Lessons of Cyprus and Depositor Liability in Islamic Banks

There is a common explanation that Islamic banking can alleviate the European debt crisis, or could have prevented the financial crisis. Normally, these claims are not thought through enough to provide specific policy recommendations, and they instead just form the normal cheerleading heard at many Islamic finance conferences.

However, with the ‘bail-in’ of depositors in Cyprus, Islamic banking may have a specific recommendation for conventional banks based on the products used by Islamic banks. Rather than just lump creditors together an encourage complacency around the potential losses, make these explicit by dividing them into ‘safekeeping’ deposits and ‘profit-sharing and loss-absorbing’ deposits, and connect them with the specific pools of assets within the bank to provide increased transparency.

Join the ThomsonReuters Islamic Finance Gateway to read the rest of this post. 

Join the discussion on this subject and others in the IFG Community on Tuesday mornings at 9:30am Mecca time (GMT+3).  

Receive updates and discuss new developments in Islamic finance on our social media sites using LinkedIn, Facebook, and Twitter.

Islamic banking in Oman to start in 2013

The new rules for Islamic banks in Oman will be released in the first quarter of 2013 and the first standalone Islamic bank, Bank Nizwa will launch early in 2013 with Bank Al Izz to follow in 3-6 months. The draft regulations were distributed to banks, and there were reports were that tawarruq, a common structure used for inter-bank financing, will not be permitted.  The draft regulations are said to be the same as the draft guidelines issued earlier. 

As a result most of the Islamic banks in Oman will have surplus cash uninvested, and they will be likely to not have the option of placing these funds outside of Oman with Islamic banks using tawarruq through limits on foreign investments, but if they do place the funds with Islamic banks elsewhere, they will have the option to use wakala.  This will actually benefit the Islamic banks in Oman right out of the gate so long as they are lending into inter-bank markets since rates on wakala, according to data from ThomsonReuters, are higher than for tawarruq.

From the start, the shortage of options in the inter-bank money market will not be problematic as deposits are likely to flow much more quickly to Islamic banks with Islamic financing from the banks to follow more slowly (due to the time it takes to assess the quality of the creditor and approve the financing).  There will also be a question about how many Islamic banks the market can support, in part because loan growth dropped in the third quarter of 2012, although with just two Islamic banks this might not be as much of a problem as if the market were larger.

The area where Islamic banks might face a challenge is with competition from Islamic windows of domestic conventional banks, which will also be able to start up in 2013.  Foreign banks would be allowed to enter the market depending on how the Islamic banks in Oman perform once they are allowed to begin operations.  At last count, there were five that were planning to open Islamic windows, which would put the total market for Islamic finance at 7 institutions. 

The area of real concern for the standalone Islamic banks is, therefore, whether the conventional banks' Islamic windows are able to leverage their existing branch network to attract more of the market share for Islamic banking from the standalone banks.  On the other hand, they will likely face challenges adapting their conventionally-focused systems to ensure segregation of the funds between the Islamic banking business and the rest of their conventional business.  Once they do this, they will also have to convince customers that this segregation is airtight, a problem that the Islamic banks will not have to face. 

So for now, it is time to look forward to the opening of a new market for Islamic banking, one that was largely driven by domestic demand for Islamic banking products.  Once the operations begin, the discussion about these issues can commence again. 

Islamic finance complexity (Part IIh)

It has been a while since I added to the Islamic finance complexity series of posts, but I was reading an article that I thought would provide a return to the series (and also back to the liabilities side of Islamic banks' balance sheets).  The IFSB is beginning work on its standards for capital adequacy to incorporate changes in Basel 3, which prompted me to look at one of their Guidance Notes already out there (IFDB-4 [pdf]), which deals with capital requirements around profit-sharing investment accounts (PSIA), which are a large part of Islamic banks' liabilities (equivalent to deposits).

The standard from IFSB provides guidance to regulators to determine the treatment of liabilities (and the assets they finance) for capital adequacy calculations.  What is at issue with the PSIA is whether the assets financed by PSIA should be given a risk-weighting in the capital computation greater than zero (i.e. there should be some capital set aside for the assets they finance).

The theoretical proposition with PSIA is that the assets the bank invests the PSIA funds in should not be treated as assets needing capital set against it.  The logic is that since PSIA investment account holders (IAHs) are liable as rabb ul-mal (in a mudaraba) or muwakkil (in a wakala) to bear any loss and the bank only gets a share of profits (if any) or a fee, respectively, that are generated by the assets.

However, since most Islamic banks--either by choice or because they are required to by their regulators--set up profit-equalization reserves and investment risk reserves, and also can "[forego] all or part of its Mudārib share of profits on investing UIAH [unrestricted IAH] funds, or donating to the UIAH part or all of the profit on investments financed by shareholders’ funds, so as to enhance the profit payout to the UIAH".

As a result, the bank is bearing some displaced commercial risk from the investments financed by IAHs because they will--to some degree--bear the risk of loss in the funds invested that were provided by IAHs.  As a result, while the contracts in their pure form would not expose the bank to possible losses, in actuality the bank has to set aside some capital to pay for these losses.  The IFSB guidance note provides guidance to regulators to determine the calculation of what portion of assets financed by IAH depositors should be considered "at risk" (thus needing a risk weighting based on their own structure).

One of the more interesting discussions in the guidance notes was surrounding the status of IAHs, in terms of how the regulators expect depositors to be treated should the bank become insolvent:

"In practice, there is considerable ambiguity in  the nature and characteristics of UPSIA, which vary among IIFS and jurisdictions. At one extreme, IAH are highly protected so that UPSIA tend to be deposit-like products where the returns are 'stabilised'". 

At the other extreme:

"UIAH have no claim as creditors over the assets of the IIFS (as do conventional depositors). Instead, they have a claim to the assets financed by their funds (including their share of any undistributed profits and less any losses), including their share of assets financed by commingled funds, in respect of  which they rank  pari passu with the shareholders after taking account of the fact that the latter are liable for amounts deposited by current account holders and other creditors."

One note here is that current account holders are depositors under, for example, qard hasan, who have their principal guaranteed, but are not entitled to profit.  Between the two extremes, there are any number of possibilities where depositors are neither treated like current account holders or fully liable to lose the full value of their principal.  The qualification of UIAH (unrestricted IAH) is done because a restricted IAH would have specific assets financed using their funds and therefore would have their funds at risk of loss based on the performance of the assets they finance. 

The distinction in regulatory treatment of mudaraba and wakala depositors across jurisdictions provides another example of how it is not necessarily as simple as arguing whether Islamic banks' deposits should be fully pass-through (a pure mudaraba) or not.  It also highlights the fact that the regulatory environment facing Islamic banks is not uniform and also not necessarily easily transferable to how Islamic banks work. 

UPDATE: I just saw an article which describes some of the different factors that affect whether PSIAs will impact Islamic banks' capital requirements, from the IFSB seminar in Malaysia. 

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

Islamic finance complexity (Part IIe)

After thinking a lot about how products are structured, I am moving onto some real-world breakdown in the actual balance sheet balances of some Islamic banks to translate the ideas of how they design their products into how they are actually represented in terms of the bank's liquidity profile.  To do so, I picked one country (the UAE) to limit the differences between banks caused by different countries, different regulatory environments, etc, and focused just on the "Liabilities" items in the balance sheet at one point in time (December 31, 2010 for all except for Ajman Bank, which only had annual financial statements through the end of 2009).

The liabilities section is, in rough form, broken into three categories of liabilities: deposits, inter-bank borrowings and other liabilities (e.g. longer term liabilities like sukuk).  In general, deposits made up the vast majority of the Islamic banks' liabilities that I looked at, ranging from 76% to 85%.  Within the deposits, there were a few main types (current accounts, savings accounts and investment accounts).  Most of the banks had just one type of investment account, which I am guessing is almost universally mudaraba-based profit-sharing accounts.  Two banks (Al Hilal Bank and Emirates Islamic Bank) which had another category of deposits, wakala.  The banks in general used "investment accounts" as their primary funding source, representing around 60% of total liabilities (three-quarters of the deposits), although this wasn't universal.

The real difference between the banks (only two banks offered this detailed breakdown, unfortunately) came with the maturity of the deposits.  Dubai Islamic Bank had more (about two-thirds) of deposits in short-maturity or demand deposits, while Al Hilal Bank had more mid-range (3-6 month) deposits (about one-half) compared with the remainder split between longer-term (>1 year) and short-term funding (<3 months).  The split between short- and longer-term deposits is more of a business decision, than it is something that goes to the heart of how Islamic banking differentiates itself .

However, with the limitations on Islamic deposit insurance, the maturity of deposits can be a factor in how resilient an Islamic bank is to future banking system problems (longer maturity giving more protection against runs on the bank becoming destabilizing). The offsetting factor (for the bank) is that longer-term deposits are more expensive than short-term deposits, and that will be true whether the bank is Islamic or not because in practice, deposit accounts are not entirely pass-through, and also must offer rates of return that are competitive with conventional banks.

