OCTOBER 24, 2010
One of the topics I covered on the blog this week was the balance between ‘replication’ of conventional products and the development of products that, while not absent from the conventional financial sector are limited to certain types of institutions. For example, most commercial banks do not offer equity financing like what an Islamic bank would with mudaraba or musharaka. The idea has been one that is frequently discussed in Islamic finance: should debt-based products that replicate the economic outcome of a conventional, interest-based loan be a staple within Islamic finance or should more profit-and-loss sharing products be used?
There are two different lines of thought on this issue. First, what is possible in the near term? Second, what can be done to build up greater usage of profit-sharing products if that is determined to be more beneficial to the industry as a whole? The first question is relatively easy and experience within the Islamic finance industry is clear: there are legal, regulatory and practical problems that limit the usage of mudaraba and musharaka financing. Banks, including Islamic banks, hold their expertise in the area of assessing credit risk and that is not sufficient for more equity-based financing. Regulation of all banks are prefaced on their role as financial intermediaries within an interest-based system. The infrastructure is not yet there for banks to move beyond assessing credit risk and being more ‘equity’-focused.
However, that does not mean that there is not the requisite skills for profit-sharing banking within the financial services industry that could be used to help banks expand their focus from credit-risk to a more broad focus on assessing risk and rewards. For example, the type of knowledge that profit-sharing banking would require are held by investment bankers and within the venture capital and private equity areas within finance. People with this expertise would be invaluable for an Islamic bank that wanted to offer more profit-sharing-based banking (should banking regulations adapt to encourage it).
However, within the context of the risks and rewards associated with profit-sharing banking, it is not clear whether banks should be taking these risks and whether the Islamic banking system could adapt to offer profit-sharing products within the context of banking system stability. Even investment banks, which are allowed to take more risks have become ‘systemically important’. It is no longer the case that an investment bank can fail without causing systemic risk like the freezing up of short-term credit for other institutions. With banks dependent upon the confidence of retail depositors, the systemic challenges are greater. If Islamic banks are exposed to more risk, their capital will be more expensive and this will hurt profitability and open them up to future bank runs if depositors become concerned with their solvency.
Without a lender-of-last resort and deposit insurance and with a very undeveloped market for short-term liquidity management products, it would be counterproductive to push Islamic banks to take on more risks by offering profit-sharing products in greater numbers (and whether there is a market for those products is also in question). Therefore, the current direction of the industry is probably appropriate. Retrenchment from the most controversial product development that occurred before the financial crisis with a focus on the financial system infrastructure (e.g. liquidity management with the International Islamic Liquidity Management Corporation). There may be a day where Islamic banks can expand into profit-sharing products in a more significant way, but it is not today.
OCTOBER 17, 2010
This week’s newsletter is a blog post I wrote on Thursday about the politicized nature of reactions to Islamic finance in some countries. In my blog post, I focused specifically on the U.S., but there is also skepticism in some groups towards Islamic finance in other countries like India, Turkey, France and South Korea.
Reuters has an article on the “political hurdles” facing Islamic finance in the U.S. I think the title is a little misleading; it is not politics (or regulation) that has pulled Islamic finance into an ugly argument about Islam and America, but politics. I have always hesitated to give any credence to the ‘anti-Islamic finance’ arguments because they are so disconnected from reality that I feel giving coverage on this blog would elevate them to the discussion on Islamic finance would give them undue credibility. However, at many times, I have thought of a way to cover the ‘anti-’ side without giving it additional credibility, but I have always come up lacking a good way to address it. However, the Reuters article makes it clear that opposition to Islamic finance as a subtext in an argument over Islam in America is becoming a narrative that needs to be addressed.
The first thought in my discussion is that the rise of opposition to things that are viewed as ‘foreign’ is a common thread in American history and one that has been expressed in ugly displays. In the 19th century, immigrants from China, Ireland and southern European countries like Italy faced significant discrimination. In general, religion was not the primary reason for this, but it was in some cases. America’s history with Catholicism has many rather embarassing episodes. A blogger for the LA Times quotes a professor at the Ohio State University:
“the popularity of the Ku Klux Klan exploded after it rebranded itself a “patriotic” fraternal organization dedicated to safeguarding America against the threat of Catholics, Jews and the immigrants flooding the country in unprecedented numbers. […] At the time, these men did not consider themselves religious bigots. They believed themselves patriots, upright fathers and sons, husbands and brothers protecting their families, and the nation, against a foreign threat they feared was intent on their destruction.”
The author was specifically focusing on the anti-Catholicism of the early 20th century, but the sentiment lasted well later in the 20th century: John F. Kennedy was viewed skeptically for his Catholicism and it was feared that he would be an agent of the Pope as president.
Of course, this was unfounded and the positive in American history is that the country does move past this type of fear mongering–no one questioned whether John Kerry’s Catholicism would hurt his ability to be president when he ran in 2004. However, it is not a quick process for Americans as a whole to move beyond past their suspicions towards groups of people for which they have no justifiable reason to lump together as a ‘threat’ to America.
And today, the ‘other’ that nativist politicians have focused on is Muslims. Every effort of Muslims to express their religiousness is viewed by some as a ‘threat’ to America’s values and American freedom itself (the Economist deals with this issue in a good recent article). However, just as the “Catholic threat” was unjustified as a reason to suspect all Catholics, the “Muslim threat” is equally as unjustifiable. And Islamic finance is being lumped into this broader narrative in an equally unjustifiable way.
