Gov. Zeti tells it (mostly) like it is

An article in Arab News describes the prospects for Islamic finance as seen by Zeti Akhtar Aziz, the governor of the central bank of Malaysia, Bank Negara.  Included in the article is a quote from Gov. Zeti which I think does an admirable job at describing the ways in which Islamic finance is affected by the global financial crisis and the recession which followed.  She said:

"The Islamic finance industry was insulated from the first round of the crisis (the global financial crisis). Islamic financial institutions (IFIs) are more resilient because they are closely linked to the real economy, with in-built checks and balances such as profit-sharing and risk-sharing. As such, there are greater elements of responsible lending. As economies slow down and financial markets experience a correction, these will impact financial institutions including IFIs. That is why it is important to have capital buffers, risk management and governance practices that are sound. We are continuing to develop mechanisms, institutional arrangements and financial infrastructures such as greater liquidity management and more so that the Islamic finance industry would continue to be resilient."

There are some things I think are not necessarily true.  IFIs do have some elements of responsible lending because they cannot move risk off balance sheet quite as easily (and in opaque ways) as conventional banks through credit default swaps (which the FT Alphaville blog described in two posts earlier today).  But, I am not sure that IFIs are any more linked to the real economy than conventional banks (with the exception of situations like before the credit crisis when some banks were loaded up with CDOs created (synthetically in many cases) from subprime MBS.  Most (smaller) banks didn't participate in these instruments, but were still hurt because of tightening credit, falling real estate prices and a slowing economy.

However, she is absolutely correct that IFIs are susceptible to a slowdown in the economy, which necessitates a similar level of regulation as other financial institutions.  Gov. Zeti is usually a good source for clear statements on the Islamic finance industry and this quote is a good example.

A couple other things in the article caught my eye.  First, the 3 applications for Islamic mega banks are not from Western institutions, and are reportedly backed by GCC-based investors, which continues the trend of convergence between the GCC and Malaysia.  Second, Governor Zeti is quoted saying: ""The IILM [International Islamic Liquidity Management Corporation] is currently obtaining the required rating, as well as fulfillment of all other parameters for the issuance including high quality underlying assets".  This to me suggests that the sukuk will be more likely an istithmaar sukuk, backed by Shari'ah-compliant financial assets from the central banks that are the members of the IILM.  Under standard practice, fewer than 50% of these assets will be murabaha and istisna'a if the sukuk are going to be tradable (though I think AAOIFI rules stipulate a cutoff of 33%). 

Islamic finance can learn from the credit crisis, Malaysia mandates rebate in mortgage products

The CEO of Capinnova Investment Bank had some interesting comments about Islamic finance in an interview with Emirates Business 24/7. He believes that there should be a unified Islamic banking authority to create more standardization and facilitate cooperation between different entities. He also suggested that it is "worth looking at the current credit crunch in conventional finance to see how easily one problem can spiral out of control. This is something that Islamic finance practitioners need to take on board and make sure that they are prepared to expect the unexpected". I think this is essential because Islamic finance institutions, particularly banks, can be subject to a crisis that could impair the confidence in their ability to survive which could turn into a destabilizing process where depositors 'run' on the banks. If this happened, the bank would have one of two choices: fail or turn to a conventional lender of last resort.

In both cases, the Islamic banking industry would be hurt. If a large Islamic bank failed, it could lead to questions about the solvency of other Islamic banks and make it harder for them to attract and retain deposits. This would force them to turn to other sources of capital which could be either more expensive or shorter-term, or both. The other alternative--an Islamic bank turning to a conventional lender of last resort--would raise questions about the bank's Shari'ah-compliance and also create questions about what other Islamic banks would do in a similar situation (with added confusion from the impact of different country's regulatory systems). For example, banks offering Islamic deposit products in the US are required to have those deposits FDIC insured (for banks) or NCUA insured (for credit unions). If the institution were to be seized by the regulators, would depositors have a choice about whether they wanted to avail of the non-Shari'ah-compliant deposit insurance?

The best time to determine what needs to be done in a future crisis is now, before a crisis starts. Once a crisis is in full swing, there will not be sufficient time to consider these potential pitfalls. This was demonstrated in the recent financial crisis. The cause of the crisis was not addressed; the focus was entirely upon preventing it from spiraling further out of control.