The other two areas of liabilities on Islamic banks' balance sheets varied bank to bank to fill the remaining 15-25% of the liabilities with some having more in inter-bank financing while others had longer-term liabilities like sukuk or the Central Bank wakala financing that was provided to banks during the Dubai debt crisis.  However, in general, the larger the bank the less reliant on inter-bank financing, although the three largest banks (DIB, ADIB and Emirates Islamic Bank) all had wakala financing from the UAE Central Bank, which skews the relative shares.

Removing the wakala financing from the Central Bank (assuming it was replaced with inter-bank financing) removes the previous relationship between longer- and shorter-term other (non-deposit) liabilities between larger and smaller banks (the smaller banks being Sharjah Islamic Bank, Al Hilal Bank and Ajman Bank; Noor Islamic Bank does not put financial statements on its website).  The ratio of short term to the sum of short- and long-term non-deposit liabilities is the metric I looked at (moving wakala financing from long- to short-term) ranged from a low of 29% to a high of 87%.

The sample I chose was purposefully non-representative to try and limit the fluctuations due to country-specific factors, but a few trends emerge.  First, most banks have deposits as the largest source of their funding, which is probably good because it is lower cost than sukuk and less volatile than inter-bank financing.  The one exception to the stability of bank deposits is in a banking crisis and the UAE Central Bank did what central banks are supposed to do in a crisis: they lent freely on more costly terms than they normally would (the wakala is convertible into equity).

In the non-deposit liabilities, the wide range of splits between inter-bank financing (short-term) and longer-term financing like sukuk was mostly explained by the difference between banks that had sukuk outstanding and those that didn't.  The banks with sukuk outstanding had lower reliance on inter-bank financing than banks that did not issue sukuk.  This suggests that one way to mitigate the reliance of banks on short-term inter-bank financing is to further develop the sukuk market, especially finding structures that don't require physical assets, but can fund longer-term assets on the balance sheet with longer-term funding.

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

Islamic finance complexity (Part IIc)

Wakala and murabaha deposits

Reading through the previous posts, I realized that I focused on only two of the four types of Islamic deposit products (qard and mudarba).  The other two--wakala and murabaha--should also receive a quick discussion. The wakala deposit product is very similar to the mudaraba, except that the profit accruing to the bank is determined differently.  In mudaraba, the bank receives a share of profit as mudarib, while in a wakala, the bank charges a fee for serving as the wakil (agent).  In both cases, the losses are supposed to be borne exclusively by the provider of funds (rabb ul-maal under mudaraba and muwakkil under wakala) but in most Islamic banks, there are reserve funds to preserve depositors principal to remain competitive with conventional banks and also to limit the likelihood of a run on the bank.

The other product, murabaha, is a more recent development and is often a commodity murabaha.  On the one hand, a murabaha is a useful product because it is not ambiguous like a mudaraba or wakala, in that the deposit is directly exposed only to the credit risk of being a creditor of the bank, rather than existing in a middle ground of being exposed to the risk of the investments made by the bank, but in practice, relying on the bank prudently creating a reserve fund to protect depositors funds.  On the other hand, the use of murabaha in deposit accounts further entrenches the product which is seen by many as less than desirable because it further enforces the idea that Islamic banks develop products that replicate conventional bank products.

Islamic Deposit Insurance

However, the main issue I have not yet addressed is Islamic deposit insurance.  The idea of deposit insurance is at first glance anathema to an Islamic banking system that is based (at least in rhetoric) on profit-and-loss sharing.  There are benefits to making rewards related to the risks, but in a bank, putting risks on depositors shoulders when those banks are competing with conventional banks is likely to hurt their competitiveness when there are no protections to depositors like deposit insurance (or to a lesser degree reserve accounts).

Depositors are generally focused on safety of their deposits and immediate access to their funds on demand, with returns (to keep pace with inflation) being secondary for most depositors with current (demand) deposit accounts.  Time depositors sacrifice immediate access to their deposits for some return to offset inflation, but  generally are not focused on high returns, especially if those returns put their principal at risk.  For both demand and time depositors, the safety of their principal is important and without some form of Islamic deposit insurance, a proportion of these depositors would move to conventional banks that can offer deposit insurance.

Without deposit insurance, the security of depositors' money is reliant on their faith in the solvency of the bank and its ability to properly accumulate enough reserves to offset the losses of funds that are invested on behalf of the depositors.  However, the confidence in the bank and its reserve accounts are likely to be highly correlated with depositors' faith in the solvency of the bank and if one is put at risk, there is a possibility for a bank run to start, which will turn doubts of confidence into a self-fulfilling prophecy (in some, but not all, cases).  Thus the need for deposit insurance.

There is limited experience with Islamic deposit insurance.  Most of the Islamic deposit insurance programs (detailed in a survey by the International Association of Deposit Insurer's (IADI) Islamic Deposit Insurance Group (IDIG) conducted in 2009) are either part of a conventional deposit insurance program entirely or are done with small changes to be Shari'ah-compliant.  The only fully Islamic deposit insurance program is Sudan because the banking system is (or was at the time) fully Islamic.

Two deposit insurance programs which I looked at were Bahrain's (run by the Central Bank of Bahrain) and Malaysia's (run by the country's deposit insurance agency PIDM).  The deposit insurance systems are different.  Bahrain's covers deposits, not including mudaraba deposits or other deposits not involving safekeeping or custodianship where the depositor would be entitled to share in profits and losses.  It is post-funded (i.e. deposit insurance assessments are only collected from banks when there is a failure) so there are no issues with how the deposit insurance premiums are invested (although the CBB website does indicate that a new deposit insurance program is under construction that would shift it to being pre-funded raising the issue of investing the premiums collected by the Central Bank).

PIDM, in contrast, does both collect premiums (it is pre-funded) and does cover mudaraba depositors in addition to deposit contracts based on custodianship or safekeeping (e.g. wadiah).  The deposit assessments are calculated in a similar way to conventional banks, but the premiums are held in a separate fund from those collected from conventional banks and are invested only in Shari'ah-compliant government investments (e.g. bonds, notes, bills issued by the Government or Bank Negara Malaysia, the central bank).

Since PIDM's deposit insurance program does cover mudaraba, it would be natural to assume that it limits the profit-and-loss nature of mudaraba deposits, but the deposit insurance program does not cover regular losses that would accrue to mudaraba depositors.  It only comes into play when a bank that is a member of the deposit insurance fund fails.  In order to not place return-generating accounts above those that do not generate a return for depositors, the wadiah and qard depositors are placed ahead of mudaraba depositors in the seniority of creditors of a failed bank.

The deposit insurance issue should be more aggressively developed now that the Islamic finance industry has the experience of surviving a global financial crisis.  It is probably luck more than just about anything that there were no bank runs on Islamic banks during the crisis, and in part also due to the ad hoc interventions by governments.  A deposit insurance program (operating under kafala bil ujr, a guarantee provided for a fee, like Malaysia's) is essential if Islamic banks want to compete with conventional banks while also avoiding being covered by conventional deposit insurance programs (which may lessen perception of their Shari'ah-compliance).

As the Malaysian program shows, deposit insurance programs do not offset any profit-and-loss sharing of mudaraba deposit accounts, except if the bank fails.  This is probably prudent because while depositors are likely willing to risk small fluctuations of their deposits in rare occasions (where the reserve accounts are not large enough), they are unlikely to accept the total loss of their deposits, and will move to conventional banks if that possibility is shown to be real by the failure of an Islamic bank somewhere in the world.

The existence of Shari'ah-compliant deposit insurance (deposit takaful?) will, I think, increase, rather than decrease, the profit-sharing nature of Islamic banks by taking the 'tail risk' away from mudaraba depositors. They will still have to have faith in the bank adequately maintaining a reserve account (something that the bank regulators should focus on), but it will make the returns generated from a mudaraba account seem worthwhile, even if small, because the unlikely event that they suffer a large loss has been removed.  For proponents of a profit-and-loss sharing bank system, this should be a priority, especially before murabaha deposits become the norm rather than qard, wakala or mudaraba that prevail today.

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

Commodity murabaha spreads to deposits

The Indonesian subsidiary of CIMB, CIMB Niaga, is planning on launching a commodity murabaha deposit account, according to Bernama.  A commodity murabaha is a product mostly used between banks to manage liquidity where one bank buys a commodity (like palm oil) in the spot market, sells it to the counterparty with deferred repayment, and the counterparty then sells the commodity in the spot market.  It is as close as you can get to a conventional interest-based loan in Islamic finance.  Its use has been controversial (commodity murabaha is the same thing as tawarruq) but deemed necessary to keep the Islamic finance industry running (and I accept its use where there are no or very few suitable alternatives, like in inter-bank money markets).

