The GCC embarks on the journey of developing a bankruptcy regime

The financial crisis of 2007 -2009 did not spare the GCC region or Islamic finance as many real estate-related companies, and some financial institutions with exposure to this sector, either failed or were forced to restructure their debt.  A number of these companies had Shari’ah-compliant financing that was involved.  One of the most well known is Nahkeel Development Company whose $3.52 billion sukuk led to the Dubai debt crisis.  

Kuwait Finance Centre (Markaz) released an interesting report in January 2013 (PDF) detailing how much development the GCC needs to implement bankruptcy legislation that meets international standards.  There have been some efforts—some more successful than others—like the Dubai World Tribunal (established by Decree No. 57 of 2009) and Kuwait’s Financial Stability Law which was passed in March 2009. 

The primary resolution in the GCC for corporate defaults is either liquidation of the company or a consensual restructuring of the debt obligations.  There is no established process for distressed companies to enter a court-led process that aims first for the restructuring of debts and the reorganization of the business so that it can become viable, as there is elsewhere (e.g. the Chapter 11 reorganization process in the United States).  Markaz described: “A closer look reveals that the Bankruptcy laws in GCC are primarily liquidation laws and are insufficient to help an ailing company to restructure its debt so that it can continue in business.” (emphasis in original). 

Markaz further comments that:

“There is a stigma associated with bankruptcy in the GCC, which makes filing for bankruptcy protection almost unheard of in the region. This is both due to the cultural stigma attached in addition to the inadequacy of regional bankruptcy laws where they exist.  The lacking regulation and legal framework came into focus with the financial crisis whereby many firms in the GCC encountered debt and insolvency issues with very little in the way of legal recourse for resolution.

The primary outcome of the financial crisis-related defaults by GCC corporates, including the government-related enterprises like Nakheel was that creditors were forced into some form of restructuring through an ad hoc arrangement outside of any established legal process and where an emergency legal process was imposed, it was subject to either significant uncertainties (e.g. Kuwait’s Financial Stability Law) or was limited in scope (the Dubai World Tribunal established by Decree No. 57).  It should not be surprising—nor is leveling too much criticism in hindsight particularly valuable—since many countries even where there were established bankruptcy laws resorted to one-off or otherwise unusual resolution processes for the financial sector following the financial crisis. 

However, the recent experiences do highlight many areas where improvements can be made so that future defaults can be better managed without leaving the restructuring to be done outside of an established process.  Because, while some restructuring outside of periods of financial crisis may proceed relatively smoothly (e.g. the restructuring of the $1bn Dana Gas sukuk) with minimum market disruption, it relies too much on the hope that there will not come a time when a voluntary restructuring agreement cannot be reached. 

A stopgap measure for some companies will be to use the bankruptcy law of another country, like Arcapita did with its Chapter 11 filing in the United States (PDF), which has led to a proposed reorganization plan that will allow the company to leave Chapter 11 and conduct an orderly exit from its investments with a formalized process for splitting up whatever value remains for the secured and unsecured creditors.  But, not all companies are eligible to file for Chapter 11 bankruptcy (which requires some assets in the US, where Arcapita had an office and many of its investments).  As an article on cross-border insolvencies by Howard Seife, a lawyer at Chadbourne & Parke LLP (PDF) explained:

“Section 109(a) of the U.S. Bankruptcy Code permits a Chapter 11 filing in a U.S. bankruptcy court by a person (defined in Section 101(41) as including a corporation) ‘that resides or has a domicile, a place of business, or property in the United States.’  Cases that have considered the ‘property’ requirement with respect to foreign corporations have found it satisfied by even a minimal amount of property located in the U.S.”

For example, the Dana Gas sukuk, where assets were located in the UAE, Egypt and Iraq would probably not be able to take advantage of the Chapter 11 process if it had failed to restructure its sukuk.  It could, instead, let creditors take Dana Gas to an English court (which was the law chosen for most of the dispute resolution for the sukuk), but as the prospectus notes: “in respect of foreign court judgements, the UAE courts are unlikely to enforce an English judgment without re-examining the merits of the claim and may not observe the choice by the parties of English law as the governing law of the transaction.”