Malaysia's central bank, Bank Negara, has said that Islamic mortgage products offered using bai bithamin ajil (BBA), and murabaha must include language in the contracts that make the rebate (ibrar) mandatory. Previously, in a default followed by an asset sale (or a prepayment), the lender was entitely to the entire loan amount (cost plus profit) for the entire term of the mortgage. Most banks granted the rebate of what in a conventional mortgage would have been future accrued interest. However, when the rebate was not granted, it often led to court cases.

Other News

• Mushtak Parker criticizes the article about Islamic banking being 'a flop'. He places much of the blame for IBB's loss-making on the bank itself being undercapitalized and without an experienced Islamic banker running it. He also criticizes the product mix that was offered by the bank. In a different article, Mr. Parker describes the progress being made in Australia towards equal regulatory treatment for Islamic and conventional financial products.
  
• The UAE Ministry of Economy issued a law that regulates the takaful industry. It had been previously regulated under a law for conventional insurance companies.
  
• Sukuk prices are at their six-month highs following a number of sukuk restructurings, according to the Dow Jones Citigroup Sukuk Index. The yield on the Malaysian sovereign sukuk has fallen to 3.61%, a spread of 175 basis points over similar maturity US Treasuries.
  
• One of Nakheel's largest trade creditors Arabtec expects the inital payment by Nakheel soon with the remaining amount in a sukuk within a few months.
  
• Funds continue to flow into US-based socially responsible funds, including faith-based funds like the Amana Funds.
  
• Jordan is speeding up the issuance of a planned sukuk as its borrowing costs rise.
  
• Kuwait Finance House (Malaysia) set up an internal department to control non-performing financings, which were 6.72% in September 2009. It also defended its dismissal of one of the firms which rated it, RAM Ratings. KFH Malaysia's parent company is expected to post a higher profit in the second quarter compared to the first, which was 21.4% from the first quarter of 2009.
  
• Dubai-based Fajr Capital will invest in Bank Islam Brunei Darussalam (BIBD), an Islamic bank in Brunei.
  
• The Islamic Bank of Britain won a dispute in the World Intellectual Property Organization (WIPO) with a technology service company that had decide to auction the domain name used by the IBB.
  

Can Islamic banks be too big to fail? Dr. Elgari proposes Shari'ah governance standards, Nakheel sukuk options

A poll conducted by FinanceAsia magazine found that over 40% of voters in the poll said that Islamic finance had been damaged in the financial crisis. I agree with them, although it is more relevant whether Islamic finance was more or less damaged than the conventional financial industry in the countries where it is predominant. A direct comparison with the large banks in the U.S. and Europe is not very appropriate because Islamic banks had far less time to create toxic products (although those would have been more difficult under Shari'ah guidelines). The real lesson from the financial crisis was that there are insufficiently clear legal experience for bankruptcy and default compared to conventional finance. U.S. Treasury Secretary Timothy Geithner suggested today that too big to fail institutions should have a

"bankruptcy-like regime for large financial institutions that mismanage themselves into failure and can no longer survive without special government support. In that process, equity holders would be wiped out and the firm will be placed in a form of receivership so it can be broken apart, sold over time, with no exposure to the taxpayer."

While this has no specific bearing on Islamic financial institutions, it does highlight a similar problem facing Western regulators with regards to too-big-to-fail (TBTF) institutions as is facing the government of Dubai as it deals with Dubai World (whose subsidiaries were active in the Islamic capital markets). The problems with the Dubai World resolution mirrors the problem of TBTF institutions: there is no legal history to fall back on for guidance about how to deal with situations of crisis. With an Islamic bank being launched with $3 billion in capital, which could support total assets of between $30 billion and $60 billion assuming a 10-20x leverage ratio, it will be important for Islamic finance to consider whether this creates a systemic risk that even new bankruptcy laws developed for smaller Islamic financial institutions and players in the Islamic capital markets cannot deal with.

