September 2010

SEPTEMBER 26, 2010

One of the lessons for Islamic banking–investment banking in particular–from the crisis is that all finance, conventional and Islamic, is cyclical.  When the crisis intensified, deal activity declined sharply and Islamic investment banking lost a large proportion of its revenues.  As the revenue evaporated, several Islamic investment banks defaulted on their debts.  Does this represent a failure of Islamic investment banking?  I don’t think it does; but it does expose a weakness that had not been realistically planned for.

As the business cycle turns from expansion to contraction, Islamic investment banks will always see their revenue decline along with dealflow and if they want to withstand future cycles, they will have to create more stable sources of revenue alongside the investment banking business.  The easiest area for investment banks to complement their primary business is to move into asset management.  Asset management, particularly fee-based businesses will provide them with a relatively stable source of revenue that depends less on business cycles than investment banking and can also provide a natural client base to source their investment banking deals.

In addition to the natural business pairing between investment banking and asset management (often regulated by the same bodies–in the US, the Securities and Exchange Commission regulates both broker-dealers and investment advisors), it fills an underserved area within Islamic finance.  Asset managers that specialize (either partly or exclusively) in Islamic finance are a noted gap in many countries.  Therefore there is a relatively untapped market for such services.

In addition to the market need, asset managers can serve a valuable service to the industry as a whole.  Prudent portfolio management spans asset classes (equities, fixed income, commodities and alternative assets) and the area where the contribution potential is greatest is in fixed income.  Asset managers do not typically employ a buy-and-hold mentality for the investments they select for clients and therefore they can provide a source of secondary market liquidity in sukuk.  As their view on individual sukuk changes, they will want to sell their holdings and buy new ones (or reallocate into other asset classes).  This can provide a source of liquidity for other holders of sukuk, but this will not spring up overnight.  The process of gathering assets takes time, as does the process of creating the supply of sukuk and the infrastructure for facilitating secondary market trading.

If Islamic investment banks turn towards asset management as a business that can smooth revenue across the business cycle in a sustained way, it could help provide one of the key inputs towards a successful and vibrant secondary market in sukuk that benefits issuers (who will see the illiquidity premium they have to pay investors decline) and investors (who will see more opportunities for fixed-income substitutes that are a critical portion of their asset class allocation).

SEPTEMBER 19, 2010

Apologies for the light posting last week.  Posting should be more frequent going forward.

The issue of Shari’ah risk is back on the table with the head of Shari’ah at the Islamic Development Bank reiterating the Organization of the Islamic Council (OIC) Fiqh Academy criticism of organized tawarruq.  The OIC Fiqh Academy fatwa was largely a non-issue, but there has been other developments since then of some Malaysian banks committing to reducing their reliance on bai’ bithaman ajil (BBA), while other Malaysian banks reiterate their view that the product–which is not accepted in the GCC–is Shari’ah compliant.  As the Islamic finance industry develops, there will undoubtedly be more instances of Shari’ah risk (although not as significant as the AAOIFI ruling that coincided with the onset of the financial crisis.

It will remain to be seen how the Islamic finance industry will develop a method to contain future instances of Shari’ah risk on an industry-wide scale, however, something should be done to avoid a repeat of the disruption caused by the lag between Sheikh Usmani’s comments on sukuk and the eventual AAOIFI ruling.  It is easy to suggest that the industry needs to “do more to standardize Shari’ah rulings” but this rings hollow to me because there will always be differences between what each Shari’ah scholar and board believes is permissible and creating a static consensus would deprive the industry of opportunities to innovate.

A more workable alternative would be to create a centralized database, available to interested practitioners as well as scholars, that catalogues the existing fatawa, with the Shari’ah board’s rationale and a summary of the underlying transaction being ruled upon.  This would provide an invaluable resource that could be used in training younger Shari’ah scholars and providing context for practitioners developing new products.  The analogy I would give in this regard is the Westlaw database that provides a similar service to lawyers with the court rulings in a number of different areas and jurisdictions.  Before a lawyer makes up his mind about how to approach a new issue, he can consult this database to see how different courts have approached and ruled on different issued with similarities to what he is researching.

While there would be some skill required on the part of people searching the database to find the most applicable Shari’ah case law for any particular situation, it would also provide a reference source for financial professionals to look at to understand the motivation of Shari’ah boards when they have approached other financial products.  While the fatwa for a given product is not something which becomes a public good (each fatwa is generally only valid for the specific situation in which it is given), the combined knowledge and experience of Shari’ah boards should be.

In economics, a public good is one that is non-rival and non-excludable.  In simple terms, that mean it is something where the use by one person does not reduce the ability of others to use it as well (non-rival) and it is something whose use cannot be restricted (non-excludable).  For the first test, accumulated experience in Shari’ah-compliance meets the requirements.  For the second test, the accumulated knowledge–if not the fatwa itself–also meets the requirements.  Once one product is developed and put into the marketplace with a fatwa from a Shari’ah board, it can be replicated (if not exactly) by other financial institutions.  The research has been performed, the product is approved; it is only a matter of time before another product is developed that is similar to it and based on the research performed in the initial approval.  Currently, this embedded knowledge remains untapped as a source of guidance for the industry’s development.  Ideally, a non-profit organization would step in to create a database of the embedded knowledge, but failing that, it would seem valuable to the industry as a whole for a private company (perhaps Thomson Reuters, which incidentally also owns Westlaw) to step in and organize this knowledge in one database that could be consulted for background information before a Shari’ah board is asked to rule on the Shari’ah-compliance of a particular product.