However, when it is introduced as a deposit account product, it is an unequivocal statement that 1) Islamic banking is not any different from conventional banking; and, 2) Islamic banking cannot offer anything new to consumers that will fulfill the role of deposits (liquid, safe places to store money and earn a return).

On the first point, the ideal structure (at least from early theoretical models) is that Islamic banks operate as financial intermediaries between depositors and borrowers (as in conventional banks), but introduce a profit-sharing mechanism that somewhat insulates the bank from the maturity mismatch in conventional banking because depositors are theoretically required to bear loss from their deposits.  They provide the bank with capital under mudaraba and the bank provides financing under mudaraba.

The mudaraba model of banking on the asset side is not common.  The asset side of banks balance sheets has always been more debt-based using ijara or murabaha (including tawarruq) to create a predictable stream of income and a financial statement that bank analysts can easily identify with (and which fits into regulations designed for conventional banks).  On the liability side of the balance sheet, Islamic banks have mostly left the mudaraba model intact.  Depositors are typically required to accept the possibility of loss, although in practice, they are protected from losses by surplus profit or profit-equalization reserve accounts, which shift the first loss position to equity holders and also hold the profits that would accrue to depositors in excess of conventional banks' interest payments on deposits.

In addition to the reserve accounts that protect depositors, there are other forms of deposit accounts like amanah, where the bank guarantees the principal of the account but does not pay a return.  There are other deposit structures like wadiah and wakala that are also used that also require the depositors to (mostly theoretically accept losses).  In the UK, the Islamic Bank of Britain was allowed to give customers the option to refuse deposit insurance if a loss in their deposits would occur due to bank insolvency (as far as I know this is not allowed in the US, although consumers could theoretically refuse to withdraw any deposits held in bank accounts of failed institutions which offer Islamic banking, if the FDIC got involved).

The striking thing about the use of commodity murabaha is that it acknowledges that any model where there is a possibility of loss (mudaraba, etc.) or where there is guaranteed principal but no return (amanah) is not enough to attract depositors.  Instead, the conventional deposit account with principal protection and a return on deposits has to be (re-)created.

There is one other alternative that I can think of and that this product is being used to create Islamic certificates of deposit for retail consumers where funds are locked up for a certain period of time with principal guarantee and a fixed profit.  If this were the case with this product, it would make some sense, but it still amounts to the bank managing its balance sheet into a form that is familiar to conventional bankers (and consumers!).

I would imagine that this type of deposit account is used by other Islamic banks, so I don't want to single out CIMB Niaga, but the implications of bringing commodity murabaha into the equation with depositors when so many near-equivalents are possible and already in use are not positive.  It adds one area of the balance sheet to the list of "things the industry does to make it as close as possible to conventional finance".  As much as I support using replicated products to offer new services to consumers in Islamic banking, I try to limit my support to areas where Islamic finance has not yet found a different way to do these things.  Besides equity, deposits stand alone as the area of an Islamic bank's balance sheet where other, less cynical products are available and already in use.

The rise of istithmar sukuk

From my newsletter:

On June 20, 2011, the Malaysian central bank, Bank Negara, unveiled its newest liquidity management product, although few details were offered. In the first auction on the following day, Bank Negara sold RM500 million.($165 million) of the 1- to 3-year sukuk. The product itself is based on the istithmar structure, which combines other receivables from murabaha as well as ijara transactions. In general, under AAOIFI rules, the portfolio must have at least 33% ijara sukuk in order to be tradable, although in many cases, a more conservative interpretation is used where 51% of the portfolio must be ijara.

It is always interesting to see new Shari'ah-compliant liquidity management products come out with different structures (istithmar, commodity murabaha, salam and ijara are the ones I have run across). However, beyond the liquidity management space, the istithmar structure is becoming more widely used with institutions like the Islamic Development Bank. The International Finance Corporation used a similar wakala (agency structure) which securitized a portfolio of other contracts.

The thing that I find about this interest in istithmar sukuk is that it (and/or wakala) have potential to replace mudaraba and musharaka sukuk, which were used (and misused) extensively before the financial crisis and the AAOIFI ruling clarifying the rules around the buyback clauses used at maturity of those sukuk. There may be less concern about misusing structures (or misapplying their rules) in an istithmar sukuk (compared with a mudaraba or musharaka) because the former type is designed to be specifically an investment portfolio, where latter is commonly associated with venture financing (either providing financing from one party in mudaraba or through a joint-venture financing in a musharaka).

It will remain to be seen how much uptake their is in the istithmar sukuk structure but they are likely holding many ijara and murabaha assets on their balance sheets that could be securitized. It will likely depend on whether they have sufficient ijara assets to match up with murabaha to get to the threshold to make their sukuk tradable.

As I re-read the newsletter, it occurs to me that the entire area of securitization has largely passed Islamic finance by, although it would be a natural source of new sukuk were Islamic banks to pass on their risk and return to investors. However, the likely reasons for the absence of securitization (with a few exceptions) is the absence of standardization of the contracts for securitization, as well as the collapse in the securitization market that occurred just as the sukuk market was reminded of the rules around mudaraba and musharaka sukuk, which had been widely used (and as I mentioned, misused).

Now that the securitization market is coming back to life in the conventional market, it would be a good time to look towards pure securitization. It has the "ideal" structure (in the eyes of many) of making investors participate in both the risk and reward, would allow for the relatively quick creation of a lot of new sukuk in a market that has been coming back strongly from the credit crisis and the istithmar and wakala structures are much better vehicles, at least on a high-level view view, than mudaraba and musharaka, which were somewhat co-opted for creating sukuk based on a pool of financial assets.

There are, of course, some caveats. The first would be to find and address the reason why Islamic banks are reluctant to securitize their assets. Perhaps they believe that they will be more highly rewarded by holding the assets themselves, although that creates additional risk within the system as a whole. Or, perhaps, the infrastructure for creating cheap securitizations does not exist. Compared to the first possibility, this would be the best case. The International Islamic Financial Market (IIFM) is already reported to be working with Hawkamah on a standardized contract for ijara sukuk.

There is also the ever-present risk to investors that Islamic banks will securitize their bad assets and keep the ones they believe will perform the best. Given the ability of some Islamic banks (Gulf Finance House is the best known name) to use questionably ethical business models, the potential for Islamic banks to dump risky assets into securitized sukuk risks creating Subprime (v.Islamic). Perhaps the Western Islamic banks could take the lead in developing the infrastructure for Islamic securitizations.

Considering the possible IILM liquidity tool structures

The International Islamic Liquidity Management Corporation (IILM) announced that it plans to issue the first short-term liquidity management instruments by the end of 2011. This is disappointing because the products are needed, the sooner the better. However, it is usually better to get it right than just to get it out there quickly. The size of the first issue will likely have a minimum size of $300 million, depending on demand, which is tiny compared to the volume of commodity murabaha contracts used for liquidity management which is estimated at $1.2 trillion.

No structure has been announced yet for the IILM, but it would likely not be commodity murabaha, which is not tradable. An article from Bernama describes (citing Mohd Razif Abudl Kadir, the deputy governor of Bank Negara Malaysia): "the main function of the IILM is to issue high quality papers as the shareholders are the central banks, which recognise it as eligible papers that can be traded among the players". Commodity murabaha (all murabaha) is not tradable on the secondary market outside of Malaysia except at par because it represents a debt receivable, subject to restrictions on trading in debt (bai al-dayn). He added that the maturity can be short-, medium- and long-term and gave the specific example that "it can be an avenue for the Malaysian government to tap global funds for the Mass Rail Transit mega-project". The Mass Rail Transit mega-project is a nearly 10 year project to put in 150km of rail in the Kuala Lumpur area by 2020 that is estimated to cost RM36.6 billion ($12.1 billion).

From this point, it is only speculation what the IILM product will look like, there are a few established and developing liquidity management tools (described well by Simmons & Simmons in a document from 2008 [PDF]; they are the basis of the descriptions I provide of the products):

Wakala/Mudaraba: In a wakala, two Islamic financial institutions (IFIs) enter into an agreement where one places funds with the other, who invests it on their behalf. The party placing funds (the lender) bears responsibility for losses. This could be a viable option for the IILM, but only on a short-term basis (unless a secondary market developed quickly). The IILM could provide an "indicative" rate of return, but is non-binding and is not a guarantee. However, the IILM would face a credibility problem if it did not meet the "indicative" rate of return. Central banks undoubtedly want to avoid losses, even if they are less concerned with generating a profit. Once the funds are placed with the IILM, they would have to be invested in something which generates a return that meets or exceeds the "indicative" return investors expect.

The advantage of this structure is that it could provide perpetual sukuk (or sukuk that were issued in equal amount as they matured), so long as the IILM is able to find things to invest in to generate a return sufficient to meet the "indicative" return (adjusted for changes in interest rates; the indicative return may even be calculated as a spread over a benchmark like LIBOR or KLIBOR). This would define the focus of the IILM. Instead of rotating assets from member banks to use as backing for, say, ijara sukuk, the IILM could focus on generating a return with the funds and on facilitating the secondary market.