The UAE is addressing one aspect of the problem with a new bankruptcy law that was expected to be enacted by the end of 2012, but it has since been pushed back to late 2013.  A managing director at Deloitte Corporate Finance explained the purpose of the new law as “provid[ing] a method by which stressed and distressed companies can either come to a place where they are able to resume trading profitably and to the advantage of all parties, or be wound up and liquidated in a controlled manner.”

Reuters reported that the draft law is likely to be based on the French bankruptcy laws, which is debtor friendly (the US’ Chapter 11 process is also viewed as being debtor friendly). 

The development of a bankruptcy resolution process is positive, and even with a delayed development of a bankruptcy law in the UAE will help attract investors.  If it is based on the French or US bankruptcy law, as indicated, it could allow for either reorganization (where the company remains in business with a modified capital structure where, for example, some debt is converted to equity) or liquidation, depending on whether the business is seen as viable.  However, as the Markaz report highlights (specifically in the table below), there are other factors that are important besides just the reorganization laws.

Islamic finance and sukuk in particular, the first three rows in the table are of particular importance.  Many sukuk issued by GCC corporates and governments are not rated and while ratings agencies have taken significant criticism following the financial crisis for the high ratings they gave to what turned out to be low quality securities, they can still provide information to investors.  Currently there is no requirement for new sukuk to be rated (e.g. in order to be listed), whereas Malaysia requires a rating for any sukuk that are offered to the retail market.

The second and third rows are all important as well in developing the ability of sukuk holders to take possession of the underlying collateral in asset-backed sukuk.  Currently, sukuk holders can enforce on some collateral because the sukuk are based on English law (mostly), but they are limited in enforcing on collateral within the GCC region.   

If more sukuk are issued using an asset-backed structure, which is often suggested as being preferable compared with the asset-based sukuk that mimic unsecured bonds through a purchase undertaking by the issuer, there will need to be the ability of sukuk holders to take possession of the asset to sell it to recover some of their investment if a sukuk defaults.  That will probably not happen in the near-term, but in the context of thinking about the role of a bankruptcy process in the GCC, it should not be ignored either.  

In the end, there is not a well-developed process for bankruptcy in the GCC and, particularly in the wake of restructurings necessitated by the financial crisis, might have held back the sukuk market (although from the growth in new issuance, it has not had a dramatic effect).  It is good to see the problem acknowledged and first steps made to fix the problem, but it is just the beginning of the process since even when laws are enacted it will take a while for enough cases that use the bankruptcy process to create certainty for investors about what they can expect if the issuer of the sukuk they buy needs to use it.  

Sign up for the ThomsonReuters Islamic Finance Gateway (it's free) and join the Morning Wrap as we discuss this subject and others, Tuesdays and Thursdays at 9:30am Mecca Time (GMT+3).

More Information

• Markaz. 2013. Dealing with Bankruptcy in the GCC: A Key Missing Block in the Reform Agenda.  Available from http://www.markaz.com/DesktopModules/CRD/Attachments/BankruptcyintheGCC-MarkazResearch.pdf
  
• Seife, Howard. 2004. “Bankruptcy for Bankers,” Banking Law Journal, 121(4), April, pp. 341-349.  Available from http://www.chadbourne.com/files/Publication/57a21544-1309-4974-acab-99c9cc612831/Presentation/PublicationAttachment/dcf5e197-7e13-4f70-99e9-9dd7ecfb6fef/BLJ-0404.pdf
• Financier Worldwide. 2012. “10Questions: The United Arab Emirates’ New Insolvency Law,” August. Available from: http://www.financierworldwide.com/article.php?id=9540&page=1
• Reuters. 2012. “UAE new law draft may be delayed until end-2013 –Lawyer,” Available from: http://www.reuters.com/article/2012/12/05/emirates-bankruptcy-idUSL5E8N54WC20121205

Don't prohibit Islamic banking!