There is not anything wrong with a global Islamic bank with assets of upwards of $50 billion: this is far smaller than the TBTF institutions that Secretary Geithner is speaking about. However, with $50 billion in assets, this could account for 5% of total Islamic finance assets in one institutions and would be a significant size relative to many of the economies in the Gulf (ex-Saudi Arabia). For example, it is more than three times the GDP of Bahrain, which could house the bank. That rivals the ratio of RBS, Barclays and HSBC combined as a percent of UK GDP (337%). Creating a resolution regime for large Islamic banks should be a big focus for the Islamic banking industry and it would create a bad image for Islamic finance if it had to wait for an equally large crisis as the one that conventional finance faced in the fall of 2008.

It is hard to provide a good summary of Mohamed Elgari's call for greater Shari'ah governance in the Islamic financial industry and it the article from Arab News deserves a full real. His views cover the many areas including transparency in Shari'ah governance as well as creating greater public dialogue among Shari'ah scholars about the Shari'ah standards under which Islamic products are judged. He rightly notes that there will not be a consensus nor can (or should) there be total standardization of Shari'ah standards. That would remove the ability to adapt the interpretation by Shari'ah scholars to changing environments and lessons learned from how Islamic finance develops.

The first Nakheel sukuk since the one that matured in December will mature on May 13 and there are a number of options being considered according to Reuters reports. The sukuk is likely to be part of the Dubai World debt restructuring plan and the Nakheel sukuk, unlike its predecessor, does not have a guarantee from Dubai World. The most likely option according to Reuters is an extension of the maturity, although this would depend on whether the creditors would be forced to take a haircut and the size of that haircut.

Other News

• Dr. Abdel Fattah M Farah, the Economic Advisor to the Ajman Chamber of Commerce and Industry, proposes a model for a Shari'ah-compliant charitable investment bank that is very interesting.
  
• An Islamic advisory in the Dubai International Financial Centre, Tabarak Partners, will become the first such firm to be wound up under DIFC laws. With a peak valuation of AED1 billion ($272 million, mis-stated in the article as $27.2 million), it would be relatively small compared to Dubai World, but could provide an example for future (larger) cases.
  
• Al Hilal Bank received a license to open the first Islamic bank in Kazakhstan.
  
• Al Rajhi Bank has received approval to offer banking services in Jordan. The Oxford Business Group has an article on building Islamic finance in Jordan.
  
• Turkey's Islamic banks made profits of $470 million. This represents a 9% growth over 2008. Total assets grew 30% to $22.4 billion.
  
• Japan's Tokio Marine may expand its Islamic insurance operations.
  
• The new ETFs allowed by the Saudi Arabian regulators can include sukuk and commodities.
  

New Islamic bank to have $200 billion in capital; Rushdi Siddiqui on 'opportunity' for Islamic finance

The mega Islamic bank being planned for launch in Bahrain at some point this year will have total capital of $200 billion, according to Sheikh Saleh Kamel, president of Saudi bank Dallah Albaraka Group. The banks shareholders will include the Islamic Development Bank, Albaraka Group, Kuwait Real Estate Bank and '10 other banks'. $100 billion will be raised in investment funds and sukuk. There is a $3 billion IPO that will be listed in Dubai and Bahrain, probably in the fourth quarter. The new bank will be named either "Al-Istikhlaf or Al-Emaar" according to Kamel.

Rushdi Siddiqui, the head of Islamic finance for ThomsonReuters and formerly head of Dow Jones Islamic Market Indexes is quoted describing the 'unprecedented' opportunity available to Islamic finance:

"This is an unprecedented opportunity to seek a 'new or improved' financial intermediation, investing and trading paradigm. In fact I'd go as far as saying that this is a once in a lifetime opportunity to present an ethical alternative to what has been described as an unscrupulous, often highly leveraged instruments, derivatives based without the base investments. Shari'ah law really could be an interesting pathway for G-20 countries on asset backed/based financial intermediation, investing and trading"

France may be the next country in Europe to encourage the development of Islamic finance alongside conventional banking like the U.K. has done. Between 5 and 10% of the country's population is Muslim.

The huge interest in the Indonesian sovereign sukuk may pave the way for other sukuk issuance. The global credit crisis and revisions to AAOIFI standards for sukuk have significantly dampened issuance of new sukuk in the past 4 or 5 quarters.

