UM Financial Receivership Ends, RMCP Investigation Continues

The UM Financial saga is almost over with the filing of a (likely) final report (PDF) from Grant Thornton, the receiver, to the court.  The final filing gives an update on the status of the mortgage portfolio as well as an estimate of the losses for Central 1 Credit Union, which financed the UM first mortgages and now owns the portfolio that remains.  For a description of the case up through this point, see my blog post from earlier this year. 

When UM Financial was placed into receivership, there were 172 mortgages outstanding.  During the receivership, 49 mortgages were refinanced (leading to a payout to Central 1), 20 were disputed and 2 were under third-party sales processes, leaving 101 mortgages which were sold (through a credit bit) to Central 1.  This resulted in payments of $22.9 million consisting of the value of the credit bid of $12.1 for the 101 mortgages, $0.8 million in first mortgage receipts, and $7.5 million in payout receipts.  With Central 1 estimating that they were originally due $31 million from UM Financial, this leads to losses of roughly $7.5 million.

Grant Thornton described:

 "On account of the Companies' outstanding indebtedness to Central 1 in excess of $7.5 million for principal, interest and costs exclusive of unbilled or unposted recovery costs which has yet to be accrued, the Receiver seeks an Order authorizing and directing the Receiver to (i) immediately distribute a further amount of $400,000 to Central 1; (ii) complete a further distribution to Central 1 without further Order of this Court of up to $2,000000; and, (iii) approving the distribution, in kind, of the Companies right title and interest in the Gold and related causes of action to Central 1.  The Receiver does not expect distributions to be $2,000,000, but even if $2,000,000 in additional distributions were made, Central 1 would still be owed over $3,000,000 (after taking into account the distribution of the Gold in kind.)

So, there are still substantial losses remaining, potentially as high as 25% of the total portfolio and likely to be at least 10% for Central 1.  As a resul, Grant Thornton reviewed the legal options, and determined that "there may be viable legal actions to pursue third parties in respect of the Potential Outstanding Claims.  However, there is very significant uncertainty regarding the ability to recover on any judgment ultimately obtained".

This would likely take the form of civil lawsuits against the former executives (in particular, former CEO Omar Kalair).  After discussing the potential legal actions with Central 1, "Central 1 has indicated that it shares the Receiver's concerns with regard to ultimately recovering on any judgment obtained and that, in its view, the cost/benefit of pursuing these actions at this time is not warranted".

This is likely disappointing to the clients of UM Financial who were harmed themselves in the collapse of UM Financial, but there remains an active criminal investigation by the Royal Canadian Mounted Police (RCMP) and the Office of the Superintendent of Bankruptcy (OSB) into the bankruptcy of UM Financial.  The RCMP and OSB provided a production order in June 2012 requesting documentation from Grant Thronton, and Grant Thornton additionally provided a sworn affidavit and the requested records to the RCMP/OSB on September 19, 2012 indicating that the investigation continues.

The requested documents were relating to the "precious metals" (the gold and silver withdrawn from UM Financial's bank account by Omar Kalair shortly before the receivership in 2011) and "in relation to mortgage payments allegedly misappropriated including [...] 20 disputed mortgages totaling approximately $3.4 million and unreported prepayments [received from mortgage clients] of $910,000". 

This investigation is looking into whether the following offences occurred:

• Bankruptcy & Insolvency Act - Fraudulent disposition of property
• Bankruptcy & Insolvency Act - Refusal to answer fully & truthfully
• Bankruptcy & Insolvency Act - Failure to keep proper books
• Bankruptcy & Insolvency Act - Failure to comply with duties
• Criminal Code - Bankruptcy Fraud over $5000
• Criminal Code - Conspiracy to defraud creditors

It will likely be a while before the result of the investigation is revealed and whether the RCMP/OSB eventually decide to bring charges against any of the former executives of UM Financial, including the former CEO Omar Kalair and former Chairman of the Shari'ah Supervisory Board Mufti Yusuf Panchbhaya.

In the meantime, the case has likely damaged the prospects for Islamic finance on the retail level in Canada, although there were many areas where, according to the previous reports from Grant Thornton, there were weaknesses in the governance systems of the company that could be improved by a new Islamic finance company in Canada.  

UM Financial receivership may be nearing an end

During my time writing for The Islamic Globe, one of the stories where I directed a lot of attention was the receivership and bankruptcy of UM Financial, Inc. (and its sister company UM Capital, with the two companies referred to as "UM Financial" for the rest of this post), which offered Islamic mortgages to consumers in the Toronto, Ontario area, funded by the Credit Union Central Ontario, which was later merged with Credit Union Central British Columbia, to become Central 1 Credit Union.  

The trigger for the receivership was the decision by the funder, Central 1 Credit Union, to decline to offer additional funding to UM Financial and then requesting the receivership on the basis that UM Financial was in non-monetary default on its credit facility with Central 1.  However, the situation moved from typical problems in a messy business separation after a breakdown of the relationship to the bizarre, when Grant Thornton, the receiver discovered $2.1 million missing, having been withdrawn by the CEO of UM Financial, Omar Kalair, in gold and silver in the months before the receivership. 

The gold was purportedly in partial payment of an invoice drafted by Kalair and Mufti Yusuf Panchbaya, for Shari'ah advisory services provided by the board, headed by Mufti Panchbhaya since the inception of UM Financial.  The timing of the payments immediately before the receivership--when at least Kalair was aware was pending--raised red flags for Grant Thornton, based on statements in a number of court filings.  The transfer of the gold, according to Kalair's sworn testimony, occurred in a dark pharmacy parking lot, with $1.8 million and $300,000 in silver being transferred from Kalair's trunk to the trunk of Joseph Adam's car, a shopkeeper who ran an Islamic clothing and bookstore (Adam is also known as Gamal Hegazy).

Shortly after, Adam departed Toronto for his native Egypt with the gold, having returned the silver to Kalair who then gave it to Panchbhaya, who later turned it over to the receiver (it was then sold with a $90,000 loss due to the fall in silver prices).  There is considerable confusion on who the gold was intended to be paid to, the local Shari'ah board, Adam, or other consultants who worked with the domestic Shari'ah board.  The final story given was that it was paid to unnamed Egyptian scholars who had issued a fatwa for UM Financial, who were introduced through a relative of Adam's, though the only evidence is a one page document with a number of unidentified signatures.  Adam admitted in a deposition via Skype that he had taken the gold bars in his suitcase to Egypt, and distributed them, but would not reveal to whom he gave the bars.  The gold has still not been located.


During the entire process, many of the homeowners who received financing were left in limbo as the receiver sorted through the paperwork, uncovering second mortgages along the way that increased the confusion about how much had been paid on each property.  From the initial 172 clients, a number of mortgages were discharged after being refinanced and 20 were discharged after the customers demonstrated that they had paid UM Financial the remaining balance, which was then not passed along to Central 1. 

In the process, the receiver was collecting fees according to the "Musharaka Home Financing Agreement", which included annual 'renewal' fees and prepayment fees of profit for the full year in which the refinance occurred.  The receiver has decided to keep the annual fees, but rebate the prepayment penalties on a pro rata basis (based on when the refinance took place), and has asked for court approval to do so. It has also asked for approval to sell the portfolio to Central 1, after bids for the portfolio received during a sales process were rejected because they offered a price that was at a discount to the amount owed by UM Financial to Central 1. 