An article describes the failure of the proposed Islamic bank ZamZam from opening in Ethiopia.  I don't know the situation, so I can only offer limited comment on it, but from how this article describes the situation, the National Bank of Ethiopia issued a directive which prohibits the licensing of a wholly Islamic bank, but allows Islamic windows to operate (although I could be mis-reading the analysis of the directive, and it could be only permitting non-banking financial activities by an Islamic financial institution). 

The situation resembles the difficulty so far faced in India, where Islamic banking is not allowed under the existing regulatory rules, although recently the National Commission on Minorities weighed in supporting a fresh look at changes which has led the finance ministry requesting the country's central bank, the Reserve Bank of India to reconsider. 

The two cases, if I am understanding correctly (and I am not familiar enough with either country's banking laws to say definitively) relate to political questions about whether Islamic banking could fit within the country's banking laws, and potentially other objections to Islamic banking, which highlight the dilemma facing Islamic banking in several countries. 

It places on opposite sides of the issue those who say that Islamic banking and finance are fundamentally different from conventional finance with those more pragmatically minded who point to the similarities between conventional and Islamic banking.  The former are generally coming from the perspective of Islamic economics, which views Islamic banks as unique entities that are not really 'banks' the way a bank is commonly understood.  The latter, are the Islamic finance professionals who view Islamic banking (and finance) as just banking using different products to avoid violating the ban on riba by structuring products to make profit from leasing, or cost-plus sales. 

On the issue of where Islamic banks fit into the regulatory framework, I side with the latter camp and think that it is possible to offer banking services in a Shari'ah-compliant way, where the economic outcome is largely the same.  That does not mean that this way of doing business is optimal; it may offer the same service at higher cost.  But it is taking the regulatory system at its face value and finding a way to work within it to offer products that appeal to consumers who would otherwise be unbanked.  That, I think is a positive, as long as the products are not exploitative and the current state of Islamic banking is not viewed as the goal (that is, as long as it is accepted that there is significant room for improvement). 

But, Islamic banking should not be quashed just because it is 'Islamic'.  I know quite a bit about that living in the US where a substantial portion of the political rhetoric about Islam (representing still a small minority of the population) agitates against Islamic banking and finance on the grounds that it either finances terrorism or is a step on the road to 'imposing Shari'ah'.  Those arguments are nonsense, but can hold sway in political circles and can make Islamic banking and finance more difficult to offer by limiting the regulatory flexibility needed to deal with Islamic banking and finance as what it is: an alternative structure for conventional banking services, designed to avoid riba, gharar and the other prohibitions. 

While I think Islamic finance offers a compelling promise, I lack the demand for the product as it exists today simply because it is 'Islamic'.  But I am not a Muslim, and quite a few million Muslims disagree with me and will choose a product because it is approved as Shari'ah-compliant, and I think they should have that right.  If it offers a competitive economic proposition to what I get today from conventional banking (I bank with a credit union), then I will reconsider. However, so long as a banking institution can operate within the rules governing capital adequacy and soundness, I think it should be permitted, and there should be flexibility to regulations to allow for different product structures that accomplish the fundamental business of banking.  Prohibiting something just because it is 'Islamic' is a pointlessly retributive exercise. 

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.

Berkeley Islamic Finance Forum

I will be speaking at the Berkeley Islamic Finance Forum next Saturday, April 9, 2011. Below is a poster for the forum.

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.

US court dismisses lawsuit about AIG's takaful business

A Michigan court dismissed a case filed against the US government challenging the permissibility of the Federal assistance provide to American International Group (AIG) on the basis that AIG provided Islamic financial products and therefore the assistance violated the First Amendment of the US Constitution, which prohibits the government from engaging in the establishment of religion. The case ultimately revolved around the size of AIG's takaful business, which the Court noted accounted for only 0.022% of total revenues in 2009; the subsidiary which offers takaful in the United States generated 0.0006% of its revenue from that product in 2009. The case was filed on behalf of Kevin Murray, a military veteran, by the Thomas More Law Center, a right-wing Christian legal organization. When I inquired in 2009 after the plantiff's standing to proceed with the case was upheld, Dr. Robert Tuttle, a Professor of Law a George Washington Law School and expert on Establishment Clause cases, expressed doubts that it would succeed.

