stance towards Islamic financial institutions and the legal and regulatory changes which places Islamic finance on equal footing with conventional financial institutions.

Many Islamic banks in the GCC are converting government deposits into Tier 2 capital in order to strengthen their capital position. The two most recent banks to convert are Emirates Islamic and Abu Dhabi Commercial Bank.

Other News

• Russian bank VTB may become the first Russian company to raise funds using a sukuk.
  
• There is an interview with the CEO of the only Islamic bank in South Africa.
  
• A Russian mufti calls for increased use of Islamic finance.
  
• An article describes how the new Shari'ah-compliant gold ETC is monitored from a Shari'ah-compliance perspective, including unannounced reviews.
  
• The decision about whether or not to merge Amlak and Tamweel, Dubai's struggling Shari'ah-compliant mortgage providers is in the final stages and liquidation of the two institutions is not being considered. Tamweel announced that it had not seen an increase in the numbers of foreclosures despite deteriorating economic conditions.
  
• The IFSB summit that will be held in Singapore will focus on whether the current structure of the Islamic financial services industry will need to change as the industry matures and grows.
  
• Zawya Dow Jones interviewed the CEO of the Asian Finance Bank.
  
• The president of the Islamic Development Bank is interviewed before a conference in Kazakhstan. The president, in a different interview, said that the bank is planning to issue a $500 million sukuk in the next few months.
  
• The head of Kuwait Finance House (Malaysia) says that assets in Islamic funds will decline in the near term but grow over the longer term. He also said that the global economic crisis will lead to more local currency sukuk instead of being issued in dollars.
  
• Global Investment House released a report on Bahrain's Islamic finance industry and said it expects the industry to rebound in 2009. During 2008, the volume of sukuk issuance fell to $700 million from $1 billion in 2007.
  

Interbank markets & rates; sukuk preference strongly towards ijara

During the economic crisis, sukuk issuers and investors have shown a preference for ijara sukuk over mudaraba and musharaka because it creates a more stable, asset-backed (secured) stream of cash flows. More than 45% of all sukuk issued in 2008 were ijara sukuk and mudaraba and musharaka sukuk issuance fell by 83% and 68% respectively.

The development of an Islamic alternative to LIBOR could be potentially destabilizing if participants exploit arbitrage opportunities between conventional and Islamic markets according to a Shari'ah scholar. There are two things that stand out to me immediately. First, any IsLIBOR (Islamic interbank offer rate) would function in a similar way to any other LIBOR alternative (KLIBOR, SIBOR, KIBOR) in that it is similar to LIBOR with additional country-specific risk of the market in which the banks operate. Second, unless the Islamic finance industry offers a majority of financing in a way substantively different from the conventional products in the same regions, the IsLIBOR should mirror the interest rate benchmark for an overlapping region.

The Malaysian palm oil Commodity Murabaha House could be a preface to a global Islamic interbank market that is being planned by the Islamic Development Bank. The planned initiative, the International Islamic Inter-Bank (IIIB) market is expected to have initial capital of $10 billion to facilitate inter-bank liquidity management and serve as a 'lender-of-last-resort'.

A Scottish banker says the country could benefit if an Islamic finance house were established by attracting money from the Middle East.

The Investment Dar continues to mull asset sales including stakes in Aston Martin and Boubyan bank

Indonesia's government has been warned that it is a bad time to issue its first global retail sukuk.

Islamic finance and risk management, an extra layer of scrutiny

Roger Smee, a former soccer player in the U.K. who is now a businessman involved with Islamic finance,is quoted describing the benefits from Islamic finance in an article in the Times:

Instead of looking down on what we are quick to reject as cumbersome legal restrictions, we should take a page out of the Middle East’s book and use the principles of Sharia to begin building real and sustainable economies.”

This alludes to the primary benefit from Islamic finance versus conventional finance: the restrictions created by the need for Shari'ah-compliance serve as an extra layer of risk management. It is not necessarily the fact that it is a faith-based method of finance, but the specific rules that are followed that provide Islamic finance with its relative resiliency in times of financial turmoil. Sure, the benefit in some cases is offset by the lack of access to inter-bank lending as I have stated before as well as concentration in certain sectors, but the real key is in how the rules are applied.

In addition to conventional risk management and credit analysis to determine suitability, Islamic banks are forced to focus to a greater extent on the actual structure of the transaction and has a quasi-independent board (the Shari'ah board) who do this. They look at the structure to decide whether it is excessively speculative or onerous on each party in order to come to a decision on the product's Shari'ah-compliance. Although in the retail Islamic banking business, this is not done in any case, there are internal Shari'ah auditors who review the execution of the transactions to ensure they follow the strictures set down by the scholars.