The sale is being done through a credit bid, where Central 1 is bidding the amount it is owed by UM Financial, in exchange for the debt being extinguished, in effect, receiving the portfolio in lieu of any payment by UM Financial.  The purchase and sale agreements were signed on June 15th and the court will consider the offer on June 29th, which will likely end the UM Financial saga, although the homeowners affected (through the first and second mortgages) will continue to be impacted, just with a new servicer on the first mortgages, Central 1. 

Kalair, Adam and Panchbhaya, according to court filings, face a continuing investigation.  Adam told the lawyer for Grant Thornton that he had spent several weeks in the hospital due to stress and the flu.  He is seeking a way to return to Canada for medical treatment, but will be arrested and jailed for 6 month for contempt of court unless he can provide the receiver with a return of the gold bars and answer the receiver's questions. 

The fate of Kalair and Panchbhaya are murkier still since Grant Thornton reported an ongoing investigation by the Office of the Superintendent of Bankruptcy and the Royal Canadian Mounted Police into alleged Bankruptcy and Insolvency Act and Criminal Code offenses, relating to the receivership and bankruptcy of UM Financial.  The investigation also includes allegations of offenses relating to the transfer of gold, which brings the Multicultural Consultancy Canada Ltd, a company formed by Panchbhaya to receive the gold, into the picture.  Among the alleged offenses are fraudulent disposition, bankruptcy fraud and conspiracy to defraud creditors, according to a production order served on Grant Thornton as receiver of the 2 UM Financial companies. The investigation does not mention Kalair or Panchbhaya by name, but they are likely to be included in the target of the investigation, "the Debtors [UM Financial Inc and UM Capital Inc] and the operating minds behind the Debtors and MCC". 

Whatever the eventual fate of the parties involved with UM Financial, it serves as a reminder that even in Islamic finance, there can be breakdowns of trust between businesses and between a company and its customer and the fact that a business represents itself as being 'Islamic' does not mean that everyone involved will act ethically. 

There are specific examples in the UM Financial saga where the management of a company may not be fully independent of its Shari'ah board, which dulls the effectiveness of the Shari'ah board as an independent check for investors and customers.  There were also instances where too much control over the handling of money occurs without oversight by either customers, creditors, internal personnel besides management and regulators (UM Financial was unregulated). 

At the end of the day, the worst part of the UM Financial saga is that it harmed homeowners, and will limit trust in Islamic financial institutions in Canada, likely for many years to come.  It should remain as a lesson for the industry as a whole to remain vigilant to protect the entire industry's reputation, which is much easier lost than it is rebuilt. 

Related Documents:
Latest court filing (PDF)
List of all court filings released by Grant Thornton, the Receiver

Islamic mortgages: Is there anything new?

An article I read tonight raised an old question about Islamic mortgages that I think is interesting, specifically, whether they offer anything different from conventional mortgages.  The answer (both yes and no) is a bit complicated for the basic question asked. The context is the UK market, but it applies in any market and has less to do with the specific regulatory requirements for companies offering home financing.  The article describes:

Risk sharing, not profiting unjustly or unfairly, not charging excessive charges; in a residential purchase context, allowing part rent, part purchase, sharing equity upside, sharing downside property risks. These characteristics apply equally to an approved Islamic home finance plan as they do to a new conventional purchase plan designed for a housing association in the north east of England.

There are a few different themes expressed here which affect Islamic mortgage financing.  The first comes up in the first two words: "risk sharing".  This is often used as the big difference between conventional finance and Islamic finance, in many cases erroneously (disclaimer: if you reverse the two words you come up with the brand I operate under).  There is nothing in Islamic finance that requires sharing risk any more than conventional finance.  It would be perfectly acceptable for a business to structure its contracts so that they are Shari'ah-compliant and where one party accepts only minimal risk beyond the credit risk that conventional banks specialize in dealing with. For example, an Islamic bank may only offer financing using murabaha, which is the most commonly used structure for assets on Islamic banks' balance sheet .

The next part is, in my opinion, more important for what Islamic finance is designed to do: "not profiting unjustly or unfairly, not charging excessive charges".  In the modern concept of finance, this is where Islamic financial institutions should be cleaning up and taking business from conventional banks (for both Muslim and non-Muslim consumers).  However it has not happened and there have been failures of business models (e.g. Arcapita and Gulf Finance House) and institutions themselves (e.g. UM Financial) where ethical behavior has converged with the conventional industry or even dropped below the (low) industry standard. 

This is more a problem of regulation.  The Islamic investment bank models practiced in the GCC where the banks would invest and then sell on to investors at a premium with minimal disclosure (I am speaking here more of GFH where there is more evidence of the practice) would have not been allowed in more strictly regulated markets.  In the case of companies like UM Financial, which escaped regulations almost entirely, had they been subject to even minimal standards of regulation in the industries they operated, they would have been shut down far earlier than they were. 

More than any other financial sub-industry, Islamic finance should welcome regulation (both in the traditional sense and in the additional Shari'ah regulation).  There are issues with how the industry imperfectly self-regulates today (on the Shari'ah side), with egregious abuses in conflict of interest have occurred in both Chicago (Sunrise Equities) and Toronto (UM Financial) where the companies' founders were excessively connected with the heads of their respective (supposedly independent) Shari'ah boards rendering them in practice as non-independent. One hopes that other regions have better standards, but I am not encouraged by the fact that UM Financial is still listed as a member of AAOIFI. 

Regulation to prevent bad actors is necessary to maintain the credibility of the industry as a whole, especially in overly politicized environments (like the US and Canada) where any wrongdoing (or even right-doing) by an Islamic financial institution is seized upon as "evidence of a plot to impose Shari'ah". 

But I have become distracted from the main point of this post, which is to address the description of Islamic mortgages: "allowing part rent, part purchase, sharing equity upside, sharing downside property risks".  This was the point that inspired the post and I think is the most interesting about how Islamic finance works in practice: it is much easier for Islamic mortgage companies in the US to share in the upside of transactions than it is in the downside, but it almost never happens. 

Banking regulations in the US are extremely hesitant to allow a depositor to lose money and most of the potential uses of deposits for an Islamic bank would be in mortgage financing.  However, the discussion always revolves around the banking side of the equation: why do Islamic mortgage providers use Freddie Mac to provide much of the liquidity to fund Islamic mortgages?  Why don't Islamic financial institutions use more of a profit-and-loss sharing method of mortgage finance?

The answer may not necessarily be the financial institutions' fault (they do have to fit within the US' financial regulations, but there are many forms they could take to serve the market if profit-and-loss sharing were demanded).  It may be that most potential customers demand a Shari'ah-compliant product that leaves them with the upside.  Given the evidence of the industry's roughly 40 year history, it appears that when presented with the costs and benefits most consumers prefer to keep the upside, and use more debt-based financing models for home finance. 

The present form for Islamic finance is, of course, not where it will be in 10 or 20 years and it will (should) change substantially over that time period, but the key for that change in the mortgage market will be consumers themselves giving up their monopoly on the upside gain.  Are financial consumers willing to give up a portion of the appreciation of their house's value to be able to pass along some of the loss if home prices fall, especially when Islamic mortgage companies are offering non-recourse Shari'ah-compliant loans?  I am not sure of the answer today.

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.

How can Islamic finance in the West grow?