The Court reviewed the financing provided by the US government to AIG, but excluded $40 billion in preferred shares that were used to repay debt owed by AIG to the Federal Reserve Bank of New York, leaving only the $30 billion extended under the Emergency Economic Stabilization Act (the TARP), of which $7.5 billion had been drawn on by AIG by February 2010. AIG was required to certify the uses of the funds provided by the US government. The plantiffs in the case argued that the AIG bailout was undertaken with the purpose of advancing religion because AIG was provided funds "to support all of its activities" including Islamic finance (takaful).

However, the court decided that the TARP legislation and the AIG bailout was created for a secular purpose (preventing the collapse of the financial system) and relied upon the small share of total revenue generated by Islamic finance by AIG to support its case in this case. The Court also rejected the claim by the plaintiffs that the TARP bill led to the government taking control of AIG, which included its subsidiaries that offer Islamic financial products noting that "the Trust [which holds ownership for the benefit of the Treasury department] was established by actions taken pursuant to Section 13(3) of the FRA [the Federal Reserve Act]--not the EESA [the TARP]". Section 13(3) of the Federal Reserve Act allows the Federal Reserve, which gives the Federal Reserve Banks the power to intervene in unconventional ways under "unusual and exigent circumstances".

In this claim which was based on the government being entangled with AIG's Islamic finance business by virtue of the financing it provided, the plaintiffs argued that the case is similar to the government providing grants to religious organizations and used their expert witnesses to attest to what they consider the insidious aspects of Islamic finance, which the Court found was irrelevant because it did not address AIG's takaful business specifically. The Court also noted that "Plaintiff cannot defeat Defendants' motion for summary judgement, or prevail on its own, but arguing that the evidence in support of his claim is so overwhelming that he need not present any [evidence] to the Court".

In addition, the Court found no evidence to meet the other ways in which the government could be entangled based on AIG's offering of takaful products; in order to do so, the organization would need to be primarily 'sectarian' (i.e. provide a primarily religious mission) or the government funding would have to fund religious teachings directly. In the other claim for excessive entanglement between the TARP funds and AIG's takaful business, the court ruled against the plaintiffs on the basis that the plaintiff's ceded the point by declining to provide evidence and failure to respond to the US government's arguments against their claim.

Finally, the plaintiffs claimed that the Treasury Department had given its stamp of approval to Islamic finance by publishing a paper on by Dr. Mahmoud El-Gamal on Islamic finance, by creating the position of scholar in residence, which was held by Dr. El-Gamal, by having a member of the Treasury Department speak at the Harvard University Forum on Islamic Finance and by holding an "Islamic Finance 101" conference. The Court found that, in addition to those events being held prior to the TARP legislation, they did not "show that the government favorably endorses Sharia-based Islam or religion in general" and that it was permissible for the government to endorse an educational message relating to religion citing previous court rulings permitting using the Bible for the "study of history, civizilation, ethics, comparative religion, or the like".

The case is significant for Islamic finance in the US because it demonstrates that not only did the Islamic finance activities of AIG when it was under majority ownership by the government not pose a threat on grounds of money laundering or the financing of terrorism, it did not violate the establishment clause. The former was not mentioned in the order, even as the Thomas More Law Center, which brought the lawsuit, cited as justification for the lawsuit that "in abetting the spread of Sharia-compliant financing, AIG and the federal government are abetting the same legal system that motivated the murder of nearly 3,000 Americans on 9/11". This case should have been the spotlight for Islamic finance if it were engaged in illegal practices because the plaintiffs were arguing that not only was AIG supporting Islamic finance, but the government was by virtue of its ownership of nearly 80% of the company. However, there was no finding that Islamic finance had led to support of any illegal acts and beyond that, the government's actions did not violate the Establishment Clause.