Interbank markets & rates; sukuk preference strongly towards ijara

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Other News

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

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

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

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

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

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

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

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

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

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

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

World Islamic Economic Forum

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

OVERCOMING GLOBAL FINANCIAL CRISIS:

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

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

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

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

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

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

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

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

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

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

The benefits and limits of Islamic finance in the wake of the credit crisis

An article in The Star describes many of the challenges facing the Islamic finance industry including Shari'ah standardization, the shortage of qualified professionals in Islamic finance, development of risk management systems that incorporate the unique qualities of Islamic finance and liquidity management products. One paragraph, however, illustrates a realistic assessment of Islamic finance vis-a-vis subprime lending:

"Notably, Islamic financial institutions are able to make ‘loans’, such as for financing home purchase and could, in theory, have been exposed to subprime mortgage problems. However, their inherently conservative risk management limits not only their ability to lend as a percentage of their own assets, but also the granting of excessive interest rates which enabled unqualified borrowers to take out such loans."

The essence of the argument made, which I believe is accurate, is that creating home financing products for subprime borrowers could easily be done through financial structuring but one would hope that the Shari'ah screening process would exclude those products that are exploitative or deceptive and also ensure that the level of risk taken on by the Islamic financial institution is not excessive. But I think it is important to recognize that products that replicate the seeds of the current crisis could be synthesized (as short sales already have), but if the industry's review process for Shari'ah-compliance works well, the products would nevertheless not be approved.

Andy Jobst, Heiko Hesse and Juan Solé describe the impact the collapse of the securitization market had on Islamic finance and sukuk in particular as well as the differences in Islamic finance instilled through the Shari'ah review process to mitigate conflicts of interest that were made apparent by the recent crisis.

Illusions of the 'immunity' of Islamic finance hinder growth and innovation

The governor of Bank Indonesia, during a speech, made the claim that because of the Shari'ah screens, "if implemented properly, we can say that sharia economy and banking pose no risk of a crisis. Amid the ongoing global crisis, the presence of sharia banking is actually a hope." Although there are benefits in reduced risk created by the restrictions on gharar and maysir, the use of Islamic financial products cannot be said to be entirely free of risk of crisis. Islamic finance is still a tool used to finance purchases, including assets that can be inflated in a bubble (see Dubai's property market) and claims that asset price bubbles cannot happen when using Shari'ah-compliant financial services distracts from the real benefits from using these financial products and could, in the extreme, be detrimental if there is a general belief that crisis cannot happen.

One immediate outcome of a focus on the 'immunity' of Islamic finance from crisis is that it distracts attention from a much needed focus on real risk management, particularly whether and what types of derivatives and forwards could be judged permissible to provide a way to hedge exposure to some of the risks that Islamic banks face. In general, derivatives are not permitted because they are judged as gambling, but there is a valuable place for some hedging products to offset the lack of liquidity of some Islamic financial products, the maturity mismatch between assets and liabilities on banks' balance sheets and the lack of an interbank lending market (outside of Malaysia) that could keep a crisis from spreading by providing a buffer against illiquidity becoming insolvency.

The sukuk market shows no signs of improving despite there being over 100 sukuk issues planned because there are doubts about whether there will be buyers. Also, the AAOIFI ruling on sukuk from February 2008 has led to a greater proportion being ijara sukuk, depriving many issuers without the assets needed for the sale-leaseback transaction. Despite this, there are a few companies raising funds to purchase sukuk in the expectation that the lack of demand has made the future returns greater.

Other News

• Asset managers in India are becoming more interested in offering Shari'ah-compliant services. The equity markets in India are deeper than in other countries with larger Shari'ah-compliant asset management companies like Malaysia and some managers expect that over 60% of the total market capitalization in India pass common Shari'ah screens.
  
• Assets under management by Shari'ah-compliant asset managers in Kuwait fell 45.5% in the second half of 2008 to $4.4 billion, a similar percentage fall as seen by conventional fund managers.
  
• Abu Dhabi Islamic Bank will receive AED2 billion in a capital infusion from the government. The government will receive a sukuk paying 6% semi-annually. The structure of the sukuk is not clear.
  