One of the key drivers for Islamic finance in the West has been the immigration of Muslims into those countries. As these immigrants have moved in, the domestic banks have tried to develop products that cater to their needs. However, the process has been slower than one might expect, particularly in some countries like France and Germany which have relatively large shares of Muslim residents compared to their populations. The first Islamic bank branch in Germany, a branch of Kuveyt Turk, opened earlier this year in Mannheim. Al Baraka Bank says it plans on opening an Islamic bank in France in 2011, something it has planned for several years.

An article recently described the growth of multicultural banking in Canada and alluded to the relative shortage of Islamic banking in the country despite the growing Muslim population, that is growing in large part because of immigrants to the country. The country has had Islamic home finance co-operatives for decades and in the last several years, UM Financial has offered Islamic mortgages (as well as a pre-paid Shari'ah-compliant debit card and some work on forthcoming sukuk). The larger banks, including Bank of Montreal and Scotiabank are considering whether to enter the market while RBC offered Islamic mortgages, before dropping the product due to low volumes. In Canada, it appears that the large banks entering the market have been hamstrung by difficulties entering the Muslim marketplace, while the smaller institutions have been set back by shortage of capital for new originations. In the United States, the shortage of capital has been eased with the entrance of Freddie Mac, which provides the financing for Shari'ah-compliant mortgages. There is not a similar institution in Canada, so the best way forward may be for the large banks to work through the smaller providers to combine the former to benefit from the latter's better exposure within the Muslim community and the latter to benefit from the former's access to capital. Were this to happen, it would open up the possibility of the larger banks securitizing Islamic mortgages, which could then be sold to fund managers to allow them the investment possibilities they need to offer retail Shari'ah-compliant fixed income investment products to the Muslim marketplace where fixed income is always a challenge (and very often limited or absent from the market).

Sukuk in the next year

The sukuk market has been one of the most commonly discussed areas of Islamic finance, and not without reason. It is one of the more dynamic (and cyclical) parts of the Islamic finance industry. It has also been an area that companies from the West and multilateral institutions (GE Capital, the World Bank, the International Finance Corporation, for example) have become engaged with the Islamic finance industry. When the sukuk issuance volume collapsed in 2008 and early 2009, it was viewed as the end of growth beyond 'traditional' markets for Islamic finance. This was, of course, a rush to judgement, but the rush was on in all areas from the conventional financial sector in the West, Islamic finance and in equities. In a crisis, the first thing that is lost is optimism for the future.

In the year following the bottoming of equity markets in the West following the crisis, the sukuk markets became divergent. Initially, the drop in issuance was more pronounced in the Asian markets and the GCC was able to continue on (in part, probably due to a recovering price of oil). However, around November 2009, with the onset of the Dubai debt crisis and the oncoming maturity of the $3.52 billion Nakheel sukuk, the trends changed sharply. The GCC was viewed as too risky and demand dried up for new sukuk. The primary issuance was from sovereigns with a few corporate issuers sprinkled in here and there. In contrast, the Asian sukuk markets rebounded sharply and issuance of sukuk (along with the equity markets in countries like Indonesia and Malaysia) grew rapidly. However, the recent news indicates that the growth in sukuk may be returning in the GCC and also to the West (particularly the UK, with politics interfering in the US--see my post on Thursday). Consider the headlines from just the last couple of days.

• "Sukuk Entice Canada Issuing $2 Billion to Spread Funding: Islamic Finance"
  
• "UK government ‘seriously considering’ first sukuk issue "
  
• "Gatehouse plans to launch Pounds70m sukuk next month, says chairman"
  
• "Saudi Aramco, Total ink $1b Sukuk for Jubail JV"
  
• "Saudi firms to launch 10 sukuk"
  
• "Nakheel to issue sukuk by January 2011 - CEO"
  
• "Abu Dhabi Islamic to Meet Investors Before Bond Sale"
  
• "Sukuk eye record on Asia growth and Gulf issuance"
  
• "GCC bond issuance jumps 140% in Q3" (Conventional)
  
• "Emirate of Ras al-Khaimah eyes benchmark bond issue-paper" (Conventional)
  

Arguably, the two most important sukuk coming are the potential UK sovereign sukuk and the Total-Saudi Aramco sukuk. The former would be the completion of an effort that has stretched back several years to when Gordon Brown was prime minister. The latter would be important because of its potential size. The $1 billion sukuk would be one portion of at least $12 billion in total cost of the planned Jubail refinery.

In the regrowth of GCC credit markets, it is interesting, but not surprising, that the conventional bond market in the region has rebounded quicker following the first part of a Dubai debt restructuring and the expected resolution of trade creditor's claims of Nakheel (which will also include a sukuk for 60% of the claims). According to NCB Capital, conventional GCC bond issuance rose from $4.5 billion in the second quarter to $10.8 billion in the third quarter (14 issues in Q2 versus 26 issues in Q3). During the last quarter, issuance in the GCC was below the level of the first quarter of 2010 even as total issuance was $10.3 billion in the quarter ($9.2 billion of which came from Malaysia).

In addition to the potential issuance from the GCC, which would follow the recent growth in the conventional bonds from GCC issuers, one of the notable pieces of news is that there may be corporate and government-related sukuk coming from Canada, which has not been the source of any sukuk so far. According to Omar Kalair, the CEO of UM Financial, which is based in Toronto, HSBC Bank Canada may offer $500 million and three government-related borrowers from one Canadian province may issue $1.5 billion of sukuk (quoted by Bloomberg). As the past few years have demonstrated, the potential for sukuk is only a guide for future issuance, but regardless, it is another step forward for the internationalization of Islamic finance that new issuers could enter the market.

The fourth quarter will be a good guide to whether the regrowth of sukuk issuance globally (particularly ex-Asia and in the West) will likely continue into 2011 and the breakdown between sovereign/corporate, regional and the different structures will provide a guide to what the next year and more will bring.

Islamic retail banking in the West: Can the US provide an example?

There are a number of articles about the challenges facing the Islamic finance industry that caught my eye in the last couple days but none challenge the conventional wisdom as much as an article from Bloomberg that Islamic banks or conventional banks Islamic windows in the UK have been set back substantially by the recession. Further, there may be too many banks (22) chasing too small a market ($19 billion versus $93 billion in Malaysia). Another article in the Independent focuses on the withdrawal or shrinkage of retail Islamic finance at large banks in the UK. One of the areas where the Bloomberg article flies in the face of conventional wisdom is that the UK government has not supported the Islamic financial industry sufficiently. This contradicts the widely held view that the UK is preeminent among non-Muslim-majority regions in both its level of development and the scope of government support. As much as this challenges these ideas, there is a caveat that is not mentioned in the article: it is mostly focused on the domestic market, not the participation of UK-based banks in the global Islamic finance industry. However, it does set back the idea that Islamic banking can become a widely accepted subset of the domestic financial industry in non-Muslim-majority countries with sizeable Muslim minorities.

On the scale that Bloomberg is looking, there probably is not a large enough market that can easily be penetrated by large institutions and the one solely retail focused and Shari'ah-compliant institution, the Islamic Bank of Britain represents too small a sample to generalize about the prospects for smaller institutions. In this regard, the United States may provide an example of how Islamic banking can be feasible without participation from large conventional banks. The US market--for reasons of regulation and geographical concentration of the Muslim population--has no product availability among the large banks, but under the radar exist community banks, credit unions and non-bank financial companies that provide Islamic financial services. This may be the maximum size that is profitable currently in countries without sizable Muslim populations and that should be recognized as a success. Although the headlines are drawn by the largest and the newest products and institutions, having financial institutions that recognize the value of remaining small enough to serve their customers and avoid overexpansion is a virtue in itself. Not all areas in the U.S. have remained under the radar. For example, the Amana mutual funds have grown over the past decade and two of the funds are the largest Islamic equity funds in the world, in large part because they have transcended their natural market and attracted non-Muslims based on their performance.