However, this strength would also create a weakness. It would force the IILM to compete with the Islamic Development Bank and would also limit the size of the tradable market to the amount of funds the IILM could invest in quality projects to generate a return sufficient enough to make profit payments to the holders of the certificates. This is less of a hurdle than it appears at first. If the figure above were only for overnight liquidity management (i.e. the same amount was created and redeemed each day), it would represent just under $5 billion in certificates (i.e. $1.2 trillion divided by 250, the rough approximation of business days in a year). Assuming that the demand for these certificates increase 20% per year for the next 10 years and only 1/2 of the outstanding certificates trade in a given day, that would allow $60 billion in certificates in ten years to replace the equivalent of $7.5 trillion in commodity murabaha contracts. [Note: my assumptions for this calculation is by no means realistic, but used as an exercise to put the $1.2 trillion of commodity murabaha into context]

While the wakala/mudaraba structure seems like it is viable as a structure (there are many asset managers with more than $60 billion in assets), it would be difficult to create the liquid market for the certificates. Pricing would be relatively easy if the IILM is able to garner a credit rating at least as good as its member states (for comparison, the Islamic Development Bank has a AAA rating).

Wadiah: The two IFIs agree that one will place funds with the other and the one receiving the placement invests the funds like in the wakala. However, the placing institution does not have the right (although the receiving institution can voluntarily make profit-sharing payments) to any profits, but is entitled to a return of capital in the full amount, regardless of the performance of the investments made with the funds placed. This has the benefit that the IILM could use it as a way to get certificates into the market. However, it would be more likely to incur losses in adverse market environments. This is unlikely because although the IILM would be forced to pay out deposits in full (in contrast with the mudaraba/wakala), in both situations it would be expected to incur these costs to keep its credibility.

The benefit of the wadiah for the IFIs would be that even though they give up the legal right to a share of profits, they are entitled to their deposit back in full. Given the way markets and institutions operate, the IILM is likely to pay out profit-sharing payments in the good times and make good on deposits in bad times. However, this introduces a new risk to IILM member central banks. Under wadiah, they are obligated to make full payment of deposits on request even if the investments turn out to be unprofitable. It is definitely a "tail risk", but it is worth considering with the hindsight of the experience in the US with Fannie Mae and Freddie Mac, which operated under implicit government guarantees from the US government that were called upon following the US financial crisis. In wadiah, the guarantee would be explicit, while under mudaraba/wakala it would remain implicit.

Accrued Notes: An accrued note works like the wakala product but allows the IFI to either reinvest the profits or take them out in specified intervals. This would allow the IILM to underake longer-term projects with its capital because instead of paying out profits every period (month or quarter), it would issue new certificates to investors who reinvest the profits. Depending on the percentage of certificates held for a longer term (e.g. cash held by money market funds), this would both require less capital to be held in liquid form (i.e. cash) if new certificates could be issued for the same par value as the outstanding certificates. Longer-term investments have the potential to generate higher yield but are also have more risks, which would introduce a greater likelihood of a 'tail event'.

Capital Protected Products (including multi-currency products): In a capital protected note, there is a combination of a commodity murabaha and a wa'd-based swap of returns from a specified index. This is an unlikely structure for the IILM because trading would be difficult because of the commodity murabaha to create the capital protection. It would also be relatively unnecessary if the IILM were able to get a high rating that I would expect (i.e. similar to the Islamic Development Bank). If the IILM is operating on a global scale, it would be able to issue multi-currency certificates and the wa'd-based multi-currency feature would be better served by the Islamic window at a conventional bank, which could limit its currency risk by using conventional hedging tools.

Tradable Sukuk: Besides the wakala/mudaraba and wadiah, this is the most likely product. In fact, it might be more likely because of the relative familiarity that the market has for sukuk. The biggest problem in sukuk markets besides lack of supply is liquidity. Where the wakala/mudaraba product needs both a new market for the certificates and sufficient liquidity, an IILM sukuk issuance needs only a liquid marketplace. The central bank members of the IILM might not have the assets needed to issue a large volume of sukuk, but the comment in the Bernama article that the IILM would consider short-, medium- and long-term products and could use the funds for domestic projects suggest that other assets that are not directly owned by the central banks could be used to back sukuk.

The risk from IILM sukuk being used to fund national projects (like the Malaysian rail project mentioned in the article) is political. How will the assets be selected to back IILM certificates? Even with an IILM guarantee, the certificates would not be identical. You could buy a sukuk that was backed by the transit system in Malaysia (which has Ringgit exposure) or the one in Luxembourg (which has Euro exposure) and your sukuk might be denominated in dollars. It would be preferable to reduce external factors by having the certificates backed by a large number of diversified assets.

This could be accomplished either by the use of wakala or murabaha contracts or by the IILM issuing sukuk using mudaraba or wakala as the underlying contract. Reflecting on the description of what is created with mudaraba or wakala certificates, I think I was essentially describing sukuk certificates. In my opinion, an IILM wakala or mudaraba sukuk is the most likely structure.

Sukuk repos: This is an unlikely product for the IILM because it would duplicate the efforts of the IIFM (which is on the first stages of a difficult road towards a repo master agreement) and would step on the member central banks' toes because one of the primary uses of repos is for monetary policy. It also requires a larger supply of sukuk than exists today (particularly higher-quality sukuk) for it to become feasible.

I would hope that more details are released as we see the IILM develop and the next opportunity for further announcement is coming up when the IFSB holds a seminar on liquidity management in Islamic finance in Istanbul, Turkey on April 6th and 7th.

More thoughts on the ILMC

There are still few details about the International Islamic Liquidity Management Corporation that was established in Kuala Lumpur, Malaysia by the members of the Islamic Financial Services Board (IFSB). One new piece of information is that the ILMC will issue short-term papers in international reserve currencies (starting with the US dollar and Euro). I don't have any source for other than my own intuition, but I would suspect that the short-term issuance will be based on commodity murabaha (perhaps using the facilities at Bursa Suq Al-Sila'). The Bursa Suq Al-Sila was established in late 2009 as a Shari'ah-compliant trading platform in crude palm oil in Malaysia to facilitate Islamic financial institutions' liquidity management. That platform has already been used by international Islamic banks like Al Rajhi Bank's Malaysian subsidiary, which became a Commodity Trading Participant in August.

The use of commodity murabaha (if this were the choice made for the short-term issuance) would provide some benefits, but it would be outweighed in some areas by the costs of using the murabaha structure. First, the benefit is that commodity murabaha is globally recognized as being Shari'ah-compliant and therefore would sidestep any potential debate about whether the Shari'ah standards used were globally recognized. Even without using the commodity murabaha product, the difference in Shari'ah opinions is somewhat overstated as it relates to the ILMC because it would follow a well established trend for Islamic finance institutions to have a diverse Shari'ah board to command global respect for their rulings. Recently, Al Rajhi Bank worked with Cagamas, the Malaysian housing agency, to develop the Sukuk ALIM to be acceptable in both Malaysia and the GCC. And long before that sukuk, the Dow Jones family of Islamic indices was launched with a Shari'ah board composed of scholars from many regions, including both the GCC and Malaysia. In addition to the Shari'ah-compliance issue, using murabaha would be familiar to bankers who currently use inter-bank murabaha to manage liquidity. The ILMC would formalize this and reduce the counterparty risk associated with short-term interbank lending.

While the benefit would be substantial of using a structure that everyone accepts, even if there is debate about the appropriate level of reliance on murabaha by the industry as a whole, it would impose costs. The largest cost would be that the short-term bills are generally not tradable, except at par, because they represent a debt from the issuer and do not provide the investor with ownership of an asset that would be the basis for any secondary market trading. I recall (although I may be misremembering) that these bills would be issued with maturity of up to 1 year and therefore the absence of a mechanism for their secondary market trading would deprive the industry of a benefit from having a global, multi-currency short-term issue. This is not a problem that would be unique to the ILMC; in addition to its short-term ijara sukuk, the Central Bank of Bahrain issues sukuk al-salam, which have a similar limitation. The cost of not having secondary trading is that the ILMC would miss the opportunity to provide a reference rate of return that--by virtue of its shareholders being central banks and regulators--would be close to a risk-free rate of return on which other pricing could be based.