• The merger of Islamic mortgage lenders Amlak and Tamweel into Emirates Development Bank is being rethought and the companies may be nationalized according to an analyst at EFG-Hermes.
  
• Malaysia's central bank, Bank Negara, will issue Ringgit 400 million ($110 million) in ijara sukuk next week.
  
• The size of a Malaysian bank's Gulf aviation fund may be cut in half as a result of the economic downturn.
  
• The State Bank of Pakistan is developing guidelines for Islamic financial products for the agricultural industry.
  

The fall in sukuk in depth, new Islamic bank planned

The IFIS report on sukuk issuance in 2008 is out and it provides a deeper look in the 66% decline in sukuk issuance (with the fourth quarter seeing the lowest quarterly issuance since 2002). One particularly interesting part relates to the idea that Islamic finance was immune from the global credit crisis, which IFIS describes as the Islamic version of the now discredited decoupling theory:

"As the GCC bond market flourished even after the initial impact of the subprime mortgage crisis in 2007, there were those who thought that Islamic finance can withstand this downturn intact due to the nature and features of Islamic banking and finance, and therefore of the sukuk market. This led to some unreasonable expectations for the industry. Some industry observers thought that Islamic finance had successfully separated from global conventional credit markets, which was an Islamic variation on the now debunked decoupling theory. Others claimed that Islamic markets were now mature, independent markets, not related to the price of oil. A third view that was sometimes expressed was that lower leverage and emphasis on holding and selling real, tangible assets will save the industry from the full impact of the subprime crisis and subsequent credit crunch. Essentially, all of the above emphasises the fundamentally different natures of Islamic finance and conventional finance. But the evidence counters this. Sukuk have not done well in the past year. Total issuance in 2008 dropped by 66% compared to 2007, showing no immunity from the global downturn."

As the sukuk market succumbed to the credit crisis, some of the debt finance provided by sukuk was replaced by syndicated lending, according to IFIS.

Despite evidence to the contrary, there are still claims that the Islamic finance system is 'unscathed' by the credit crisis and a belief that if the financial system was structured along the lines of the Islamic financial system, there would not have been a credit crisis.

An un-named Islamic bank with $11 billion will be launched by June despite the challenging market conditions. I would foresee great difficulty for this launch, especially since $10 billion of the initial capital is expected to come from an IPO. The bank's role is compared with that of the European Bank for Reconstruction and Development, which is a regional development bank for Central and Eastern Europe established after the fall of Communism.

Other News

• Malaysia's sukuk market is expected to be $4 billion in 2009 compared with $5.86 billion in 2008, which was already a steep (78%) drop from 2007.
  
• Turkey's government announced a sukuk expected to be issued by the end of January to raise $1.15 billion, called "Rent Certificates" linked to the income at four state-owned enterprises.
  
• There are no Muslim faith based debt counselors in the U.S. because "there is no need for a debt-counseling service company, because a practicing Muslim doesn't subscribe to debt service products, such as credit cards"
  
• Bahrain Islamic Bank report falling profits in the wake of the global credit and economic crisis
  
• An existing bank in London, BLME, is starting a new private bank in the U.K.
  
• Another university in Europe, this one in France, is starting an Islamic finance degree as Paris Europlace, the Paris Financial Center, tries to attract Islamic finance to France
  
• Indonesia may extend the term of its forthcoming retail sukuk from three years to five

Correction: I mentioned the $4 billion in debt that Emaar listed on the London Stock Exchange. Of this amount, the European MTN were conventional debt and $2 billion were sukuk.

Sukuk markets not functioning; some companies are turning to conventional debt

The problems in the sukuk market are forcing companies like Malaysian developer IJM Land, to turn to traditional debt, "shattering earlier beliefs the industry would escape the downturn largely unscathed".

Sukuk issuance falls 66% in 2008, lowest since 2005

The issuance of new sukuk fell to $15.77 billion in 2008 compared with $46.65 in 2007 according to data collected by the Islamic Finance Information Service (IFIS), a drop of 66.2% year-over-year. The last time issuance was lower than the 2008 total was 2005 when $10.76 of sukuk were issued. The global credit crisis and difficult economic conditions were blamed for the fall which demonstrate that, although Islamic finance does not have exposure to the direct causes of the crisis (subprime-backed mortgages and derivatives), it is affected by the health of the conventional credit market and global economic conditions.