Areas of the Islamic financial industry that are not yet able to attract significant non-Muslim participation but are able to avoid growth-at-any cost may not make the headlines, but the experience of the Amana Funds shows that this is not necessarily a failure. The Amana Funds remained small for many years before starting their rapid growth at the beginning of the last decade. Their growth was "supply-driven"; it was "demand-driven" based on their ability to provide a service demanded by consumers both Muslim and non-Muslim based on its performance. There cannot be a direct analogy that could work elsewhere in non-Muslim majority countries, but the contrast could provide lessons for other non-Muslim-majority countries with aspirations to develop a domestic Islamic finance market. Maybe the next decade will be the decade for retail banking.

Other News

• Rushdi Siddiqui has two great articles in Gulf News. In one article he suggests: "For Islamic finance, a lack of Muslim inclusion should be a greater concern than lack of standardisation. When we speak of convergence, it may well entail technology (mobile phone) and banking for the non-bankable Muslims. Hello, is Islamic finance listening at the other end?". In the other, he interviews Dr. Mohammad Nedal Al Chaar, the Secretary-General of AAOIFI.
  
• As the Islamic finance industry grows in Canada, the Rotman School of Management at the University of Toronto is the first to offer a course on the subject for MBA students.
  
• Saudi Binladin Group sold a short-term sukuk with a maturity of 9 months for $187 million (SAR700 million). Most sukuk have a tenor between 3 and 7 years.
  
• Sukuk sales in 2010 are expected to be $23-$25 billion according to a poll by Reuters. This was close to the $23.3 billion issued last year and lower than a poll conducted in April which forecasted $28 billion in sukuk sales. Asa Fitch wrote a good article in The National about the growth of the sukuk market and the rapid decline during and after the financial crisis.
  
• Even after a four-month rally, the yields on Nakheel's sukuk are twice as high as 2007. A credit analyst at S&P in Paris, Mohamed Damak who also is co-chair of the Islamic finance working group for S&P points to this as evidence that the market is still hard to access for real-estate-based companies.
  
• Kazakhstan has resumed planning for its first sukuk, which is not expected soon and will likely be an ijara sukuk of roughly $300 million. There are a number of regulatory issues that need to be dealt with.
  
• Russian bank Vneshtorgbank (VTB) has also resumed work on a sukuk issuance and "a range of other Islamic financial products". The Association of Regional Banks of Russia established a task force on Islamic financial institutions.
  
• An article in Arab News describes the backlash facing Islamic banks in South Africa over high fees. However, the criticism of the high fees are not limited to Islamic banks.
  
• A report about Islamic banking in Indonesia was released recently.
  
• The Saudi Electric Company is planning a fourth sukuk. The timing, size and pricing are yet to be determined.
  
• Abu Dhabi Ports Company is considering a bond or sukuk of up to $1 billion in early 2011.
  
• Bermuda is trying to attract the Islamic finance industry following a trip by the CEO of the Bermuda Stock Exchange to Bahrain.
  
• An opinion piece in China Daily by the program director of the University of Hong Kong SPACE on the development of Islamic finance in Hong Kong, including the areas where it is being held back, particularly in human capital.
  

What does 2010 hold for sukuk?

The primary sukuk markets will see growth this year according to both Moody's and KFH Research with the latter expecting over $30 billion in new issuance. KFH Research predicts, according to senior analyst Tursina Yaacob, that private sector projects will see a revival, especially in Asia. The sovereign Indonesian sukuk for $889 million that was recently issued (triple the planned amount on significant demand with a bid-to-cover of over 7 times) is the largest sukuk issued this year according to KFH. Moody's projects that the first half of the year will see sovereign, supranational and government-related sukuk issues (which were the largest share in 2009) make up the largest share before private sector issuance recovers in the second half of the year. Emirates Business 24/7 has a detailed analysis of Moody's predictions for issuance by country. The Moody's press release focuses on the impact of legislative and regulatory changes as a source of a boost in new issuance, particularly from the sovereign or quasi-sovereign issuers. In addition to the legal and regulatory changes, the Central Bank of Bahrain is providing training on banking to Shari'ah scholars, while the Bank Negara Malaysia, the central bank, is launching a new Shari'ah governance framework to be effective beginning in 2011.

The Financial Times recently provided a short FAQ on sukuk which is a good introduction. As a part of the legal and regulatory environment being changed to accommodate Islamic finance, the Monetary Authority of Singapore revised its banking regulations to clarify its position on istisna'a financing, which was described in the opening remarks at the Singapore Islamic Finance News Roadshow 2010. Business Week notes the planned sukuk issuances, which include a $1.9 billion issue from Saudi Electric Comapny. Ernst & Young also released its World Takaful Report which predicts that the takaful market will surpass $8.8 billion this year.

Dubai Civil Aviation used a new ijara facility in April 2009 to repay a portion of the maturing $1 billion ijara facility that was due at the time. Recently, the first of three equal installment payments of $227 million was paid on this ijara facility, which included three tranches (in Emirati Dirhams, US Dollars and Euros).

Other News

• The AFP has an article on UM Financial's new iFreedomPlus MasterCard.
  
• Kuwait Finance House is exploring investment opportunities in alternative energy over the next two years. It's expansion into Canada through a recent joint venture after amendments to the tax law and was delayed by the credit crisis.
  
• The International Investment Group, based in Kuwait, has defaulted on its $200 million sukuk and a dissolution event (for the trust) will occur if the sukuk default is not remedied within three days. The IIG sukuk was a mudaraba sukuk and was exchangeable into either shares in IIG or cash and was listed on the NASDAQ Dubai (formerly DIFX) in June 2007.
  

Islamic finance and financial stability

The Islamic Financial Services Board meeting recently saw the launch of the IFSB-IRTI-IsDB report on financial stability in the Islamic finance industry. I have not had a chance yet to read the report, but my initial impression of their effort is supportive. It recognizes that the global financial crisis did impact the Islamic financial system and can provide lessons as institutions grow larger. There have been many times, most recently a couple weeks ago where I question whether too big to fail is not a problem that could afflict Islamic finance. I argued (and still maintain) that because the industry is concentrated in small countries in the Gulf, a big institution (like the planned Islamic mega bank or institutions like Dubai World, which is not an Islamic financial institution, but has received significant Shari'ah-compliant funding) could endanger the financial stability of the country it is based in. This problem is heightened because there are no Shari'ah-compliant options for 'lender of last resort', the role the US Federal Reserve played to keep healthy banks from being destroyed as global liquidity dried up. The potential problem does not end there. There is inter-bank funding occurring (although not generally overnight funding which caused virtual runs on conventional institutions) and so one bank's trouble spills over to other banks with exposure to the troubled bank. If a few large lslamic banks became insolvent, it is likely that their debt would be held on other banks' balance sheets and the writedown of the insolvent bank's debts held by other banks could put stress on the solvency of the other banks. This could be heightened if this caused retail banking customers to withdraw their money, which could cause a liquidity squeeze that would put the previously healthy banks at risk of insolvency. With that rather gloomy (although relatively unlikely) prospect in mind, I think it is a good thing for the establishment of an Islamic Financial Stability Forum, which was recommended in the report.