While it is easy to offer a criticism of the ILMC if it were in fact to choose commodity murabaha as the structure for its short-term bills, it would be difficult to develop an alternative that addresses the concern. First, it would have to probably be either a wakala, mudaraba, musharaka or ijara contract to be tradable and thus offer a reference pricing benchmark for other short-term financing. From these structures, there would have to be an easy, and relatively costless, way to issue short-term financing to attract widespread usage. All four of these contracts raise issues for which I don't have an easy answer for. The wakala structuure would benefit from using a structure that is relatively common in inter-bank liquidity management. However, with one of the parties (the one borrowing money by issuing sukuk) being a multi-lateral institution owned by central banks and regulators, there would have to be some use of the funds that would generate a return to pay for the wakala return or else the structure would raise issues of Shari'ah-compliance (with the ILMC acting as agent for the provider of funds, the return would have to be based on some activity). The mudaraba and musharaka would raise similar issues: what activity is being financed by the ILMC that generates the return paid to investors in the short-term sukuk?

The ijara structure would be easier to structure because their returns can be based on the rental of property or some other good. However, the ILMC is expected to be located inside the Petronas towers in Kuala Lumpur and would therefore not have sufficient assets on which to base the ijara sukuk. Even if the ILMC owned assets like its headquarters building, it is hard to see how it could have sufficient assets to issue the level of sukuk necessary to fill the demand for short-term sukuk. Every increase in the demand for the short-term sukuk would require the expansion of the assets held by the ILMC (not to mention the expansion necessary if they were wakala, mudaraba or musharaka sukuk). This would increase the cost and limit the demand for the sukuk, which would defeat the stated goal of providing liquidity management products to Islamic banks. With the alternatives posing difficulties, it seems likely that the ultimate structure will be commodity murabaha and despite the issues raised with this structure, it is the 'least costly' setup for creating better liquidity management tools, and the need for the product makes accepting the limitations of a commodity murabaha structure.

IIFM Repo Report

In my weekly newsletter (subscription form on the left side of the screen) for the past week, I wrote about the idea of Shari'ah-compliant repos before I had a chance to read the IIFM report. As such, I focused mostly on the criticism I could foresee about the effort. As I mentioned, I think that the repo product is important enough to overcome the objections of replicating conventional products because the lack of similar products to repos limits Islamic banks' liquidity management by forcing them to hold excess cash which provides no return. The other side of the coin is that without Shari'ah-compliant short-term liquidity management instruments, it makes Islamic banks potentially more susceptible to large depositor withdrawals forcing a firesale of assets in an otherwise solvennt institution.

In the newsletter, I wrote:

"I have not yet had time to read over the IIFM report on Shari'ah-compliant repurchase agreements (repos). However, I am sure it will be viewed negatively in some respects with an argument made that the repos are just another example of Islamic finance replicating conventional financial products. The argument is valid in some respects. In a repo transaction one party borrows money by selling a debt with an agreement to repurchase at a higher cost at some specified point in the future. The transactions are generally short maturity debts, even if the underlying bond being sold and repurchase is of longer maturity (usually Treasuries or some other highly liquid investment).

By that definition, there would seem to be several issues that are worked around that would make a repurchase agreement not Shari'ah-compliant. There is trading in debt, interest payments, and a forward contract on a debt at a specified price; all of which would make a traditional repo agreement not Shari'ah-compliant. The new structuring will likely replicate the outcome through a different Shari'ah-compliant structure. In the past with other transactions, that usually leads to criticism."

"The criticisms usually neglect the difficulty of developing an alternative to conventional finance working within a financial, legal and regulatory system that was developed with only the conventional financial system in mind. As such, it is hard to create an industry that competes with conventional finance and works within the financial system and so replication of conventional products--while not necessarily desirable long-term--do provide the Islamic financial industry with a starting point and as it develops further there will be changes that seek to improve it."

"The argument that product replication is desirable is not clearer in my view than for the case of repos and other short-term liquidity management tools. These allow banks to invest more of their capital (rather than holding it in cash), which makes them more competitive with conventional financial institutions while also increasing the stability of Islamic financial institutions by increasing the liquidity of their balance sheet. So long as their counterparties in repo transactions believe they are solvent, they will be able to manage withdrawals of deposits without being forced into a firesale of their assets. There are always potential areas where problems can arise like the Lehman Brother's Repo 105, which manipulated the bank's assets to make it look more healthy than it was and this could become a problem with Islamic repos. However, as long as sufficient controls are put in place by regulators, the benefit from greater ability for banks to manage liquidity will outweigh the criticism of just another highly structured conventional product with a structure that makes it Shari'ah-compliant."

Having had a chance now to read the report, I think that my comments were correct. It could be viewed as an attempt to replicate repos in a Shari'ah-compliant structure, but the benefits from making short-term tools like Islamic repos available will ultimately benefit the Islamic financial industry. The report covers four concepts that were described and alludes to a fifth that is currently under discussion.

The first concept is a bilateral repo (I'aadat Al-Shira'a or 'IS'). It is the closest to a conventional repo. Two parties agree to a sale by one party in the spot market with a repurchase of an identical (although not necessarily the original) security at a later date at a set price. The set price (not dependent on the market price at the time of repurchase raised issues of riba with the Shari'ah considerations with the scholars they asked. The use of an identical (part of the same offering) rather than the original security was generally accepted as avoiding the problem of debt trading (bai' al-inah).

The second concept changed the purchase undertaking to a wa'd (unilateral undertaking to purchase or sell), but raised more Shari'ah issues that the authors said would be "difficult to overcome". As a result of the difficulties associated with bilateral repos ('IS'), the third concept abandoned the bilateral structure for a three-party structure, which is different from the conventional tri-party repo.

The three-party structure inserted a third party in between the two parties with a sale to the third party by the 'borrower' and a purchase from the third party by the 'lender'. There was also a purchase undertaking for a specified price between the 'borrower' and the 'lender' to return the securities for a pre-specified sale price at maturity of the repo agreement.

The issues in the three-party repo were covered more extensively than in bilateral repo, which suggests that the three-party repo is a more preferable model, at least from the perspective of the report's authors. There remain significant financial and accounting issues concerning margin calls, overcollateralization, accounting treatment of the repos. From a Shari'ah perspective, there are issues with the purchase undertaking, specifically whether it can be exercised by the lender (to force repurchase by the borrower) or whether it is a unilateral promise (wa'd) by the borrower to the lender.

In my opinion, the issues highlighted by the authors are valid and it will be difficult to create a three-party repo that has the substance of a repo transaction (and be acceptable to both parties, regulators and accounting bodies) while avoiding the pitfalls mentioned from the Shari'ah perspective. The sale and purchase transaction at the outset is in the spot markets and is probably acceptable (although if the transaction were overcollateralized, there might be issues). However, the purchase undertaking for securities raises issues that are much more difficult. If the purchase undertaking were unilateral (not binding on the borrower), then it would in essence be a call option, which would not be acceptable for the lender. If the values of the securities fell, the borrower would just abandon them to the lender (let the call expire) and the lender would be left with a loss. In the conventional setting, most repos are conducted using highly secure and highly liquid bonds (like US Treasuries) and the use of overcollateralization or haircuts can mitigate this risk to the lender (as can the enforceability of the repurchase agreement). However, these are not possible in the Islamic repo transaction.

The final concept outlined is one that is essentially a modified commodity murabaha transaction. As in a commodity murabaha transaction, the lender buys a commodity and sells it with deferred repayment to the borrower. Unlike a straight commodity murabaha, the repayment obligation is secured by the sukuk held by the borrower (and overcollateralized to cover fluctuations in the value of the collateral). If the repayment is made on schedule, the sukuk are not sold and is returned to the borrower. If there is a default, the lender takes possession of the sukuk and can sell them to recoup the unpaid repayment. There are a number of issues that were encountered in the three-party repo (margin maintenance, accounting treatment and Shari'ah issues) as well other issues as whether the securities held as collateral could be re-hypothecated (i.e. used by the bank holding the collateral in its own business).

The final concept uses the most similar structure to Islamic short-term liquidity management instruments used today, but if re-hypothecation were allowed, it would be the most 'replicated' product structure. The addition of transfer of securities as collateral (without compensation) on top of the use of commodity murabaha would raise the most objections, I believe, on grounds that the product is cynical and does nothing to really help the industry develop new products. With the three-party repo at least, there would be a purchase and sale of the securities and the obligation created by the wa'd (purchase undertaking) would be based on another purchase of securities, however difficult the Shari'ah and financial issues it presents are.

None of the four proposed methods are perfect and as I described in my newsletter, that was likely from the outset. However, by providing an overview that describes the benefits and the limitations and Shari'ah-compliance issues involved with each, I think that the authors of the IIFM report have done a great service. Not only were the issues laid out, they were done so publicly. While it may receive criticism as being an exercise in replication of a conventional product for the Islamic financial industry, this degree of transparency can only serve to start debate about what alternative structures could be used. For example, would it be more worthwhile for other central banks to follow the lead of the Central Bank of Bahrain and begin issuing short-term (non-tradable) securities like the sukuk al-salam? Is the Malaysian example instructive (it is probably a non-starter on Shari'ah grounds in the GCC)? However, now that four suggestions have been laid out, the burden is on the critics to propose a solution that addresses the need by the Islamic banking industry, moves away from commodity murabaha and wakala and offers a better solution than has been proposed. With the level of talent working in Islamic finance and a shared desire to create a better liquidity management tool for the Islamic financial industry, I believe this is just the first step on the road to a solution to the problem at hand.