Cerulli Associates estimates that Shari'ah-compliant funds have $65 billion in assets under management and are expected to grow at an annualized 12% rate. The article describes this total as "a figure that’s more modest than the hundreds of billions of dollars often cited by regulators and industry players". Although there is fair criticism to the $300-$500 billion number often cited as the size of the Islamic finance industry (reliable statistics are largely unavailable), the $65 billion in the fund management industry should not be compared with the "hundreds of billions of dollars". Usually the $300-$500 billion figure is cited to account for the entire size of the Islamic finance industry worldwide which includes assets management, retail banking, sukuk and the other areas of Islamic finance like private equity.

The Dubai Shariah Hedge Fund Index was launched containing four Shari'ah-compliant hedge funds using Shariah Capital's long/short trading platform, most of which focus on commodities. Because conventional short selling is not Shari'ah-compliant because of prohibitions of selling things one does not own, the hedge fund platform has raised some criticism that the idea of an 'Islamic hedge fund' is not possible nor desirable.

The growth rate of the Islamic finance industry is expected to exceed the general economic growth rate in Malaysia. The second finance minister of Malaysia Nor Mohamed Yakcop believes the Anglo-Saxon capitalist system has failed and "If the Islamic banking system had made an impact earlier, then it may have been possible to avoid the economic disorder as the system will not bring such problems". I believe this is further expression of naivete that the Islamic financial system will not be accompanied by any of the problems of its conventional counterpart such as greed.

A real estate company in the UK used Islamic finance to refinance the debt on its property holdings in London.

Indonesia will issue a sovereign sukuk aimed at retail investors in February.

One of the conventional banks in Kuwait, the Global Investment House, has defaulted on its debt. Global Investment House along with Islamic bank The Investment Dar announced that they needed up to $1 billion in loans from the government. The Investment Dar has been reported to be selling assets including part of its stake in Aston Martin which it acquired in a Shari'ah-compliant LBO in 2007.

Islamic finance 'not immune' to credit crisis--Moody's; Standardization at the DIFC

Reuters came out with an article today (in response to a Moody's report [pdf]issued last week) to pierce the mistaken impression that Islamic finance is 'immune' from the credit crisis. This is something I have tried to emphasize as a note of warning (including in my 'Expert Opinion' column in Business Islamica magazine ('No room for complacency: Islamic finance faces its own risks', December 2008, pp. 24-25). Although there are a number of factors that helped Islamic finance avoid some of the most egregious products in the credit crisis, they are not immune from spillover effects in the property and equity markets, as well as general economic conditions. The Reuters article describes:

"Moody's said Islamic financial institutions in the Gulf showed strong resilience during the global financial turmoil, but that they are not risk-immune due to a shortage of liquid instruments and the lack of an Islamic interbank market. [...] Islamic banks now stand in the same firing line as their non-Islamic counterparts, facing a slump in equities valuations and a slump in Gulf real estate, to which they are heavily exposed. Even though Islamic banks avoided the speculative investments and complex financial instruments that derailed Western banks, their balance sheets still show a mismatch between assets and liabilities, and they depend more on short-term maturity liabilities than conventional banks."

Now that there is more awareness from prominent sources like Moody's and Reuters (and talk of a post-bubble Dubai), I feel a little freed up from trying to be the Cassandra and go back to writing about the aspects of Islamic finance that are the most promising.

A consultancy, Minhaj Shariah Financial Advisory (MSFA), has been named to organize a Shari'ah board for the Dubai International Financial Centre (DIFC). The Shari'ah board will provide Shari'ah rulings for companies at the DIFC and also "approach government entities and encourage the Central Bank to appoint a Shariah board to monitor the country’s banking sector". This is a positive step for the GCC region along the lines of the central Shari'ah Advisory Council in Malaysia. Unlike Malaysia, the central government will not appoint a board which decides on which products are halal and which are not and individual institutions will still be able to appoint their own Shari'ah boards, I think this is a huge step towards providing some standardization in the application of Shari'ah to financial products because it will provide comparability in 'fatwa standards' because the scholars issuing the fatawa will be the same across the companies which approach it.