Other News

• Rushdi Siddiqui, the global head of Islamic finance for Thomson Reuters, argues in a column in GulfNews that there should be more linkages between the halal industry and Islamic finance.
  
• Dar Al-Arkan made a periodic coupon distribution on one of its sukuk.
  
• To broaden its investments, Kuwait Finance House signed an agreement to invest $450 million in Canadian real estate working with Killiam Properties.
  
• The first takaful policy for a space satellite was announced recently.
  
• The Investment Dar is fighting over the buyback option on shares in Boubyan Bank it lost.
  
• Asharq Alawsat's columnist Lahem al-Nasser says that Shari'ah boards should be treated like external auditors and should be liable for their decisions.
  
• Pakistan will sell domestic sukuk within the next three months. The central bank is also considering ways to provide short-term sukuk for Islamic banks' liquidity management.
  

Islamic wealth management, avoiding future crises, Moody's says Islamic finance could reach $5 trillion

The Islamic wealth management report from Bank Sarasin raises one point which I believe is true across the Islamic finance industry: the diversification of assets is not nearly as expansive as in conventional finance and in many cases leaves investors with too much exposure to real estate. It also is too focused on transaction-based compensation for Islamic bankers. The emphasis is placed on deals and there is too little focus (and compensation based on) the long term needs of Muslim investors. As an asset manager myself, I have watched the Islamic finance industry expand, particularly in the issuance of sukuk, with much of the focus on new financial products that expand the financial structures used in conventional finance. That is not necessarily problematic because good diversification relies on different asset classes from which investors can choose. However, when the focus is on creating a diverse set of structures and not on the types of investments, there will be an unmet need. For example, the equity asset class has been the easy part with Islamic indexes being around for over 10 years now. However, there remains a shortage of fixed income-like products that is only partially filled by sukuk (for example, there is still no fixed income-substitute within the United States). A lot of the other structures being created have still focused on property finance. There can be many different ways created to provide investors with exposure to real estate markets, but that still only addresses one asset class. It may create diversification (e.g. geographical) within that asset class, but a focus on real estate markets as a predominant investment area leaves asset managers struggling to create a diversified portfolio for Muslim clients (whether or not they are exclusively focused on Muslim clients). Perhaps the (nearly) global property bust will will make other areas more attractive, but it may just create a new area where activity is concentrated. That would be a shame and would harm the investors that are the source for the Islamic finance business.

The CEO of Fajr Capital, Iqbal Khan, said that Malaysia can provide an example for reform within the Islamic finance industry, particularly to separate the utilitarian and financial intermediation roles to prevent the problems that arose during the credit crisis. Mr. Khan said that there should be a separation to prevent the need in a future crisis for Islamic investment banks to be bailed out the government to preserve the basic payment systems within the banking system. Those payment systems could then be backstopped if necessary but ""Everything else - Mudharabah-based, asset-based, unit trust and investment fund - goes into separate business. These two, never the twain shall meet, they have to be kept separate". I believe he is absolutely correct. The flaw with the universal banking model and allowing the investment banks and commercial banks to merge (in the U.S., this was through the Gramm-Leach-Bliley Act) forced the government to bail out all or none of the banks and the combination of the two into large financial holding companies meant that in order to keep the payment systems intact, the investment banks had to be bailed out lest their losses endanger the institutions as a whole, which led to the crisis within the 'boring' areas of the credit markets unrelated to the investment banks' operations.

Moody's says that Islamic finance assets could grow to $5 trillion without providing a date by which this could be reached. They said assets were $950 billion in 2009, which is higher than previous estimates from other groups which were in the range of $800-$850 billion. Moody's says that Shari'ah-compliant derivatives, if 'employed with care', could provide a useful purpose for hedging purposes. The recent IIFM master agreement on Islamic derivatives includes a requirement that they only be used for hedging, not speculation. Moody's VP and Senior Credit Officer Anwar Hassoune cautioned that "IFIs aim to utilize derivative instruments to hedge against risk and to improve risk monitoring practices. However they are keen to do so in a Sharia-compliant manner, rather than imitating conventional derivative instruments, in order to avoid losing their special status as Sharia-compliant banks, which makes them very attractive to a large population of Muslims." Moody's warns that IFIs have weak asset-liability, investment, and liquidity risk management. An article published by the Wharton School at the University of Pennsylvania discusses the role of ratings agencies within the Islamic finance industry, specifically within the sukuk market.

Other News

• An article in the Financial Post (Canada) discusses the recent UFANA conference in Toronto (at which I was a speaker).
  
• $4.67 billion in sukuk were issued in the first quarter of 2010 according to Zawya, compared with $0.63 billion in the same period in 2009. Malaysian issuers accounted for 53% of all new issues, Indonesia for 33.5% and Saudi Arabia with 9.6% from the Dar Al Arkan sukuk of $450 million. Malaysia is planning a US dollar-denominated sukuk.
  
• An opinion column in the Kuwait Times asks whether Islamic banking has enough focus on providing a competitive and quality product to ordinary people.
  
• A GCC-based VP at iShares offers an interesting view of the current state of Islamic indices.
  
• Just as private equity has faced significant headwinds over the past 2 years, so has the Islamic private equity industry and things are just starting to get back to doing deals.
  
• The New York City Bar is planning a seminar on Islamic law including a portion of the seminar covering Islamic finance.
  
• Indonesia's efforts to expand the share of its banking system made up by Islamic banks is described in an article from the Oxford Business Group. The government is planning a 5 trillion rupiah sukuk (555 million) issue on April 13.
  
• Standard Chartered's Islamic finance window has avoided Islamic hedge funds based on a concern that the arbun structure used to create short-selling-equivalent has not been widely accepted among Shari'ah scholars.
  
• An article describes what AAOIFI does and what it is working on now.
  
• Sudan, which has been largely cut off from capital markets since US economic sanctions were imposed in 2007 because of the genocide in Darfur, is issuing $300 million in sukuk.
  

Dubai World; Islamic 'lender of last resort'

News about possible options for Dubai World continue to surface in media reports and the latest is that Dubai World may seek to simply rollover its debts and lower the interest payments and repay over an eight to ten year period. The outcome for sukuk holders was not discussed specifically in the reports and I am still not sure whether the Dubai World restructuring will include specific accommodations to account for Shari'ah-compliance concerns. In my opinion, and I am not a scholar so I can't speak definitively about this, that any extension of maturity with continued lease or profit payments could be difficult because it would effectively exchange a delay in repayment for a higher level or repayment, which would probably raise some issues. However, I recall that the Nakheel sukuk incorporated defaults by extending the lease term and continuing the lease payments until repayment (analogous to what is being proposed), while retaining the lease as the source of the payments. This would probably be viewed more favorably because it would not include a delay in repayment in exchange for increasing the principal (by making periodic payments for a longer period). However, not all of the Dubai World Islamic debt is structured as ijara. One source in the FT article said that creditors could receive a share of future profits, which could be a way to extend the maturity by turning a murabaha or other facility into a mudaraba or musharaka. However, the lack of clarity on this issue in the media report suggests that there is either a minority of debt that is Shari'ah-compliant or the issue of Shari'ah-compliance is not at the forefront and is being viewed as a later issue when the general terms are agreed for something to be engineered to work around any issues. The National newspaper also offers its slightly different analysis. The Nakheel sukuk are discussed in another article as JP Morgan indicated in a note that sukuk holders could receive repayment at par.

