August 2010

AUGUST 29, 2010

The International Shari’ah Research Academy for Islamic Finance (ISRA), based in Kuala Lumpur, Malaysia proposed this week a global Shari’ah adviser platform to create some uniformity in the regulation of the relationship between Shari’ah scholars and the institutions for which they work.  There is nearly no regulation currently internationally.  There are some standards of Shari’ah-compliance–from AAOIFI and the Islamic Financial Standards Board (IFSB)–which are not mandatory in every country.  AAOIFI also has a proposal for the rules of conduct for Shari’ah scholars (e.g. serving on multiple boards simultaneously, owning stock in the institutions they oversee).  However, the ISRA proposal is distinct from the efforts of AAOIFI and the IFSB to create standardized agreements on Shari’ah-compliance because it would be more focused on the standards for Shari’ah advisers.

The ISRA proposal would create a forum for Shari’ah scholars to self-regulate their handling of issues relating to confidentiality, transparency and actual or perceived conflicts of interest.  This is a significant gap in the global Islamic finance industries.  Some countries, like Malaysia and Pakistan do have regulations on Shari’ah scholars, but other countries do not and there is no framework for one jurisdiction to accept the qualifications of a scholar from another.  The latter issue relates to the possibility that Shari’ah scholars would have to be licensed under the proposed Shari’ah advisor platform in order to serve on Shari’ah boards, if they were a part of the voluntary self-regulatory body.

The issue of licensing scholars will be the most difficult to achieve through a voluntary agreement such as a Shari’ah advisor platform, but it could have several benefits.  The obvious benefit is that the Shari’ah scholars ruling on the Shari’ah standards under which the Islamic finance industry operates would have additional credibility from the license that they are qualified, not just in the Shari’ah aspects, but also familiar enough with the financial services industry to be able to understand relatively esoteric legal contracts.  Another benefit from a global Shari’ah advisor licensing regime would be that it helps younger scholars gain enough credibility (from the license) to become recruited by Islamic financial institutions.  Currently, many Islamic financial institutions select the top scholars because they are well known and respected and their approval carries more weight than a younger, less recognizable scholar.

Were their consistent standards for licensing Shari’ah scholars, it would provide Islamic financial institutions with more comfort that their Shari’ah scholars are qualified and would also provide some measure of comfort to the institution’s clients.  That way, it would be possible to have a Shari’ah board made up of only one or two of the leading Shari’ah scholars along with younger scholars.  This would take some burden off the top scholars, but also create an opportunity for less well known scholars to gain experience and recognition.  There remains significant hurdles for such a Shari’ah adviser platform to be created and become an integral part of the Islamic finance industry, but I think it has significant potential to more easily standardize the global Islamic finance industry than an approach that tries to standardize contracts.  The scholars may not always agree, but if there are standards of qualification globally, it will at least ensure that all Shari’ah scholars meet some level of qualification in both Shari’ah as well as finance to be a part of the debate.

AUGUST 23, 2010

In my post today, I linked to an article about the lack of Islamic private equity.  It provides three reasons for a lack of Islamic investors in private equity despite what Hussein Hassan notes is its theoretically good fit within Islamic finance: 1) high levels of debt used to enhance returns, 2) investment in haram areas of business, and 3) the asset-liability maturity mismatch within Islamic banks that keeps them from longer-term investments like private equity.

I think that the first reason is certainly the strongest.  Private equity is known for employing high levels of debt, but as I mentioned, the debt is typically used to enhance returns.  There is nothing inherent about private equity that requires high levels of debt.  It can be replaced with equity (although with the trade-off that returns are lower than more highly leveraged conventional private equity) or it can be substituted with Shari’ah-compliant debt equivalents.  I don’t think that the asset-liability maturity mismatch can be blamed for the lack of participation in private equity by Islamic investors.  First, the maturity mismatch is fundamental to banking: banks take deposits and deploy those into long-term investments to earn a higher rate of return than they pay to depositors.  Second, Islamic banks would be the least likely in my opinion to invest in private equity.  Why would they hire a private equity manager to invest their capital through a private equity fund.  Their business is based upon their ability to invest in long-term assets and assess the financial and credit risk of their clients.

However, there are other investors–for example Islamic pension funds, Shari’ah-sensitive high-net worth individuals, and takaful funds–that would be more likely to see private equity as an important asset class that can add value to their investments.  Why then, have they not invested in private equity?  In some respects, the recent downturn where many investors, conventional and Islamic, took significant losses on real estate investments and private equity (for example, Gulf Finance House) and they are unlikely to reacquire their taste for the risk involved with private equity any time soon.