Dubai-based Noor Islamic Bank is postponing its global expansion plans in the wake of the credit crisis. The Investment Dar, the Kuwaiti investment company which bought Aston Martin in a large Shari'ah-compliant leveraged buy-out in 2007, may sell 10% of the company to a Saudi investor.

As the sukuk market recovers, Turkey plans to issue its first sukuk using the ijara structure. Foreign Policy has an article about Islamic finance that provides a balanced look at proponents and critics of the industry.

Barron's has an article about the Shari'ah-compliant commodity funds being developed. Foreign policy has a balanced article about the Islamic finance industry and, in particular, the role of Shari'ah scholars.

The Islamic Financial Standards Board released a draft of new standards. The IFSB is a standards setting body based in Kuala Lumpur. It will be accepting comments over the next five months. l

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

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

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

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

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

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

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

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

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

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

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

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

New sukuk are smaller than last year; profits hold up for Islamic banks although challenges remain

A blog post at PBS, the U.S. public broadcasting organization, provides a brief description of Islamic banking seen through the prohibition of usury in the three large monotheistic religions: Judaism, Christianity and Islam. The U.K. may be providing the greatest example of how to allow Islamic banking to operate on a level playing field with conventional financial products.

A panel at a conference in the Dubai International Financial Centre (DIFC) tackles difficult subjects like the effect of the credit crisis on Islamic finance and the potential for 'greater good' efforts to expand Islamic financial principles to financial products without the 'Islamic' label (e.g. 'ethical' and 'green').

In another report, data show that the sukuk market has fallen off in 2008 compared with 2007. Issuance in the GCC fell from $14.15 billion in the first nine months of 2007 to $8 billion in the same period in 2008. The number of sukuk issued in the GCC only from 36 to 34 which means that the average size of sukuk has fallen (from $393 million to $235 million). There were some sukuk significantly larger than average issued by real estate companies: eight accounting for $4.85 billion (compared with seven in the same period in 2007 valued at $3.42 billion). This means the remaining 26 sukuk issued this year only averaged $121 million compared with the non-real estate issues in 2007 which averaged $370 million.

Business Week had a story that I missed a few weeks ago about Islamic finance weathering the credit crisis, but which was mentioned in another article on Islamic finance, because of its additional screens which help Shari'ah-compliant investors avoid some of the pitfalls that have been hurt the most in the credit crisis. Some non-Muslim investors may even be attracted to the industry by its relatively simple screens used to exclude companies that, while conforming with the Shari'ah screens, may also perform better in bad markets for several reasons including a lower reliance on debt financing.

Although Islamic finance is less susceptible to the credit crisis, Moody's warns that it is not completely isolated from global economic trends and are overexposed to real estate markets, particularly in the GCC, which have only recently began slowing. Despite this, the profits of Islamic banks remained strong in the last year.

The Islamic Development is planning a sukuk to raise money to assist member countries suffering in the wake of the credit crisis.

Islamic finance and the credit crisis; sukuk issuance to rebound in 2009

The Academy for International Modern Studies (AIMS) released a press release describing the advantages of Islamic finance based on its reliance on real economic activity underlying the financial system. While there are a number of benefits of the Islamic financial system, there are also risks posed by the way it is currently practiced. Specifically, the focus of much of the financing in the GCC on real estate projects leaves many Islamic financial companies overexposed to the real estate market and thus a fall in the value of the real estate could lead to the same types of problems facing the conventional financial system albeit less amplified because the Islamic financial companies do not use huge amounts of leverage that spread and amplified the crisis in the conventional financial system. Islamic finance is not just for Muslims either; the underlying ethical screens are widely held by many non-Muslims as well
and can be expanded to include environmental screens as well. The head of the Islamic law program at the New York City Bar adds his thoughts on the potential for Islamic finance to avoid crises like the one currently experienced by the conventional financial system.