The Union of Arab Banks says it is finalizing a way to allow Islamic banks to approach the central banks of the region for support. This is an important issue because without 'lender-of-last-resort' protection, Islamic banks are more vulnerable to runs. The lack of this support potentially can turn a liquidity crisis at Islamic banks into a solvency crisis if they are forced to unload assets at fire sale prices to meet depositors' withdrawals. This vulnerability should overshadow the more conservative lending standards in the pronouncements of Islamic banks' supposed immunity to crisis. The interbank market is important for banks to be able to have lower reliance on high levels of liquid assets that can reduce their profitability and thus the competitiveness with conventional banks. Following the launch of larger banks like Istikhlaf, which appears only to be an investment bank at the time being, there will need to be more attention paid to the systemic risk posed by larger Islamic banks. Without liquidity facilities at the central banks, investment banks and retail banks in the Islamic financial industry are extremely vulnerably. Beyond the fleeing of depositors in a 'classic' bank run, the demise of Lehman Brothers and Bear Stearns show how a run can start even without depositors if the wholesale funding partners of a bank withhold credit all at once. Both 'classic' and 'Lehman' runs should be considered in judging the urgency of establishing a 'lender of last resort' facility. When there is a new bank with $3 billion in capital expected, this could translate into $60 billion in assets (assuming a leverage ratio of 20:1). That would be a huge institution that would pose systemic risk to the Islamic financial system. It is an issue that deserves a lot of attention.

Other News

• The Dubai Financial Services Authority issued five Islamic finance handbooks for firms operating in the DIFC.
  
• Having announced last year investments in Chicago and a joint-venture with a publicly traded REIT, Kuwait Finance House is planning further expansion in the US, China and Canada. Other Islamic banks have urged China to consider Islamic banking as a way to attract capital from the Middle East.
  
• Indonesia raised 999 billion rupiah ($108.9 million) in its latest sukuk auction with a maturity range of 5 to 15 years sukuk. It had no winning bids for an 11-year sukuk auction. There have been several recent failed auctions for sukuk with investors demanding too high a yield to be accepted by the Ministry of Finance.
  
• Forbes has an article (written by Oxford Analytica) on the moves towards standardization in Islamic finance.
  
• The Islamic Development Bank will soon launch a roadshow to raise money for Istikhlaf, the 'Islamic Goldman Sachs' expected to begin operations later this year.
  
• Dar Al-Arkan redeemed a $600 million sukuk.
  
• The Jordanian government borrowed $100 million from Jordan Islamic Bank to finance a stockpile of wheat and barley.
  
• Centennial College in Toronto will offer an Islamic finance course starting in May.
  
• Has Islamic finance helped cushion Bahrain from the blow of the global recession? The finance minister thinks so.
  
• The Investment Dar continues to struggle on its restructuring and may seek protection under the country's financial stability law.
  
• Amana Takaful, a Sri Lankan takaful provider received an insurance license in the Maldives. The takaful industry continues to struggle over the lack of sufficient supply of appropriate investments, like sukuk, and a shortage of talent.
  

More commentary on TID's wakala

The Investment Dar's defense in a lawsuit filed by Blom Bank over a wakala agreement is receiving significant attention throughout the industry. The contract, in which TID acted as the investment agent for Blom Bank and was responsible for returning principal plus an agreed profit margin if the investments were profitable, was signed off by its Shari'ah board three years ago. In court case, TID argued that the contract was not Shari'ah-compliant and therefore is void. The court sided with TID and ordered that TID repay only the principal. This has attracted attention to the impact the ruling could have on Islamic finance as a whole by increasing Shari'ah risk. One unnamed lawwyer suggested that TID "is clearly in financial difficulties and clutching at straws to get out of paying but [this] may cause concern for conventional institutions considering entering into a sharia transaction."

Other News

• Reuters sums up a recent Islamic finance conference in Jordan.
  
• Belgium is marketing itself to Brunei (in addition to countries in the GCC) as a destination for Islamic venture capital funds.
  
• A Malaysian company Binariang GSM has partially redeemed $1.1 billion of its senior sukuk.
  
• The recent debt exchange by Gulf Finance House led Standard & Poor's to raise the rating from selective default to CCC- with outlook negative.
  
• Bullion Management Group, a Canadian company offering two bullion funds, received Shari'ah approval from the Islamic Finance Advisory Board.
  
• France is still expected to make changes to its legal and regulatory framework to accommodate Islamic finance.
  
• The establishment of an Islamic finance company in Kerala, India is still uncertain because of the involvement of the government and the limits of government involvement with a religiously-based financial institution. It may be changed to be an 'interest-free', rather than Islamic institution.
  
• New tax changes that would implement a goods and services tax in Malaysia will be done so that it has an equal impact on conventional and Islamic financial services.
  
• Business Week provides a list of the upcoming sukuk issues.
  

Dubai, Gulf Finance House, criticism of media descriptions of Islamic finance

Dubai and GFH
The worries over Greece has spilled back into Dubai with the credit default swaps rising to their highest levels since the Thanksgiving crisis over the maturing Nakheel sukuk. The money provided by Abu Dhabi to redeem the Nakheel sukuk will finance payments due until the end of April while Dubai World negotiates a standstill agreements but rumors have been spreading about a request for a standstill on all of Dubai World's debt for six months reported (but not confirmed) in al-Ittihad article.

In the wake of rising CDS premiums and concerns over Dubai World, the price of the Dubai sukuk has fallen significantly raising yields above 10%. It remains unclear about whether the problems with Dubai World will spill over into the Dubai government (which does not explicitly back Dubai World's debt).

The Dubai situation is not the only hotspot in Islamic finance in the Gulf recently. Gulf Finance House rolled over 1/3 of its maturing debt while paying off the remainder, which has brought attention to the offshore banking business (particularly investment banks) in Bahrain. The article above (from Reuters) notes that "most investment houses in Bahrain relied on booking upfront fees on money raised from investors for real estate projects and private equity projects, a market which collapsed following the end to a regional property boom late in 2008."

The terms on which GFH was able to postpone repayment of its entire maturing debt are costly with reports that the $100 million will cost the bank LIBOR+500 basis points plus an extension fee of 100 basis points. An analysis of the market situation for GFH is outside of the scope of what this blog covers, but there are questions about the Shari'ah-compliance of such an agreement.

Little is mentioned about the deal except that the new facility is a murabaha (replacing the old murabaha) and therefore I would imagine Shari'ah scholars signed off on the deal. The transaction itself is relatively unproblematic (if expensive). GFH received a financing facility from a group of investors which happened to be its previous creditors on a murabaha basis with an expensive profit for those investors.

However, the substance of the murabaha may be relatively common as a financing mechanism, the rolling over of debt and inclusion of an 'extension fee' seem problematic in my (untrained) eyes. I don't have the expertise in Shari'ah nor have I seen the documents for the deal, but this deal looks like an increase in the debt load on the $100 million in exchange for additional time for repayment.

However the deal was structured, this particular aspect seems to contradict at least the way that Islamic finance is supposed to operate. As I understand it, the prohibition of interest was at least in part a reaction to the exploitation caused by creditors rolling over debts in exchange for an increase in the amount owed to the creditors. I would hope that someone would come out and publicly explain how the deal was structured to avoid breaching the restrictions imposed by the Shari'ah.