Islamic Bank of Britain raises GBP20 million; sukuk markets send mixed signals

There are a number of articles on the Islamic Bank of Britain's raise of GBP20 million at 1 pence per share. The most detailed is from Ovum. There are a couple other articles. Mushtak Parker wonders whether the capital raise "addresses the bank's fundamental shortcomings". At the end of 2009, the bank had 546 million shares issued and outstanding so the 2 billion shares issued in the offering represent significant dilution for existing shareholders and will require approval of the bank's existing shareholders. From a cursory look at the annual report, the increase in the loss in 2009 compared with 2008 was due to a sharp decline in the profits on the bank's assets, despite an increase in the bank's deposits. As the company describes it: "In addition, those customer deposits that have not been used to fund asset growth produced lower returns due to declining yields in the Islamic inter-bank markets affecting the Company's margin."

In short, the balance sheet expanded with the deposit base increasing although those extra deposits were largely placed with other banks in commodity murabaha and wakala agreements (many of whom are based outside of the UK). This is the wrong direction for a bank, particularly an Islamic bank that is supposed to be focused primarily on pure intermediation: mobilizing profit-sharing deposits to finance businesses. Instead, the bank has been able to attract the deposits but has not found enough demand for those funds (or was constrained by capital requirements that would have required more capital based on their risk weighting on the asset side of the balance sheet). There was growth in home purchase plans (Islamic mortgages) from GBP7 million to 33 million, which does provide one good sign for the bank, but as described below, the reliance on Islamic inter-bank markets as a destination for the bank's assets remains high.

If the bank is focused on attracting deposits (GBP186 million in 2009 compared with 153 million in 2008) that it cannot use in a way that attracts a higher rate of return, it is not working the way it needs to be a profitable institution. As the deposits grew, the commodity murabaha and wakala with other banks increased from GBP152 million to 156 million out of total assets that were GBP207 million in 2009 compared to 181 million in 2008. This is a retail bank where around three-quarters of the assets are lent to other banks. I agree with Mushtak Parker; this is a temporary solution to the bank's needs to offset losses and it remains to be seen whether the bank can address its limited ability to find credit-worthy borrowers to finance. [NOTE: As described in the disclaimer on this blog, nothing contained here should be considered investment advice or an offer to buy or sell any security mentioned]

Sukuk yield premiums in the GCC are widening as conventional yields are falling. Another article points to the best month for sukuk since March with yields on some sukuk falling. The discrepancy is probably due to the selection of sukuk; the latter article primarily focusing on Asian sukuk like the Malaysian sovereign and Petronas sukuk. The planned $1 billion sukuk that was reported to be part of a joint venture financing between Saudi Aramco and Total has been abandoned because of market conditions. A Bloomberg article has another take on the Saudi sukuk market, pointing to the likelihood that issuance of sukuk from the kingdom will double in 2010 compared to 2009 and lead the GCC region. Taking these four articles together suggests that investors remain hesitant to invest in GCC-based sukuk after the Dubai debt crisis despite significantly different economic conditions across the countries of the GCC. At the same time, Malaysian sukuk remain attractive to investors.

Other News

• AAOIFI released two new accounting standards. One which covers sukuk, shares and similar instruments breaks down the accounting treatment based on whether it more closely resembles debt or equity. The other standard provides institutions adopting AAOIFI standards for the first time with a starting point.
  
• Sameer Abdi of Ernst & Young was on CNBC talking about the E&Y report on Islamic fund management. I posted a few links when the report was released in May.
  
• Arab News provides a short article on the IIFM report on a potential Islamic repurchase agreements (repos).
  

Gulf sukuk market recovering, Asia leads; asset-based vs. asset-backed sukuk

The Gulf sukuk market may begin to open up as yield spreads fall with the issuance of sukuk from highly-rated issuers. This is one step in the process of recovering following the effect of the financial crisis which was most noticeably manifested by the Dubai debt crisis. Since the Dubai debt standstill, most of the few GCC-based issuers have been investment grade with the exception of Dar Al Arkan. GCC-based sukuk represented 30% of the Q2 and previous four quarters total global sukuk issuance value according to data from Zawya's Sukuk Quarterly Bulletin. HSBC expects to see a recovery in sukuk led by Asia as it has during the past year. [UPDATE: Bloomberg released an article about the shrinking yield spreads on Asian sukuk]

As the GCC market opens up and high-grade corporate and multilateral institutions like the Islamic Development Bank issue sukuk, it will provide somewhat of a benchmark for pricing other sukuk, particularly those from lower rated issuers. However, the benchmark from new issues will only become meaningful for encouraging new sukuk if there is liquidity in the secondary markets. In contrast to Malaysia, secondary market liquidity in sukuk is low. However, the new issuance is a start. Bloomberg provides a list of forthcoming or planned sukuk. One of those issuers is Abu Dhabi Islamic Bank, which filed a base prospectus for up to $5 billion in sukuk with the London Stock Exchange on July 8th.

Sheikh Yusuf DeLorenzo is quoted in an article in Bloomberg that suggests investors are more likely to demand asset-backed rather than asset-based sukuk based on the recent defaults. The difference is similar to the difference between a secured and unsecured debt and would also tackle the criticism that using an asset-based structure is fitting the round peg of Islamic finance into the square hole of conventional debt structures.

The European travel firm Thomas Cook failed to place $50 million in sukuk in the GCC because of its small size and investor's belief that the coupon of 7% was too low. It would have been the first European corporate sukuk. Based on its small size, I would tend to minimize the impact of the failure on future European corporate sukuk. If a larger European issuer fails to issue a sukuk, particularly if it is of benchmark size, then it may dissuade other European companies from issuing sukuk.

Indonesia auctioned only Rp246 billion ($27 million) in 15 year (Rp7 billion) and 20 year (Rp 239 billion) sukuk compared to the target of Rp1 trillion. As in previous failed acutions, investors submitted enough bids to cover (Rp 1.18 trillion) but the yields were higher than the Finance Ministry was willing to accept. The higher yields have been attributed to the lack of liquidity in secondary markets.

Other News

• Cagamas, the national mortgage company in Malaysia is expected to issue the first tranche of its sukuk which it developed with Al Rajhi Bank to be in compliance with AAOIFI standards. Many Malaysian sukuk are not accepted in the GCC. The sukuk is an al-Amanah Li al-Istithmar (ALIm). It will be backed by a mixed asset pool, but contain enough ijara assets to be tradable. The remainder of the assets will be based on bai, wakala and bai' bithaman ajil (BBA).
  
• A blog post notices the growth of Islamic banking and wonders if it could take a bigger role than it has. I think it can if Islamic banks decide that supporting and financing Islamic microfinance is a good way for Islamic banks to engage in corporate social responsibility.
  
• Malaysian bank Agrobank announced it plans to go fully Islamic by 2015. It has offered Islamic banking products since 2008. The bank reported that 60% of its non-Muslim clients choose Islamic banking products.
  
• Barwa Bank is close to completing its acquisition of First Finance Company.
  
• Gatehouse Bank acquired One Sovereign Street, a building in Leeds, for GBP40.175 ($60.9 million).
  
• Malaysian property developer LBS Bina is issuing a RM135 million ($42.1 million) sukuk to finance a housing project.
  

Late payment penalties, liquidity management, creating secondary markets in sukuk

An article in Arab News discusses the issue of a fee charged by an Islamic financial institution for late payments. In May, Bank Negara Malaysia's Shari'ah Advisory Council said that charging a fee in case of late payment is allowable and separated out the cases where the bank can and cannot keep it and recognize it as income. In the case where the fee is charged as a fine or penalty (gharamah), it must be donated to charity and not recognized as income. Where the fee is for compensation (ta'widh) for actual loss by the Islamic bank, it can be kept and recognized as income. While the distinction is clear between the two concepts, it seems likely to be difficult to distinguish in practice. Perhaps it might be a better practice for Islamic banks that use this to treat everything as ta'widh until the actual costs of collections are met and only then be able to treat any fees as allowable income. However, it is unlikely that such a solution could be approved because it would not be possible to provide ex ante certainty in the contracts between the bank and its customers. Whether this is used or not, it could allow Islamic banks to increase the total fees to Islamic banking customers, which would make the products less competitive and probably result in a slower growth rate for Islamic banking. It would also complicate the Shari'ah audits because it would require that the fees be reviewed to determine whether the bank has basis for compensation if it used the principle of ta'widh.

A fantasstic article from Islamic Business & Finance discusses the challenges facing Islamic finance in developing short-term liquidity management products, despite their importance. The article specifically looks at the UAE commodity murbaha Islamic CDs, the idea of Shari'ah-compliant repo transactions and an electronic wakala/murabaha platform.