Returning to the intial point about mitigating Shari’ah risk, there would be no better way to create context for a new Shari’ah ruling (like AAOIFI’s) than to have the previous rationale catalogued in one database.  This would give financial institutions and consumers of the financial products an opportunity to compare new rulings with the thoughts of other Shari’ah boards on similar issues.  Each financial institution, in consultation with its Shari’ah board would then have the opportunity to determine how best to deal with the new instance of Shari’ah risk.

SEPTEMBER 13, 2010

One of the stories I found interesting during the past week was that Malaysia wants to expand its position beyond just a ‘hub’ of Islamic finance within Asia for issuers (like the World Bank and International Financial Corporation, both of which have issued Ringgit-denominated sukuk) to becoming a legal hub for Islamic finance as the legal jurisdiction for Islamic financial products (and the court that would hear any disputes).  The basis for this desire is that Malaysia believes it has the best legal framework incorporating Shari’ah-compliance alongside a secular legal system (excepting the Shariah courts which have jurisdiction only in areas of family law for Muslims).

In theory, the dual legal system with a secular legal system based on English law–the current jurisdiction used most widely for Islamic financial products–and the national Shari’ah Advisory Council housed at the central bank, Bank Negara.  However, there are two issues that would make it difficult to overcome the inertia behind the use of the English legal system.  First is the familiarity that most of the international financial institutions have with English law.  It is predictable and the people within the international financial industry know that from experience.  Most global financial institutions would be much more secure having a dispute decided by an English court versus a Malaysian court, even if the outcome is identical.

The other problematic area would likely be the different standards of Shari’ah used in Malaysia.  Products that are not acceptable in the GCC are accepted as Shari’ah-compliant and therefore Islamic financial institutions within the GCC may have a suspicion that their claims of Shari’ah-non-compliance as the basis for a dispute may not be accepted if they are adjudicated under the Malaysian (Shafi’i) standard of Shari’ah.  However, this can be overcome I believe–just as there are Shari’ah boards that have members from both the GCC and Malaysia (for example, the Dow Jones Islamic Index).

Outside of these concerns, there could be benefits from having a jurisdiction where Islamic finance claims are governed.  There would be much less need to ‘educate’ the courts hearing cases and there would be more likely to be a quicker judgement.  However, the idea that the Shari’ah-compliance of a product could be adjudicated after the fact (and overruling the institution’s own Shari’ah board) could create additional Shari’ah risk that might slow the recovery of Islamic finance from the economic crisis.  If this Shari’ah risk were to become a part of the industry, it would adapt just as the financial system (both conventional and Islamic) adapt to changing laws and regulations that govern it in other areas besides Shari’ah-compliance.  It will be interesting to see if any formal steps are taken in the months ahead towards this aim.


One of the trends I have noticed over the past six to twelve months in sukuk issuance is that there has been little or no new issuance from financial institutions.  One of the reasons I see for this is that the AAOIFI rule changes regarding mudaraba and musharaka took away one of the primary structures used by financial institutions for structuring sukuk.  Without mudaraba and musharaka sukuk with purchase undertaking to ensure repayment of principal at maturity, Islamic banks have found it difficult to structure sukuk to provide themselves with addition debt capital.  There have been exceptions–the mudaraba sukuk issued by Saudi Hollandi Bank tweaked the old mudaraba structure to be acceptable under the new AAOIFI rules.

However, despite the new structure being used by one bank, other Islamic banks have not followed with their own mudaraba sukuk.  This may reflect difficulties at the banks–or no need for additional debt for those with excess capital and reduced demand for financing.  However, sukuk from Cagamas (despite being based in Malaysia, the Sukuk ALIM was focused towards the GCC), the Islamic Development Bank and most recently by Kuveyt Turk.  The commonality between these sukuk is that they are generally backed by a portfolio of ijara and murabaha (and other) contracts.  The sukuk are tradable if at least 33% of the contracts are ijara (or another type that passes ownership of the underlying asset on to sukuk investors) under AAOIFI rules, but in general, the sukuk that have been issued using this structure have applied a more stringent 50% threshold.

This is a natural structure for Islamic banks to use because, with some modifications, it could become a asset-backed securitization.  So long as stringent financing standards are met, more securitization would benefit both issuers and investors.  Islamic banks would be able to free up their balance sheets to offer more financing and would likely retain some income as the servicer of the loans.  At the same time, the investors would have a ready source of new investment opportunities that could be tailored to different time horizons and risk appetites.  As long as the underwriting standards remain strong, bank securitization of portions of their balance sheets could benefit the banks as well as investors.  Moreover, in the wake of the financial crisis, both sides would be well aware of the potential risk.  Investors would be more diligent with respects to the bank’s underwriting standards and banks would (should) know that even though securitizations are generally non-recourse, there will be pressure for the bank to support the securitization pools if they start to sour because of lax underwriting standards.