General Islamic finance

The National newspaper has an article on the growth of Islamic finance that has some interesting comments from Michael McMillen, a partner at the U.S. law firm Fulbright & Jaworski. Commenting on the defaults, and the ongoing bankruptcy case of East Cameron Partners, he said "In my view, the impact is likely to be net positive. Thus far, the responses of involved parties provide grounds for optimism."

I think his assessment is correct, except for the impact on the investors in the sukuk. The default resolution process is one of the areas that has been a continuing source of uncertainty. One concern I have with the way Islamic finance is described in the article (not by Mr. McMillen) is the assertion that "Islamic banking is based on five pillars: no interest, no uncertain speculation, no financing of companies involved with goods and services deemed haram, such as weapons, pork and gambling, the sharing of profit and loss and the understanding that all financial transactions must be backed by tangible assets."

There are two points made here that I think are somewhat misleading. Islamic finance does not always involve a sharing of profit and loss. There are several commonly used transactions like murabaha and ijara where profit and loss are not shared.

In a murabaha, the transaction is a sale with a markup. The risk is placed on the debtor who must repay the cost plus profit regardless and if they do not do so, they are generally in default. The way it operates is that the bank operates as a wholesaler and the price they charge includes a markup. The financing feature of the transaction is that the buyer is offered deferred repayments. There is not interest charged on the deferred payments and the buyer must make these payments to remain current on the financing, just as if they were purchasing a good from another wholesaler.

The other statement I think is misleading is that "all financial transactions must be backed by tangible assets". This is also incorrect and does not give a clear picture of how many transactions are structured. To use a generic example, look at an asset-based ijara sukuk. In the standard transaction, the issuer sells the beneficial interest in an asset to an SPV which raises money from investors through a sukuk. The issuer then leases back the asset with a pre-determined rent payment (often benchmarked to an interest rate like LIBOR). At maturity, the issuer repurchases the asset at the sale price to allow the SPV to redeem the sukuk at par.

The transaction involves the sale of the asset, but the transaction is not 'backed' by the asset. If the issuer defaults, the investors can exercise a purchase undertaking granted by the issuer that forces the issuer to repurchase the asset at the par value (often this is the only option provided to the investors). The investors then become unsecured creditors of the issuer on par with all other unsecured creditors of the issuer. There is no additional protection granted by virtue of the asset being involved in the transaction, nor do the investors have recourse to the asset used in the transaction.

The descriptions provided by The National about Islamic finance that I have clarified are not unique to this article. I think that The National provides generally very good coverage of the Islamic finance industry and their articles are mostly very informative. However, this article falls into the 'simple explanation' trap that has most of the coverage of Islamic finance has fallen into.

There are far worse examples of poor description of how Islamic finance works in other news articles, but it is high time that the industry find a different 'simple explanation' that incorporates the essential features of how Islamic finance actually works so that there is not surprise when a situation arises like the Nakheel sukuk where people realize that Islamic finance is not always 'backed' by an asset. In fact, the Nakheel sukuk was different from the traditional ijara structure because investors were provided with recourse against the assets through the granting of a fully perfected mortgage over the assets that the sukuk was based on.

Other News

• Westpac Banking Corp, an Australian bank, is planning to announce an interbank product, most likely based on commodity murabaha, according to the Trade Minister Simon Crean.
  
• Columbia University held a symposium on Islamic finance with Umar Moghul and Taha Abdul-Basser, an Islamic finance lawyer and Shari'ah scholar, respectively.
  
• A college in Canada became the first in the country to offer an online course in Islamic finance.
  
• There will be a workshop on Islamic finance held in Libya by the Union of Arab Banks.
  

CMHC report on Islamic home finance

The Canadian Mortgage & Housing Corporation (CMHC), the Canadian national housing agency commissioned a study a couple of years ago, which has recently been completed by law firm Gowlings Lafleur Henderson LLP. The CMHC reiterates at the beginning of the report that "CMHC Insurance business has no plans to insure Shari'a mortgages, nor is CMHC making changes to legislation or administrative practices". The prominence of this disclosure is probably, at least in part, a reaction to the small but loud reaction from critics of Islamic finance when the study was announced.

The study describes how Islamic finance works and in particular how Islamic mortgages work. The report provides one of the most comprehensive and detailed overviews of the Islamic mortgage markets in a number of countries including Western secular democracies, secular republics with Muslim majorities and Islamic republics.

The most interesting section of the report, of course, is the focus on Canada. This section, however, begins with an interesting observations:

"Little empirical evidence based on a sound methodology assumptions exists to accurately project what portion of the Canadian population would be interested in [using] Shari'a-compliant financing"

This point is relevant beyond just the narrow focus of the Canadian report because there is little evidence about what factors--either within Muslim populations or within the Islamic finance industry--lead to demand for Shari'ah-compliant financial products. This is clearly a much larger issue than I can cover in this short blog post, but it suggests a promising area for research about what issues in Islamic finance matter for Muslim consumers of financial products.

Returning to the Canadian market, the market structure of the market has limited the ability to provide Shari'ah-compliant home financing to those Muslims who demand them. The market has for most of the past 25 years, been dominated by small cooperatives reliant upon member's investments to finance new home purchases. UM Financial entered the market in 2005 and used mudaraba financing from Credit Union Central of Ontario for $120 million, which has been used to finance home purchases and refinancing. Until UM receives addition financing, which it has reportedly been working on, it is limited in the financing it can provide. As the CMHC report notes, of the Canadian banks and other mainstream financing institutions, which represent 60% of the mortgage market, "none of them have actually offered Shari'a-compliant housing finance, not even on a pilot-project basis".

Whether these banks enter the market on their own or through specialized Islamic home finance companies, there will continue to be a limit on the availability of Islamic home finance in Canada. This problem is accentuated by the lack of certain numbers on the size of the market in Canada. While there are expected to be between 0.98 million to 1.30 million Muslims in Canada by 2011 and between 1.23 million and 1.78 million Muslims by 2017 according to Statistics Canada, there is no clear estimate about how many of these will be homebuyers and of those buyers how many will opt for Shari'ah-compliant mortgages over conventional alternatives.

The study does cite one statistic that probably impacts the rate of Muslims who choose Islamic mortgages rather than conventional alternatives. They cite a story in the Financial Post from May 2007 which said that Shari'ah-compliant mortgages are between 100 and 300 basis points more expensive than conventional mortgages (versus a similar spread of 40 to 100 basis points in the United States). Whatever a study of Muslims in Canada would say if one were conducted, the cost of the mortgage will make the difference between whether the indifferent consumer will choose one over the other. Muslims are often subdivided into three groups (not necessarily of equal size): those that only use Islamic finance, those that would prefer Islamic finance if the cost is equivalent (or close) and those who will not use Islamic finance. The middle group will be the group that determines the size of the market in Canada for Islamic finance.

The reason I raise this issue is that the market structure in Canada is not necessarily conducive to significant growth in Islamic finance without something different that opens up capital for new Islamic mortgages. In the U.S., this roles is played by Freddie Mac (and to a limited extent Fannie Mae). There are legitimate criticisms of how Freddie Mac operates to provide capital to Islamic mortgage companies, however, the cost premium in Canada is likely due mostly to the lack of a similar provider of capital.