This won't stop the echo chambers that are the anti-Islamic finance movement from continuing to spread their baseless claim that Islamic finance supports illegal activities including terrorism, but it does discredit their claims substantially. If there were any untoward activities in Islamic finance, this would have been the ideal forum for this group and its supporters to make it. The judge's order did strike at the heart of one of their main "arguments": that non-permissible income that is donated to charity is used to support charities promoting violence or proselytizing. The judge noted in a footnote that Lexington Insurance Company, which offers a "takaful homeoners policy", "a certain percentage of the net surplus, if any, derived from the collection of premiums is paid out to either the National Children's Fund or the International Federation of Red Cross & Red Crescent Societies [...] selected precisely because they lack religious affiliation".

In the best case scenario, this ruling could provide support to US financial institutions involved with Islamic finance, whether or not they received or have outstanding loans from the TARP fund. It demonstrates that the US courts view Islamic finance as "just another business", as they should. It also supports the precedent from the East Cameron sukuk case that Islamic financial products will be judged by US courts on their merits as financial products, and not on the basis of the religious and ethical grounds for their orgination. In my opinion, the Establishment clause is important both because it limits the ability of the government to favor one religion over another, but also because it limits the ability of groups hostile to one religion or another from using the cudgel of litigation to limit the freedom to shape individual's choices based on their religious beliefs, even where these are expressed by demanding products from large financial institutions that may be bailed out by the US government from collapse based on their other business activities. This should be supportive for Islamic finance in the US because it moves the focus--both in the legal and regulatory sense--from the religious arguments to the practical arguments. How does Islamic finance work as a financial product? Is it fair to consumers? How does its structure fit in with the regulations and laws of the US? This is where Islamic finance belongs in its relationship with secular governments and it should also move the discussion among lawmakers and regulators from the "Islamic" aspect to the "finance" aspects.

UPDATE:
The court's ruling is here
The plaintiff's lawyer's long paper on why Islamic finance is a legal risk can be downloaded here

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).

Islamic Finance in the U.S.

Reuters has an article on the "political hurdles" facing Islamic finance in the U.S. I think the title is a little misleading; it is not politics (or regulation) that has pulled Islamic finance into an ugly argument about Islam and America, but politics. I have always hesitated to give any credence to the 'anti-Islamic finance' arguments because they are so disconnected from reality that I feel giving coverage on this blog would elevate them to the discussion on Islamic finance would give them undue credibility. However, at many times, I have thought of a way to cover the 'anti-' side without giving it additional credibility, but I have always come up lacking a good way to address it. However, the Reuters article makes it clear that opposition to Islamic finance as a subtext in an argument over Islam in America is becoming a narrative that needs to be addressed.

The first thought in my discussion is that the rise of opposition to things that are viewed as 'foreign' is a common thread in American history and one that has been expressed in ugly displays. In the 19th century, immigrants from China, Ireland and southern European countries like Italy faced significant discrimination. In general, religion was not the primary reason for this, but it was in some cases. America's history with Catholicism has many rather embarassing episodes. A blogger for the LA Times quotes a professor at the Ohio State University:

"the popularity of the Ku Klux Klan exploded after it rebranded itself a "patriotic" fraternal organization dedicated to safeguarding America against the threat of Catholics, Jews and the immigrants flooding the country in unprecedented numbers. […] At the time, these men did not consider themselves religious bigots. They believed themselves patriots, upright fathers and sons, husbands and brothers protecting their families, and the nation, against a foreign threat they feared was intent on their destruction."

The author was specifically focusing on the anti-Catholicism of the early 20th century, but the sentiment lasted well later in the 20th century: John F. Kennedy was viewed skeptically for his Catholicism and it was feared that he would be an agent of the Pope as president.

Of course, this was unfounded and the positive in American history is that the country does move past this type of fear mongering--no one questioned whether John Kerry's Catholicism would hurt his ability to be president when he ran in 2004. However, it is not a quick process for Americans as a whole to move beyond past their suspicions towards groups of people for which they have no justifiable reason to lump together as a 'threat' to America.

And today, the 'other' that nativist politicians have focused on is Muslims. Every effort of Muslims to express their religiousness is viewed by some as a 'threat' to America's values and American freedom itself (the Economist deals with this issue in a good recent article). However, just as the "Catholic threat" was unjustified as a reason to suspect all Catholics, the "Muslim threat" is equally as unjustifiable. And Islamic finance is being lumped into this broader narrative in an equally unjustifiable way.