Other News

• Another Minneapolis-St. Paul news site has a story on the public-private partnership that is offering Islamic home finance to local Muslims using murabaha.
  
• Mukhtar Hussain, CEO of HSBC Amanah, was interviewed by the Jakarta Globe on Islamic finance globally and in Indonesia.
  
• First Global began offering Islamic microfinance in the Colombo, Sri Lanka area using murabaha
  
• Indonesia plans to raise $580 million in its first global sukuk later this year.
  
• Malaysia is launching the Commodity Murabaha House, an inter-bank market based on trading in palm oil that is relatively controversial
  
• Two Malaysian economists wrote a paper on the growth and development of Islamic finance around the world, including in the U.S. and U.K.
  

Mid-week update

• Malaysia will sell MYR3 billion (about $1 billion) in 30-year Islamic savings bonds this year.
  
• The BBC has a piece on the growth in Islamic finance.
  
• The wealthiest Muslims did not embrace Islamic finance, but in the wake of the credit crisis, Islamic wealth managers think they could shift their assets towards Shari'ah-compliant investments to reduce their risk exposure and protect their assets.
  
• Amiri Capital is launching their Islamic hedge fund-of-funds. The launch was delayed when Lehman Brothers, the original partner in the effort, went bust.
  
• The merger of Amlak and Tamweel, the two troubled Dubai Islamic mortgage companies, could be completed this summer. A decision on the structure of the merger is expected "soon".
  
• Seven people were charged in a fraud that involved receiving financing for fictional projects and companies from Dubai Islamic Bank and alleged kickbacks. Dubai Islamic Bank issued a statement on the investig.
  

University Bank featured in the NYT; Can Islamic finance provide a way forward after the crisis ends?

The New York Times has an article about University Bank in Ann Arbor, Michigan describing the phenomenal growth of its Islamic home finance products since it began offering them earlier this decade. The bank, which owns 80% of its Islamic finance subsidiary, the University Islamic Financial Corp started in 2005, is seeing growth increasing rapidly. The article points out that a week in which 11 "mortgage-alternatives" were signed to finance home purchases was "more than twice the weekly average".

A legal magazine article describes the development of Islamic finance in Singapore, which was recently announced as the site of the Islamic Financial Services Board's (IFSB) annual summit in May. The city-state issued its first sukuk earlier this year and has taken significant steps to change laws and regulations to place Islamic finance on equal regulatory ground with conventional financial institutions.

Dr. Umer Chapra gave a speech in which he said that the current global economic condition was worse than it had ever been and that Islamic finance could provide a solution. He noted that Christianity and Islam both provided rules to limit excessive debt and "As long as those religious values were practiced, the society progressed in every walk of life". While Umer Chapra is a respected figure in Islamic finance and I have heard him speak and found it very enlightening, I have to criticize his focus on blaming a lack of religiosity for the economic crisis. It creates a distraction from the work needed to solidify the Islamic finance industry, which is currently being harmed by the worldwide economic slowdown. Instead of assigning blame for current economic problems, I think it is far more constructive to say that Islamic finance has been fairly resilient but the fall in real estate prices in Dubai (to use one example) shows areas of weakness. In that particular case, an over-concentration of investments in property that back financing instruments carried on Islamic bank's balance sheets has led to problems in those banks with the greatest exposure and those whose liabilities are not supported by large amounts of customer deposits and are instead more reliant on wholesale, shorter-term capital markets. Instead of making arguments about how Islamic finance could have prevented the crisis, I think the focus should be on increasing the stability of the Islamic financial industry through regulatory coordination, increased transparency, the development of inter-bank markets to improve liquidity of Islamic banks and the further growth of secondary markets for sukuk.

Dr. Mahmoud El-Gamal criticized the Islamic finance industry and said it bore responsibility as well for the economic crisis which is impacting the global economy. One of his criticisms was:

“In the past 30 years of Islamic banking, no ‘authority’ has been established that can inform the international concerned bodies such as the IMF about their financial and investment products. Hence, no one has a clear picture of the activities of the Islamic banks, the number of their institutions and branches”

Dr. El-Gamal is a frequent critic of the industry's current practices and in this criticism, I think he hits on a very important area of transparency of the industry's size, scope, product mix and other factors that may have an impact on the global financial system.

The official newspaper of the Vatican printed an article suggesting that financial institutions could learn valuable things from the Islamic finance industry: "The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service". The reference to "bringing banks closer to their clients" is a criticism of banks from moving away from their role as intermediaries connecting depositors and borrowers into complex financial institutions and growth in their proprietary trading activities. Islamic banks, because they are limited in the types of products they can offer, are often more focused into the role of being an intermediary. George Bailey would be proud.