In Canada this is likely to be assumed by one or more of the big five banks. This study could provide the foundation for Islamic finance products to be placed on equal footing in tax and regulatory treatment to conventional mortgages through changes in laws. It has also been reported that there are several Islamic bank applications that have been held up pending the completion of this report. Their approval would add to the pressure for the Canadian government to reform tax and regulatory laws (probably in line with changes made in the past decade in the UK).

The broader points that this report raises is that Islamic finance (particularly retail Islamic finance) is limited if: 1) it is not competitive in price with conventional alternatives; 2) regulatory uncertainty; and, 3) significant uncertainty over the size and characteristics of demand for Islamic finance.

These limitations can be reduced if: 1) Islamic financial institutions have greater access to capital; 2) regulatory and tax restrictions that add cost are removed to put Islamic finance on equal footing with conventional finance; and 3) the factors that determine whether the marginal Muslim financial consumer will opt for Islamic or conventional finance is better understood.

Friday bullets

• An executive of Kuwait Finance House told Al Arabiya that the bank will launch a $250 million investment fund focusing on Canada.
  
• An article, not focused on Islamic finance, describes the pitfalls facing Dubai in the coming months after the recent debt crisis.
  
• Islamic banks in Yemen are mismanaged, according to an economist. The economist, Ali Al-Wafi, described, "Unfortunately, in spite of attracting capital, the Islamic banks in Yemen could not manage the capital collected efficiently [...] the main problem of capital management, restricting the performance of Islamic banks in Yemen, is that administrations of these banks monopolize the use of the capital and divert it for investing only in the businesses of certain privileged segments of the society."
  

Yasaar Media report, Canadian sukuk, corporate sukuk market in the GCC

Yasaar Media released a report on Islamic investment banks recently. I am still reading the report and hope to have a post dedicated to it here and on my blog at Zawya.com. The report is available from Yasaar Media's website (pdf)

The second North American sukuk is expected to come from of Canadian company, Bear Mountain Resorts, by October. The sukuk will fund part of a resort community near Victoria, British Columbia and is expected to be about $380 million. The sukuk is being launched with the assistance of Siraj Capital whose CEO Ibrahim Mardam-Bey worked on the East Cameron sukuk which is now in bankruptcy while he was at Lebanese firm BSEC.

A new fund being offered by Dubai Islamic Bank provides investors with capital-protected returns based on a long-short strategy tracking the Rogers International Commodity Index Enhanced ex-Lean Hog, a commodity index. The structure of the transaction is not specified but seems like it is similar to a controversial product that used a total-return swap on an index and is likely to restart arguments about the products' desirability from a Shari'ah perspective that were raised by Sheikh Yusuf DeLorenzo.

Despite the many sovereign sukuk being issued by GCC governments, the corporate sukuk issuance market may remain largely frozen until 2010 according to Arab Banking Corporation managing director Naveed Khan. The delay between new sovereign issues and new corporate issues is expected to be caused by the higher pricing of the sovereign sukuk compared to where they were before the credit crisis.

Other News

• HBG Holdings will invest in companies listed on London's Alternative Investment Market (AIM) through a Cayman Islands-domiciled Shari'ah-compliant private equity fund. HBG Holdings' shareholders are primarily institutional and private investors from the Gulf region.
  
• One of the sukuk funds launched recently, Emirates Investment Services' Emirates Sukuk Fund No. 1, announced it had gained 8.5% in the first 3 months since inception.
  
• Investors in Saad Group's Golden Belt 1 Sukuk are forming a committee to represent them, according to Reuters.
  
• Malaysia is 'well positioned' to help Islamic finance in Europe according to Malaysia's ambassador to Brussels, Hussein Hanif.
  
• An article about Abu Dhabi National Energy (Taqa) includes the note that the planned sukuk from Ras al Khaimah may offer a coupon between 8% and 8.5%.
  
• In the Islamic finance industry, aggregate size numbers are always rather suspect because there is no centralized methodology on how it is calculated, but according to one article, the industry now has more than $1 trillion in assets.
  
• Despite attempts by the Japanese government to attract Islamic finance, it is having difficulties gaining steam and the Japan Bank for International Cooperation (JBIC) sukuk that has been planned for a while may be further delayed.
  
• Australian investment bank Macquarie is in Malaysia and may be considering issuing a sukuk.
  
• Islamic finance may provide benefits to Muslim and non-Muslim homeowners in Scotland, according to an article.
  

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.
  

Update on Islamic banking applications in Canada; more on Islamic finance 'immunity' to the economic crisis

There is a very detailed article about the hold-up of Islamic banking license applications in Canada which includes details that the Department of Finance has returned applications to the regulator responsible for approving them "for normal processing".

An interesting article describes the ways in which the Islamic finance industry has reacted in the wake of the credit crisis but contains a few points which are not entirely true and again raise the issue of whether Islamic finance is 'immune' from financial crisis. I have discussed at length (here, here, here, and here, for example) several cases in which this claimed immunity from crisis is not true and that Islamic financial institutions face challenges that are in some ways similar to those facing conventional financial institutions. One paragraph which cites Rodney Wilson of Durham University attributes to him:

"claims that in the current crisis no Islamic bank has failed, and in contrast to conventional banks, none have needed government funds to save them from collapsing"

The first part of the statement may be true (so far) from if looking strictly at banking institutions, but if the crisis has taught us anything it is that non-bank financial institutions may be more vulnerable than banks. One needs to only look to The Investment Dar, an Islamic investment company based in Kuwait, which recently defaulted on $100 million in sukuk as well as the Saad Group, which are now pricing in a future default according to ING Investment Management, to find counter examples. As for the assertion that Islamic financial institutions are not reliant on government bailouts, the cases of Nakheel, Amlak and Tamweel serve as counter examples.

In my mind, however, the fact that some Islamic banks are having difficulties is not an indictment of the industry in any way. Islamic finance is a business operating in difficult economic times and the whole principal of sharing risks and rewards should lead to some banks failing if they make investments which go sour. Continuing to promote the idea that Islamic finance is somehow 'immune' from the economic crisis does a grave disservice in my opinion to the industry and especially the people who work long hours to move the industry more towards profit-and-loss sharing models.

In other news, the Bahrain $500 million sukuk which was raised to $750 million and priced at 350 basis points over 5-year US Treasuries was 8 times oversubscribed with total subscriptions coming in at a whopping $4 billion for the sukuk. A press release from the Central Bank of Bahrain notes that "This issue reaffirmed the market's appetite to invest Bahrain's debt securities and was well received internationally, with a major portion of subscriptions coming from outside the GCC". This oversubscription probably comes from an unfreezing of global credit markets, the shortage of sovereign sukuk and an underlying latent demand for sukuk that had been suppressed in part because low oil prices put off potential investors in GCC issuers.

Other News

• Nakheel will provide a test case to see how state-affiliated companies manage to roll over their debt including sukuk. Nakheel has $3.52 billion in sukuk that mature in December this year.
  
• The Investment Dar met with investors to update them on restructuring, according to a press release from the company. On June 8, 2009, the sukuk investors passed a resolution stating that "the Certificateholders would in due course like to further consider the potential of asserting priority claims in respect of the Sukuk Assets"
  
• Saudi Electricity, the region's largest utility, plans $1.33 billion in sukuk.
  
• Malaysia is confident it can retain its leading position in the Islamic finance industry according to national news agency Bernama.
  
• Amara Holdings, a Dubai based Islamic investment company will partner with New China Trust to identify Shari'ah-compliant investment opportunities in China. This is one of the first cases where Shari'ah-compliant investents will be made in China.