Rushdi Siddiqui has another interesting article in Gulf News, this one covering the issue of where is the hub of Shari'ah transactions, which quickly morphs into the discussion of the lack of a hub. One point that he makes, which I agree with and have made before on this blog, is the lack of secondary markets for sukuk. He takes it one step further adding that even where there are secondary markets for sukuk, they are not deep enough or liquid enough to provide much information. He suggests that the Islamic finance industry needs to 'institutionalize' and 'internationalize' itself, primarily by moving from bilateral price discovery through over the counter (OTC) trading to "multiple price discovery". As much as the effort towards creating secondary market platforms for sukuk will help lay the groundwork for this in the future, it is impossible until there is enough supply to sate the demands of hold-to-maturity investors and leave enough exchange-listed sukuk that can be traded in secondary markets to develop meaningful liquidity that provides more information than bilateral trades in illiquid markets can.

Other News

• Sorouh raised $640 million in conventional and Islamic debt, of which $400 million (AED1.47 billion) will be used to redeem the remainder of the sukuk issued in 2008 which I described about a month ago in a blog post. At the time, there was AED1.5 billion remaining of the AED4 billion securitization sukuk.
  
• Malaysia's central bank, Bank Negara, issued its fourth Shari'ah Parameter Reference which covers musharaka. The previous SPRs covered ijara, murabaha, and mudaraba. The bank also issued a concept paper on takaful.
  
• Bloomberg compares the performance of Shari'ah-compliant equity indices with sukuk indices. Equities have lagged sukuk in the past 2 quarters due to an agreement to restructure $23.5 billion of debt by Dubai World and its creditors.
  
• Japanese firm Nomura Holdings plans to issue a $100 million sukuk in Malaysia, the first Japanese company to do so.
  
• The proposed Islamic Bank of Thailand THB5 billion ($154.5 million) is likely to be issued in the second half of 2010 depending on market conditions. The sukuk will have a 5 to 7 year maturity.
  
• Deutsche Bank's Shari'ah-compliant platform is investing in a foreign exchange strategy, based on "investor demand" according to the managing partner of the advisory firm which will create the strategy using a structured note. Deutsche Bank previously created the controversial Total Return Swap structure that allowed investors to receive a return benchmarked to a group of conventional hedge funds.
  
• Singaporean REIT company Mapletree Investments is launching an Islamic REIT whose IPO may be up to $713 million (S$1 billion). The REIT will be marketed in the GCC by Arcapita.
  

TID, Islamic CDs, the halal market and sustainability

The Investment Dar
The Investment Dar case became more complex with the Shari'ah board of TID requesting that the bank stop contesting the claim by Blom Bank based on the wakala contract's non-compliance with Shari'ah. In addition, the Shari'ah board asked that a similar defense not be used in the future without first consulting the Shari'ah board to determine the legitimacy of its contracts. An article in Arabian Business comments that "While the sharia board's statement puts a wrench in Investment Dar's ability to move forward with a case against Blom regarding the deal, legal experts say the reputational damage to the industry has already been done".

I disagree with the contention that TID's case has damaged the Islamic financial industry. In contrast, the UK courts held a skeptical view of TID's defense and now the institution's Shari'ah board has come out in support of the wakala product's Shari'ah-compliance. This accomplishes two things for the industry. First, the court's skeptical ruling on TID's defense provides another secular court precedent that a party to an Islamic contract cannot, ex post, argue that the contract is not Shari'ah-compliant to get out of their obligations. I have argued before that the court's ruling provides Shari'ah scholars and boards with more freedom to change their mind on Shari'ah-compliance without worrying about upsetting existing contracts.

Second, I believe it is positive is that TID's Shari'ah board came out against the institution and upheld their initial ruling. There is always a potential conflict of interest between a Shari'ah board and the institutions for whom they work. However, this provides one example of a Shari'ah board publicly demonstrating that their duty to ensure Shari'ah-compliance and preserve the integrity of their ruling is placed above their employment with one institution. The only clear loser in this development is TID, who are stuck between an adverse court ruling in a secular court and their own Shari'ah board's ruling that contradicts their claims in that court.

UAE central bank to offer Islamic CDs to Islamic banks
The UAE central bank is planning to offer Islamic CDs as short-term money market instruments for Islamic financial institutions. The lack of short-term money markets outside of Malaysia (and to a limited extent in Bahrain) hampers the Islamic banking industry because it leads banks to hold excess reserves in cash, which lowers Islamic banks' returns compared to conventional banks because they cannot generally generate returns from this cash. The Islamic CDs received preliminary approval last week from the Shariah Coordination Committee with what Hussain Hamed Hassan, the committee's chairman, described as "minor changes". It may receive final approved next week according to Mr. Hassan. Islamic CDs are offered in the US by one institution, the University Islamic Financial Corp and are used by some of the Islamic mutual funds in the US as a way to generate a return on their cash balances.

The halal market and social responsibility
The Managing Director of Al Islami said that Islamic branding is a "myth" at a halal market conference in Brunei. The point being made was that the halal brand--the certification--was important but without a quality product, it is not likely to succeed. The point was expanded by Shahed Amanullah, the founder of Halal Media, as a way to expand the market to non-Muslims as well either from incorporating organic and socially responsible halal certifications in food and through social responsibility in the broader marketplace so that "non-Muslims can see Muslims promoting halal values which includes social responsibility, stewardship of the earth and economic justice". I think that this is an often understated point. Although Islamic products, particularly in the financial world, were created to cater to Muslims' needs, they do not need to remain constrained to just Muslims. However, to reach out to non-Muslims, incorporating other shared ethical values and leverage the success of sustainable finance to expand the potential market for Islamic financial products.

Other News

• Hussain Hamad Hassan said it was "not a far-fetched reality" for a Gulf-wide Shari'ah board to be in place by 2013.
  
• Gulf Finance House continues to restructure its debts. In May, Mohammed Khnifer, Aatef Baig and Frank Winkler released an article called "The Rise and Fall of Gulf Finance House", which analyzes the pre-crisis years and how they might have led to GFH's current problems.
  
• Cagamas Bhd, the Malaysian national housing company, may issue up to RM1 billion ($303 million) in sukuk that are designed to be acceptable in Malaysia and the GCC.
  
• The Shari'ah-compliant non-bank financial company being established in the Indian state of Kerala has received significant interest from GCC- and Indian-based institutions (Doha Bank and Reliance Capital, respectively), although the government has said it will not sell more than 20% of the NBFC to any single investor.
  
• The Islamic Bank of Thailand became a major shareholder of a Thai leasing company, Nava Leasing Plc, in which it will own 49%.
  
• A Malaysia law firm has released a booklet in Australia to explain commonly misunderstood aspects of Islamic finance among Muslims as well as non-Muslims. The headline writers, of course, took the most sensationalistic topic titling the article: "Islamic finance not jihad".
  

Dar Al-Arkan sukuk

The Dar Al-Arkan sukuk was one of the first, if not the first, sub-investment-grade sukuk to be issued following the credit crisis and the sharp decline in sukuk issuance that followed. I have not had a chance to fully review the structure until now, but there are a few areas where the sukuk deserves its sub-investment-grade rating, in my opinion, apart from any credit rating of the issuer.

Dar Al-Arkan is a Saudi Arabian real estate company that invest primarily in undeveloped land, although it is expanding its property management business, which is generally a less volatile source of cash flow because it does not depend on the prospects for new developments as much. The sukuk uses two SPVs, one domiciled in the Cayman Islands which issues the sukuk and acts as trustee for the investors. The funds from the sukuk are then placed with another Saudi-domiciled SPV that manages the investments for the investors. The latter SPV is owned entirely by Dar Al-Arkan.

The first issue this creates is that it makes any investors' claims dependent upon the Saudi legal system, which does have a track record based on the numerous foreign oil companies operating within the country, but which is an emerging market and those concerns are also present within the Kingdom as well, in my estimation. The fallout from the Nakheel sukuk (before it was repaid with assistance from Abu Dhabi) focused attention on whether investors could enforce claims within a Gulf emerging market legal system as easily as they could within a developed market legal system, which generally has a more predictable legal system. There was a dual legal system structure in the Nakheel sukuk with the sukuk governed by English law and the mortgage provided to investors enforceable under Emirati law. In the Dar Al-Arkan sukuk, however, there is not the additional complication of a quasi-state-owned company as there was with Dubai World.