Now then, what can be done to counter this suspicion of Islamic finance and help the industry to thrive in America? Can there be a way to demonstrate that Islamic finance is no more foreign than the growing popularity of socially responsible investing, or even other forms of religious-based financial products like the Timothy Plan, a Christian mutual fund.
In some areas, there may not be a need at all. The Amana Funds, a series of three Islamic mutual funds, has already moved well beyond being a ‘niche’ product for Muslims and has attracted significant investments by non-Muslims who are generally drawn to the fund by its good performance. However, other financial products that are Shari’ah-compliant, from mortgages to insurance, have not attracted as large interest from non-Muslims.
In these areas, it will be imperative for the Islamic finance industry to continue to reach out not only to their mainly Muslim consumers to explain how they work and also highlight that they are not much different from conventional financial products. They have a different structure and follow certain rules that other mortgage providers do not have to, but besides these differences, they are just another flavor of mortgage available to all consumers.
In areas like takaful–which is less well known than even Islamic finance–there are other ways in which they could be marketed to attract non-Muslims. Unlike conventional insurers, the funds of the takaful provider are owned by the members, rather than being run through a corporate structure where the liabilities (claims) are obligations of the corporation. In an era where many insurers have been ‘demutualized’, this return to a ‘mutualization’ may attract non-Muslim consumers in a similar way that credit unions have been able to differentiate themselves from the much maligned conventional banks on the difference that their depositors are also their owners (rather than external shareholders).
There are substantive differences in Islamic finance and there will continue to be ‘anti-Islamic’ sentiment stirred up by opportunistic, nativist politicians. These are the givens. It is up to the industry to decide whether the political sentiment will be a hinderance to the industry or will spur it towards better explaining its competitive advantages to its conventional competitors. For what has become an emotional and reflexive issue, it will be more likely that Islamic finance can break through on its business merits, rather than by appealing to other arguments.
OCTOBER 10, 2010
The issue of liquidity management has been a concern for the Islamic finance industry and there may be a new, more stable source of liquidity management tools soon with the launch of the International Islamic Liquidity Management Corporation, that will be established by the IFSB members in Kuala Lumpur Malaysia later this month. However, until it is actually launched, there are few conclusions that can be developed about whether it will be effective and whether it will just further entrench commodity murabaha and tawarruq as the preferred liquidity management products for the industry.
However, even with the uncertainty about what products will be used by the ILMC, it seems more likely that it will be globally accepted and will help make the industry more stable should another global liqiudity crisis develop. And while it is usually not wise to be too sanguine about future risks when the solution has been developed with the last crisis in mind, in the case of a global liquidity management provider, I think it will be able to prevent or mitigate future problems.
In a liquidity crisis like the one that started in the US in 2008 and quickly spread worldwide, banks become fearful of lending to one another, even overnight, because of the fear that the counterparty will fail and the bank will suffer losses from its overnight lending. This type of systemic crisis cannot be avoided by the Islamic financial industry, although the excess reserves held by many Islamic banks during the last crisis limited the damage from a liquidity crisis (and there were no systemically important Islamic bank failures).
Where the ILMC provides a better solution is that it is being established by the Islamic Financial Services Board members who are primarily central banks and regulatory bodies across the world (including Luxembourg’s central bank, which is an associate member). This should provide the financial resources and more importantly credibility that the ILMC will be a secure counterparty in overnight or short-term loans. With the ILMC available as a counterparty, it should forestall any contagion caused by Islamic banks being hesitant to provide short-term loans to other Islamic banks on a bilateral basis.
As more details emerge about the proposed structure of the ILMC and its product line (as well as the degree of connectedness with IFSB members, it will become easier to assess the potential benefit the ILMC can provide to the Islamic financial industry.
OCTOBER 3, 2010
One of the news items from the past week was the acquisition by Dubai Islamic Bank of a majority stake in Tamweel, the Islamic mortgage company in Dubai. However, I think the news that Emirates Islamic Bank may acquire Amlak Finance may be more significant. The news surrounding the latter acquisition mentioned the motivation of becoming larger to compete better (likely viewing competition from multinational financial institutions like HSBC Amanah).
Outside of multinational banks, the Islamic finance industry has been populated by relatively small banks and financial institutions. The small size and limited capital makes it hard for these institutions to compete with their much larger rivals and the need for consolidation of local Islamic banks has been reiterated for several years. In addition, despite many announcements that a ‘mega’ Islamic bank was just around the corner (and even that mega bank was expected to be much smaller than many multinational banks that have Islamic windows), it has not yet launched.
Besides limited capital at the smaller Islamic banks, they have also been limited from rapid expansion by limited securitization opportunities (which would otherwise free up capital), and there have been successful examples of Islamic securitizations. Perhaps a larger Islamic bank, particularly with a mortgage subsidiary will have the scale to develop greater use of securitization (with a larger portfolio to capture economies of scale), as well as more extensively developing opportunities to leverage their balance sheet using medium-term sukuk rather than being reliant on deposits. This issue is more acute following the AAOIFI ruling on sukuk in 2008, which limited (or at least restricted) the use of mudaraba and musharaka, which were used extensively by banks before that ruling tightened the rules on what structures are Shari’ah-compliant.