Other News

• Malaysia is launching an exchange for commodity murabaha, a controversial Islamic financial product. AAOIFI says the product is not invalid, but not ideal.
  
• The Islamic Bank of Asia CEO says that there needs to be a common risk management system across the Islamic financial industry.
  
• Mohd Daud Bakar, a Shari'ah scholar, says that Islamic banks may charge fees for financial guarantees they provide, although they may not sell the guarantees to third parties.
  
• Can Islamic finance serve as an example for the financial industry in the future?
  

Islamic finance affected by credit crisis, should improve resiliency, takaful asset management problems, BBA on the way out, WIEF concludes

Shari'ah scholars say that the bai bithaman ajil (BBA) type of sale with deferred repayment that synthesizes an interest-bearing loan is losing favor and will eventually disappear. The contract is widely used in Malaysia, but is considered to not be Shari'ah-compliant in the GCC. Several courts in Malaysia have criticized the contract's validity. This demonstrates the growing maturity of the industry and its ability to gradually move away from contracts that were developed out of necessity, but which are not substantively different from interest-based financing. As the industry develops, there should be further movement away from the replication of conventional financial products in favor of financial products which are distinct from interest-based products.

An article in Asian Investor magazine discusses another consequence of the shortage of sukuk: takaful asset management. Most takaful companies face significant problem in investing the premiums they receive in Shari'ah compliant ways and in many cases end up overexposed to equities compared with sukuk, in stark contrast with the investment profiles of conventional insurers. This creates an additional risk for takaful companies because equity values are more volatile than traditional fixed income products that comprise the bulk of conventional insurers' investment portfolios.

Zeti Akhtar Aziz, the governor of Bank Negara, Malaysia's central bank, describes the risks facing the Islamic financial system with greater clarity than I have seen elsewhere:

"the global financial crisis has highlighted several structural weaknesses and imbalances in the international financial system. Whilst Islamic finance is not insulated from the effects of the current environment, the Shariah principles and values that underlie Islamic finance provide an important underlying foundation. [...] As it becomes part of the financial globalization process, Islamic finance has however become increasingly exposed to the systemic implications of external developments...its potential for sustaining financial stability and... how robust is the industry to external shocks."

The solutions she proposes are very straightforward to describe, but far more difficult to implement: global regulatory coordination, the development of an international interbank liquidity management market (a 'lender of last resort'). Finally, she describes the strengths of Islamic finance in a way that eschews the simplistic "Islamic finance is based on real economic activity" explanation that abounds from other sources. She elaborates that Islamic finance is seen as a facilitator of the real economy and the links between financial and productive flows acts as a check that limits excessive leverage, imprudent risk taking and speculative activities.

However, even Islamic finance is not immune from global economic shocks nor dumb lending decisions, although the risk profile of many Islamic financial products like mudaraba, musharaka and ijara, provide banks with greater incentive to do more extensive due diligence into the use of funds they provide. They will bear a greater risk of loss in many of these financing structures than they would as a conventional senior secured creditor. Her explanation should provide the beginning of a discussion that should not degenerate back into unsupported declarations that 'Islamic finance is immune from crisis' or 'Islamic finance is inherently more stable than conventional finance'. Even if they were true, they would be unhelpful in progressing the discourse into areas where improvements in the Islamic financial industry could benefit practitioners, regulators and consumers.

Another article talks with a few people about the exposure of Islamic finance to the credit crisis. A Netherlands-based author, Abdul Gafoor, describes something that I have been saying as well: "Islamic banks] go mostly for real estate and that kind of thing. And when real estate prices go down, [their portfolios] also go down. It depends on whether they invested directly in real estate or through securities. Here, you cannot make a general claim [about the strength of Islamic banking]. It depends on each individual bank -- how they behaved." Neil Miller, a lawyer with Norton Rose also observes that "The thing about Islamic banking, at the end of the day, in some respects, it is going back to banking the way it used to be done. So it is very much based on relationships, on analyzing risks, and understanding the risk and the relationships in the specific projects or company that you are looking to finance and getting comfortable with that." It is another example of what I think should be the focus in journalism about Islamic finance: avoid denials of problems and work to improve the resiliency of the Islamic finance industry in the future.

Although this is not a new announcement, the Financial Times reports on the possibility that The Investment Dar, the troubled Islamic investment bank in Kuwait, will sell at least part of its stake in Aston Martin which it acquired in a Shari'ah-compliant leveraged buyout in 2007.