Sukuk issuance will be slow until the second half of 2009 according to Badlisyah Abdul Ghani, CEO of CIMB Islamic. The head of Middle East capital markets at BNP Paribas expects the sukuk market to be $50 billion in 2009. The Wall Street Journal's Deal Journal Blog interviews a lawyer at Clifford Chance about Islamic finance generally and sukuk specifically.

The U.K. government will offer a Shari'ah-compliant pension option for people who do not already have a pension. An article describes Shari'ah-compliant banking in Kenya.

Islamic finance at risk from fall in prices in the real estate market; CGAP study on Islamic microfinance released

My fears that the credit crisis in conventional financial markets is spilling over to Islamic finance are becoming to be realized. The primary mechanism I identified in my blog (and in greater detail in a forthcoming opinion piece for Business Islamica magazine) for transmitting a crisis through the Islamic banks was falling property prices in the GCC countries that had mostly escaped the direct fallout from the subprime crisis that began in the United States. Although the prices have not fallen as dramatically as in Western countries, they are beginning to fall and this has an effect on Islamic banking because these assets are the underlying physical property used in many Islamic financing deals. From a Gulf Daily News article: "Falling prices in mainly Muslim countries in the Middle East and Southeast Asia are likely to affect the Islamic finance market due to heavy reliance on such assets to support deals." A senior analyst at Zawya, Alexandra Tohme, adds her opinion on the link between Islamic financial institutions and the global credit crisis.

The Dinar Standard has an interesting article about the potential for Islamic banking in Europe.

The Financial Times has a Q&A on the basics of Islamic finance, as do a number of newspapers in the U.S. and there is also an article on finance based in Christianity.

Islamic finance could still grow by 20-25% a year despite the financial crisis according to Rushdi Siddiqui, the Global Director of the Dow Jones Islamic Market Indexes, but "Islamic banks should diversify their investments to generate revenues from different areas."

Hedge fund managers are targeting Muslim investors in the Middle East by developing Shari'ah-compliant hedge funds, but is it too late for them to attract investors given their often poor returns during the past couple of years.

The DIFC has lent its support to the new Master Agreements for Treasury Placements (MATP), the standardized contract from the International Islamic Finance Market (IIFM) that was recently announced.

Zurich Financial Services Group has launched a joint venture takaful company with the Abu Dhabi National Takaful Company to expand their operations in the GCC region.

The Consultative Group to Assist the Poor (CGAP), a multi-lateral effort to promote microfinance and based at the World Bank, released a study of 125 Islamic microfinancial institutions.

Coud the credit crisis spillover into Islamic finance? Sukuk issuance expected to exceed 2007 total

Despite delays in many planned sukuk, Kuwait Finance House expects sukuk issuance in 2008 to top the total from 2007 even though issuance through the first three quarters fell below 2006 and 2007 totals for the same period. The rationale is that since the economy is still growing rapidly in the areas in which many sukuk are originated, the GCC and Malaysia, and non-Muslims continue to invest in sukuk. This has been the case for much of the year, but there are indications that the real estate market in the GCC region is slowing from its torrid pace in 2007 and early 2008. Also, many of the non-Muslims investing in sukuk were hedge funds looking to have exposure to another asset class and many Western funds have been faced with redemption requests from their investors, damping their future demand for sukuk. KFH expects a total issuance of sukuk to be between $40 and $45 billion in 2008 compared with $32.65 billion in 2007.

An article in a newspaper in Guernsey proposes Islamic finance as an alternative to the problems created in the recent past by (conventional) financial system excesses. Overexposure to real estate investments, though, may pose a threat to the Islamic finance industry. Some Islamic finance practitioners see the Shari'ah-compliant securitization that is the heart of the sukuk market as a guard against the excesses that led to the credit crisis. I think that, not only will it not necessarily protect the Islamic finance industry, the use of some securitization products, particularly the opaque, highly structured ones could create a crisis within the Islamic finance industry, and one with a similar economic trigger: the fall in real estate values.

Also, despite growing rapidly over the past 8 years, Islamic finance has yet to make a significant impression on the global banking industry.

Without specifying who should lead, second finance minister of Malaysia Nor Mohamed Yakop wants a standardized documentation and policies for the Islamic finance industry. Currently, there are two main standards-setting bodies, AAOIFI in the GCC and the IFSB in Malaysia.