Now then, what can be done to counter this suspicion of Islamic finance and help the industry to thrive in America? Can there be a way to demonstrate that Islamic finance is no more foreign than the growing popularity of socially responsible investing, or even other forms of religious-based financial products like the Timothy Plan, a Christian mutual fund.

In some areas, there may not be a need at all. The Amana Funds, a series of three Islamic mutual funds, has already moved well beyond being a 'niche' product for Muslims and has attracted significant investments by non-Muslims who are generally drawn to the fund by its good performance. However, other financial products that are Shari'ah-compliant, from mortgages to insurance, have not attracted as large interest from non-Muslims.

In these areas, it will be imperative for the Islamic finance industry to continue to reach out not only to their mainly Muslim consumers to explain how they work and also highlight that they are not much different from conventional financial products. They have a different structure and follow certain rules that other mortgage providers do not have to, but besides these differences, they are just another flavor of mortgage available to all consumers.

In areas like takaful--which is less well known than even Islamic finance--there are other ways in which they could be marketed to attract non-Muslims. Unlike conventional insurers, the funds of the takaful provider are owned by the members, rather than being run through a corporate structure where the liabilities (claims) are obligations of the corporation. In an era where many insurers have been 'demutualized', this return to a 'mutualization' may attract non-Muslim consumers in a similar way that credit unions have been able to differentiate themselves from the much maligned conventional banks on the difference that their depositors are also their owners (rather than external shareholders).

There are substantive differences in Islamic finance and there will continue to be 'anti-Islamic' sentiment stirred up by opportunistic, nativist politicians. These are the givens. It is up to the industry to decide whether the political sentiment will be a hinderance to the industry or will spur it towards better explaining its competitive advantages to its conventional competitors. For what has become an emotional and reflexive issue, it will be more likely that Islamic finance can break through on its business merits, rather than by appealing to other arguments.

Dubai update, Islamic finance & foreclosures

Dubai will issue at least $1 billion in bonds in two tranches, one of 5-year tenor and one of 10-year tenor. The (conventional) bonds would be the first issued by Dubai since the debt crisis sparked by the near-default of the Nakheel sukuk. Nakheel, which has received 85% approval from trade creditors, close to its target of 95 percent acceptance, is reported to have applied for listing of $1.6 billion in sukuk with NASDAQ Dubai. The sukuk will be issued to pay 60% of the trade creditors' claims, with the remainder being paid in cash.

In other Dubai-related news, Dubai Islamic Bank took a majority stake in Tamweel, the troubled Islamic mortgage company in Dubai, which led to a sharp rise in the price of Tamweel's sukuk. The move reduces the prospects of a merger between Amlak Finance and Tamweel, which was reported to be likely as a way of dealing with the troubled Islamic mortgage companies. Tamweel has also begun foreclosures on properties owned by people who have left the Emirate and they say in cases where people are still in the Emirate, they are trying to "find a resolution which is satisfactory to both". The issue of default and foreclosure on Islamic mortgages is one that should be balanced between the commercial needs of the mortgage holders and the ethics underlying Shari'ah, which urges lenders to be patient with borrowers who run into financial difficulties.

In general, the commercial logic will outweigh the ethical obligation to work with creditors to avoid causing undue harm for the creditor. However, this is an area where I think Islamic finance can set itself apart from conventional finance. In the post-credit crisis where foreclosures have become commonplace, there have been a number of reported excesses where banks have been overzealous in foreclosures: GMAC Mortgage has come under investigation for problems with the legal documentations and in a bizarre incident, a man in Florida with no mortgage had his home foreclosed on. In many foreclosures, there is no hope for the borrower to become current on the mortgage and foreclosure is nearly inevitable. However, there are many other cases where a negotiated settlement can be reached that is better for the borrower as well as for the lender, who will see a higher recovery value than if they foreclosed on the property and sold it into a depressed market. And one solution that has been proposed (for the conventional market) would seem ideal for an Islamic bank committed to moving towards greater profit-and-loss sharing. Instead of foreclosing on the property, there would be a negotiated refinance into a more affordable mortgage and in exchange for the concession, the lender would have right to a share of any appreciation in the home price when it is sold.