Once the funds are transferred into the Saudi SPV, the SPV acts as wakil under a wakala agreement to provide murabaha and ijara financing to subsidiaries of Dar Al-Arkan with returns greater than the periodic distribution amount of 10.75%. The first issue is one of a perceived conflict of interest with the owner of the wakil being the owner of the subsidiaries who will receive financing through the ijara and murabaha agreements. The sukuk is certainly an unsecured offering with a guarantee by Dar Al-Arkan only applicable as I read the offering memorandum if the investment manager is negligent. The portfolio of assets has to be managed in a way that ijara make up at least 51% to ensure the sukuk are tradable under commonly accepted Shari'ah standards (e.g. the most recent Islamic Development Bank sukuk).

My main point of concern with how the structure is created is that it relies on the investment manager (owned by Dar Al-Arkan) making arms-length transactions with other Dar Al-Arkan subsidiaries. This is possible, but with a fixed return on the sukuk and the excess amounts being retained by the investment manager, there is a strong incentive that is not necessarily in the investors' favor. If the investment manager is not negligent, any excess return above the 10.75% is retained by the investment manager (essentially by Dar Al-Arkan), while any losses based on non-payment of the murabaha or a deterioration of the value of the ijara assets are borne by the investors.

If I were an investor (I am not), I would much prefer to have the investment manager be independent of the issuer of the sukuk (Dar Al-Arkan) to ensure that incentives are aligned with the interests of investors instead of being conflicted with both sides to each ijara or murabaha agreement being owned by a common owner (Dar Al-Arkan). In reality, the sukuk is a debt of Dar Al-Arkan, but there are enough different entities involved that if the projects didn't materialize in the way anticipated by Dar Al-Arkan, it could create a significant tangle for lawyers and various courts to unravel the investors' claims.

Note: Because this post is about a specific investment, I would like to emphasize that (with all of my posts) it is not investment or legal advice, nor is it an offer or solicitation to buy or sell any security.

ShariaUMEX, more TID and Nakheel, wadiah-based retakaful, Islamic Repo 105?

A new Islamic exchange will be launched in London in May, the Shariah Ummah Information Exchange (UMEX). The exchange will be open to companies with at least GBP 20 million ($31 million) seeking to raise up to 20% of their market value. It will operate as a Multilateral Trading Facility (MTF) according to the chairman of Halal Industries, which will manage the exchange. MTFs are low-cost electronic trading platforms under the Markets in Financial Instruments Directive (MiFID). The ShariaUMEX expects to have 10 enterprises and 100 securities listed when it launches and hopes there will be 100 IPOs within a year. The exchange will launch Islamic equivalents to American and Global Depository Receipts (ADRs and GDRs). The primary question I have about the exchange is whether it can provide exchange listing at a similar cost to larger exchanges like the London Stock Exchange and related AIM. Presumably, the companies listed on the exchange will be subject to the same standards of reporting and transparency as other exchanges. One of the largest challenges will be whether the exchange can attract sufficient liquidity to allow relative efficiency in pricing which is necessary to attract future listings. There is certainly some minimum level of trading and listing that the exchange has to reach in order to get to a 'critical mass' where it will attract further listings.

The analysis of the TID v. Blom Bank case continues. An article in the National which continues their solid coverage of Islamic finance describes several areas where the decision could impact the Islamic finance industry as a whole. One area is the increasing Shari'ah risk in UK courts allow TID to argue that a product was not Shari'iah-compliant and therefore outside of its corporate power to enter into despite a ruling by its own Shari'ah board approving the product at the time. Generally, the ability of secular courts too enforce decisions based on religious rulings is a negative because they do not have the expertise to make a ruling in this area. The decision of a Shari'ah board that a given product is Shari'ah-compliant should be what determines whether the company can enter into it. If this is changes so that ex post, the bank can argue in a secular court that a contract is not Shari'ah-compliant for nearly any contract it has entered into if it is in financial difficulties. This erodes the role of the Shari'ah board as the arbiters of what is or is not Shari'ah-compliant. Shari'ah boards should be given the exclusive authority to judge Shari'ah-compliance of a given contract and be allowed to force an institution to change its implementation of a Shari'ah-compliant contract if it is doing os outside of the bounds of the original fatwa. The secular courts, on the other hand, should be limited to judging whether the specific aspects of the contract have been followed, not whether it is Shari'ah-compliant or not. The claim by the TID that the contract was not Shari'ah-compliant because it stipulated a fixed rate of return is another separate issue that Shari'ah scholars can discuss and highlights the problematic nature of some contracts which mimic conventional products, but that is a whole other area of discussion.

Reuters weighs in with an article on the Nakheel debt problems saying that the crisis and eventually a resolution could strenghten Islamic finance by forcing the industry to deal with issues raised by the near-deafult. It has also forced investors in the Nakheel sukuk as well as others looking on to consider the limitations that a sukuk may provide in terms of creditor protections compared with a conventional bond.

Another very interesting article in The National discusses whether accounting tricks like Lehman's Repo 105 transactions could come out and bite Gulf-based financial institutions that use similarly misleading transactions. The National reports: "The [anonymous] accountant noted the example of companies issuing sukuk, which may not transfer all of the downside risk attached to an underlying asset to the bondholder. Neither does that risk appear on the balance sheet of the issuer." This is most likely referring to an ijara, mudaraba or musharaka sukuk where the asset underlying the sukuk is transferred to the SPV issuing the sukuk certificates. I am not knowledgeable enough about accounting under IFRS to make a judgement on the accounting treatment of these sukuk, but it would not surprise me if the assets underlying these sukuk were not included on the balance sheet of the issuer (with the beneficial interest transferred to the off-balance-sheet SPV). This would make it appear that there is no asset on the balance sheet that could lose value and cause the issuer a loss. There are only the debts payable to the SPV (which would then pass them on to the certificateholders). However, if the asset loses significant value, then under most sukuk structures, the bank would be forced upon maturity to repay the principal through the purchase undertaking and take a possibly depreciated and depreciating asset back onto its balance sheet. When this event occurred, the outcome would be the bank paying the par value to redeem the sukuk and receiving an asset on its balance sheet that it would probably have to immediately write down to a fair value from the purchase price, which would cause a loss. I would be grateful if any reader more skilled in IFRS accounting could enlighten me on the subject so I could provide a more accurate assessment on the potential pitfalls of sukuk structures that are described by the accountant in the National article.

The International Shari'ah Research Academy (ISRA) has developed, although not yet released, a model for wadiah-based retakaful, which would clarify who owns what in the fund better than the mudaraba or wakala model, according to ISRA. The way it would work is that takaful providers would contribute to a fund that is managed by the retakaful provider. The funds would be invested and the retakaful provider would receive an agency fee and also be liable to pay claims from the participants. In the case that there is a profit on the investments after claims were paid, the profits would be retained by the retakaful provider and any surplus amount in the account (of contributed amounts) would be owned by the participating firms. The retakaful company is able to keep the profits from the investments, so long as the claims are paid to the takaful firms contributing capital, but the difference between contributions paid and claims paid remains owned by the participants, which should reduce the incentive for the retakaful provider to invest too aggressively, because it is forced to return to participants the difference between the contributions made and the claims paid. If it recognizes substantial losses on its portfolio and there is a surplus of contributions, it would be forced to return those funds to the participants, even if its investments lost money.

With all deference to Dr. Hussein Hamed's expertise, I have to disagree strongly with his statement at the Dubai Peace Convention that "Currency value has become interest-based and, therefore, when the crash happened, the only monetary system that was not affected was the interest-free Islamic system." The idea that the Islamic financial system, either in its theoretical form or in how it is actually practiced today is somehow insulated from economic cycles is just not true. The system is operated by people, often with noble intentions, but it is just as susceptible to crisis and recession as any other economic or financial system. The degree to which it can be decimated by poor decisions through over-leveraged financial products like credit default swaps and collateralized debt obligations may be avoided. However, the problem of, for example, overbuilding in Dubai, some of which was financed through Islamic financial products (Nakheel's sukuk, for example) cannot be avoided simply by replacing the conventional financial system with an Islamic one. Human nature being what it is will always create excesses one way or another, although the Islamic restrictions may limit some of the more harmful excesses. If anything, the Islamic financial system should be more, not less, dependent upon the economy cycle because it is supposed to be based on real tangible assets and profit and loss sharing. How many sukuk need to default and financial institutions fail or nearly fail to demonstrate that a severe economic recession can take its toll on the Islamic financial system?

Other News

• Malaysia is considering offering long-term sukuk to provide investment opportunities for takaful firms to reduce their reliance on equity and real estate investments.
  
• Hong Kong will change its laws to allow sukuk issuance. Hong Kong's financial secretary John Tsang also said "We're also enhancing market infrastructure and product development and educating market participants and investors in raising the profile of Hong Kong as an Islamic finance platform".
  
• An announcement on the fate of Amlak Finance and Tamweel is expected soon. The likely outcome will be a merger into an Islamic bank that will receive government support. The reports do not describe whether the new bank will be able to restart lending, or whether it will simply wind down the two companies in the least costly way, although there is no indication that this is the likely outcome.
  
• The United Arab Bank launched its Islamic banking unit on March 17th.