The lack of secondary market liquidity in sukuk markets may affect or delay the issue of new sukuk. If pricing in the secondary markets are distorted by illiquidity, new issues may be priced less favorably for issuers.

World Islamic Economic Forum

The WIEF concluded with the issuing of the Jakarta declaration which includes a section on Islamic finance:

OVERCOMING GLOBAL FINANCIAL CRISIS:

• Support the efforts of the OIC to accelerate greater regional economic cooperation through the effective implementation of its 10 year Plan of Action.
  
• Support the Islamic Development Bank (IDB) Task Force for Islamic Finance and Global Financial Stability to promote Islamic Finance and Banking as a viable alternative to the conventional financial system.
  
• Call upon Governments and Islamic banks to expand Shariah compliant micro-credits.
  
• Support the call for effective regulations in the global financial industry to mitigate risk and failure.
  
• Support the establishment of Islamic Banking Training centres with harmonised standards.

An editorial in the Jakarta Post says the country could benefit from Islamic finance through attracting funds from the oil-rich GCC, although the same conditions apply as with attracting conventional funds: Legal certainty and reasonable returns The Philippines Stock Exchange may launch a Shari'ah-compliant equity index while Thailand is planning the launch of its own next month.

First U.S. state agency to offer Islamic finance, Gold ETC, harmonization in Shari'ah-compliance

Minnesota Housing, a state agency, becomes the first in the U.S. to offer Muslims home finance that is Shari'ah-compliant (using murabaha) through Devon Bank, a bank in Chicago, Illinois which offers Islamic home finance nationwide. The first borrowers closed on the purchase of their first home and there are reportedly up to 10 more clients in the pipeline. The offering of home finance products to Muslims structured to be similar to conventional mortgages, but done in a Shari'ah-compliant way were pushed by Hussein Samatar, the director of the African Development Center (ADC) in Minneapolis.

Dubai Multi-Commodity Centre (DMCC), a Dubai-based commodity exchange, launched the first Shari'ah-compliant Exchange Traded Commodity (ETC). The ETCs are fully backed by physical gold stored at HSBC and each certificate is equivalent to 1/10th of 1 troy ounce of gold. The ETC website provides information about the security and the NASDAQ Dubai website has additional information.

The President of the Islamic Bank of Thailand says that while Shari'ah standard harmonization is likely in the long-term, it is neither possible nor desirable in the near term. The bank's president uses the example that it uses bay al-inah (a similar transaction to murabaha but involving a repurchase of a good by the financial institution). The rationale for the use of the product, which is not viewed as Shari'ah-compliant in the GCC region, is that it is used in transactions to provide microfinance and "the poorer people, what kind of asset could they sell to us?" for use in a sale and lease-back (ijara) financing. I think that, although it will lead to some inefficiencies particularly on products that are attempting to bridge the Asia-GCC divide, in general, it is better to have products available that meet the needs of consumers in the short-run and over the longer-term, as the industry matures, there will be more harmonization of Shari'ah standards and the process of moving this direction will be driven by both consumer demand and the requirements of Shari'ah scholars to ensure that products are moving towards convergence near the (high) optimal level of Shari'ah-compliance and not the sub-optimal race to the bottom level.

Total banking assets in the Shari'ah-compliant banking system of Malaysia grew by 23% in 2008, a year that saw significant trouble in the global banking market. In addition, the risk rated capital of Islamic financial institutions was 15.2% and non-performing loans declined to 2.4%.

Despite having a small relative share of the financial system being Shari'ah-compliant institutions, the Indonesian Vice President believes that the laws passed to facilitate the industry's growth will spur it over the next few years. However, the Vice President who was being quoted also declared that "We all know that Muslim countries with Islamic economic systems during this current [crisis] situation are relatively unaffected by serious problems". Although I do believe that there are benefits from development of Islamic financial institutions, it is extremely myopic to declare that Islamic finance has and will always be immune to crisis. Dubai has one of the most developed Islamic financial systems, but the over-dependence on property as a physical asset (which now backs about 20% of all Islamic bank assets) made the Emirate extremely vulnerable to global economic and credit conditions.

I found this interview transcript quite interesting. It is with K.K. Ali, the CEO of a musharaka-based finance company (Alternative Investments and Credits Limited) in Kerala, India affiliated with Jamaat-e-Islami Hind, a Muslim organization in the country. It provides, I think, a more ground-level view of the difficulties associated with using musharaka finance.

Scotland believes its tradition of having faith-based and ethical finance makes it a logical step to try and attract Islamic finance. A Scottish organization is holding a conference on Islamic finance in Edinburgh at the beginning of April.