Rushdi Siddiqui focuses his latest column on the need for "reflection, reassessment and reality check" (his 'R-cubed'). He makes some great points including some that I have also highlighted like the problem facing takaful providers (none of which have failed to date): "The link between Takaful operators and Islamic investing is close, as premiums must be deployed in a Sharia-compliant manner. Although there have been no bankruptcies announced in the Takaful industry since beginning of 2009, there have been challenges."

The Lawyer has a great article on the effect of Sheikh Usmani's comments on sukuk, which were followed by a ruling from the AAOIFI Shari'ah Board, as well as the financial crisis. It cited a KFH Research/NCB Capital report on the recovery in sukuk during the past year.

• Efforts to establish an Islamic bank in South Korea have faced significant hurdles.
  
• An article in the National says that Islamic finance can thrive in Dubai. The article notes that Islamic finance is based on an opposition to excess and describes the cause of the financial crisis as "excess risk, excess rewards, excess concern with short term results" without explaining how some companies--most notably Nakheel, which financed many projects with sukuk--became ensnared in the crisis themselves.
  
• Nigeria plans to issue a sovereign sukuk within the next 12 months as it tries to become the Islamic finance hub for Africa.
  
• Indonesia plans to issue 1 trillion rupiah from sukuk in an auction on October 5.
  
• Armen Papazian, a fellow of the Judge Business School at the University of Cambridge, says that Islamic finance should focus on creating an entire financial system based on Shari'ah-compliance, not just individual products.
  
• Standard Chartered is launching a nostra account product in the US for international clients that will be based on commodity murabaha.
  grow significantly and the VP of global wealth management at HSBC Amanah, Shahzad Wairach, estimates its potental of "20 percent growth over the next three to five years".
  
• Bank of London and the Middle East is planning to offer a Shari'ah-compliant Absolute Return Fund that is "in no way a hedge fund". Efforts to create Shari'ah-compliant hedge funds have been criticized for their synthesized short sales.
  
• The Central Bank of Bahrain's latest issue of sukuk al-salam was oversubscribed.
  
• Kuwait's banking system has 35 percent of assets in Islamic banks.
  

Malaysia as a primary legal jurisdiction for Islamic finance, Islamic finance news

Malaysia wants to become a hub as the country where Islamic financial contracts are governed. Currently, most Islamic finance contracts are governed by English laws, because of its predictability. While Malaysia has a unique position having a Shari'ah advisory council at its central bank and could therefore provide governmental legitimacy to the process of litigating whether certain contracts were or were not Shari'ah-compliant, it would likely run into difficulty because the country's Shafi'i interpretation of Shari'ah is viewed as more liberal than the Hanafi and Hambali interpretations used in the GCC. Therefore, it may be unlikely that an Islamic finance institution would submit to the jurisdiction where a different interpretation of Shari'ah is prevalent.

The Shari'ah Advisory Council of Bank Negara Malaysia gave the go-ahead for wa'd (unilateral promise) to be used to hedge against currency fluctuations as long as there is no compensation paid for the wa'd, which would make it a bilateral wa'd. The promise is binding on the promisor.

Rusdhi Siddiqui's latest article tackles the area of Islamic finance news, which I agree does have too little depth behind it. Bloomberg articles (not to pick on them alone) give the bullet points and then re-spout market statistics with too little context. Other news outlets just string together a few quotes with generalities about "Islamic finance is designed to avoid interest, etc". If this blog does anything, I hope it provides a current and critical look at the Islamic finance industry. It certainly has an inherent bias towards the Islamic finance industry, but I have also been critical of the "party line" talking point (for a while at least) that Islamic finance was not harmed by the credit crisis. And thankfully, there are other reporters out there who take stands against things that are either ridiculous Panglossian ideas or products that too cynically avoid the restrictions that are the heart of the Islamic finance industry. However, it is always a good time to remind oneself to think critically.

Other News

• Kiplinger has an interview with Monem Salam and Nicholas Kaiser of the Amana Funds.
  
• Details about the Dubai World restructuring are coming and I expect more to come out as the process of implementing the restructuring proceeds.
  
• Mushtak Parker wrote an article about the growth of Islamic ETFs.
  
• Pakistan's government plans to sell sukuk by the end of the month. The sukuk are expected to carry a maturity of less than on year.
  
• Despite many suggestions that Islamic finance could become viable in Russia, there are few Islamic financial institutions in the country.
  

DIFC Investments, Other News

JP Morgan said the government of Dubai may have to convert its $1 billion loan to DIFC Investments into equity, as well as make an equity investment in the company. The report also upgraded DIFC Investments' $1.2 billion mudaraba sukuk maturing in 2012 from "underweight" to "neutral" based on "improved asset coverage". Other analysts believe the rally--the sukuk rose in price to 79.15 (yielding more than 13%) --has gone to far in DIFC sukuk, as well as other Dubai-related sukuk.

Other News

• Gulf Finance House was able to roll over $100 million in debts for two years, with an option to extend it by another year.
  
• Standard Chartered is expanding its Islamic finance business. The bank recently launched a product that will allow for hedging against fluctuations in commodity prices.
  
• Bloomberg has a list of upcoming sukuk. Many new sukuk are coming from Asia including Hong Kong and Singapore, although regulatory challenges remain.
  
• The Houston Chronicle interviews Monem Salam on the Amana Funds.
  
• Moody's placed Dar Al-Arkan's credit rating (and the rating on its sukuk) on review for possible downgrade.
  
• Islamic finance has become as closely watched as celebrities, according to Lahem Al-Nasser.
  

IIFM releases report on Shari'ah-compliant repurchase agreements (repos)

Conventional borrowers in the GCC are moving away from sukuk following the Dubai debt crisis. It is not said whether they are moving away from sukuk, which often have higher structuring costs, because of the structures or because the additional costs of structuring sukuk for issuers and a higher illiquidity premium makes it not cost competitive. Despite this there were 98 sukuk issued globally for $13.7 billion in the first half of 2010, up from $7.1 billion in the same period of 2009. S&P provided comments with their data release.

The IIFM released a paper on the possibilities for Islamic Repo transactions (I'aadat Al-Shira'a). You can download the paper from IIFM's website after going through the registration process. I hope to put up a post once I have a chance to read the document.

Other News

• Rushdi Siddiqui takes on the misguided "anti-Sharia" groups in the US who view Islamic finance as a threat.
  
• There is a video of my presentation at the UFANA conference in March in Toronto. It begins at about the 3:50 mark of this video and concludes at the beginning of this video.
  
• In a blog post on Monday I suggested that an article from Bloomberg describing falling yields on sukuk in the GCC was somewhat misleading and now Bloomberg's article that is similar to their earlier article is titled: "Persian Gulf Sukuk Yield Premium Widens on Fourth Default".
  
• Kazakhstan will issue a sukuk after cancelling a conventional bond sale.
  
• The American Prospect interviews Frank Vogel, who co-authored the book Islamic Law and Finance: Religion, Risk and Return with Samuel Hayes, both professors at Harvard University.
  
• A short video of a speech by the governor of Malaysia's central bank, Bank Negara, Zeti Akhtar Aziz.
  
• Khazanah Nasional is raising funds through 5- and 10-year sukuk to finance its bid for hospital operator Parkway Holdings Ltd.
  
• Indonesia's planned global sukuk will be smaller than the $650 million initially expected because the budget deficit is smaller than expected. An unnamed foreign bank is planning an Islamic banking service in Indonesia in the second half of 2010 according to the Head of Research, Development, and Sharia Banking Management of the central bank.
  
• Two Islamic banks in Pakistan became the first merger of two Islamic banks in the country. Emirates Global Islamic Bank and Al Baraka Islamic Bank will merge. The new bank will be called Al Baraka Bank (Pakistan) and will have combined assets of $582 million.