However, I think there is a more fundamental issue involved.  Pension funds, takaful funds and high-net worth investors with the requirement to only invest in Shari’ah-compliant investments are missing a significantly important asset class already: fixed income.  Without fixed income, their investments are likely more concentrated in riskier assets like equities that diminishes their appetite for other risky asset classes including private equity.  For fixed income, they are either chasing a short supply of sukuk (which has also experienced some notable defaults in the past two years), holding cash or entering into bilateral commodity murabaha or wakala products where yields have fallen significantly (and in the case of wakala, have also seen risks rise with The Investment Dar’s court case over the wakala placement from Blom Bank).

Without the income-generating, low risk fixed income asset class to balance their more volatile investments in equities and private equity, these investors are likely to limit their exposure to the higher risk investments, particularly the most volatile and illiquid like private equity and venture capital.  If the sukuk market rebounds (particularly new issuance) to meet the demand–especially for sovereign and high-grade corporate sukuk–the risk appetite of the pension funds and takaful funds will probably return and they will seek out opportunities for alternative asset classes just as their counterparts in the conventional space have (although not always with a happy outcome).

AUGUST 15, 2010

There seems to be a trend developing in Islamic finance in the post-Dubai World period.  The GCC, which was developing as one of the centers for Islamic finance and attracting the most new issuers of sukuk, has seen risk aversion spread from Dubai-specific to become regionally-focused enough that many issuers are avoiding the GCC because it brings with it an additional risk premium.  In contrast, the growth has been more rapid–particularly in new issuance (e.g. Khazanah’s Singaporean sukuk, the entrance of Japanese firms into Malaysia with a much smaller entrance into the GCC).  Islamic finance is not just sukuk–either when sukuk are booming as they were in the middle of the last decade, or when markets are constrained by risk–but sukuk, new issuance in particular, has become something of a measuring stick for the industry as a whole.

Taking the sukuk markets as a whole as a thermometer for the industry, there is much less going on in the GCC than Malaysia.  However, at the same time the Shari’ah standards of the GCC are becoming more widely leaned upon by other regions including Malaysia.  Al Rajhi Bank and Cagamas have developed a sukuk structure that works in both Malaysia and the GCC.  The structure, called Sukuk Al-Amanah Li Al-Istithmar (Sukuk ALIM) was used by Cagamas to issue a sukuk.  The CEO of Al Rajhi Bank (Malaysia), Ahmed Rehman was quoted in an Arab News article: “The reason we have done it this way is because we want to leverage off our parent’s balance sheet to do transactions in the region. <em>We have not been active in the sukuk market hitherto because we have been working for over a year to get the structures Shariah-compliant.</em> We are now talking to certain clients to see if we can issue sukuk for them in the course of this year”. (emphasis added).

In some ways this confirms the trend for growth from the GCC to Malaysia by creating a method for Shari’ah-constrained investors to invest in Malaysia.  However, the development of a structure that is Shari’ah-compliant under standards used in the GCC signifies that the rationale is to attract the significant capital resources from the Gulf now while their domestic markets are still affected by the Dubai debt crisis (affected in some areas just by the changed perceptions following that crisis).  That would suggest that the lag in the GCC in new sukuk issuance (compared to Asia) is temporary.  There is a large reported pipeline of new sukuk and if enough of the sukuk that get issued through the remainder of 2010 after Ramadan are GCC-based corporates (rather than the sovereign sukuk that have dominated), it might return growth in Islamic finance to the GCC.

AUGUST 9, 2010

During the last week, I wrote about the Islamic Bank of Britain’s recent raise of GBP20 million and noted that it appeared that they were having trouble finding enough clients who needed (and were qualified for) financing, based on the bank’s dependence on wakala and commodity murabaha placements with other banks.  However, they did also increase the amount of financing provided significantly (in percentage terms), but it still lags significantly behind deposits on their balance sheet–and therefore a fall in the rates on the wakala and commodity murabaha (both relatively short-term) hurt their profitability.

While the recent raise was bad news for their shareholders who faced significant dilution, it doesn’t fully support the pessimism towards Islamic retail banking in the UK that has become a hot topic recently.  The global economy (for the most part) remains in a severe balance sheet recession and the demand for loans (by customers of conventional and Islamic banks) has fallen significantly over the past few years.  Individuals and businesses have been concerned about their job security and the end demand for their products and are much less willing to take the risk of taking on debt.

This will cause trouble for smaller banks (like the IBB) who are trying to add longer-term (and more profitable) assets to their balance sheet until the economic recovery becomes stronger.  Smaller banks will struggle to weather the sluggish recovery where interest rates–on which their wakala and commodity murabaha profit rates are based–remain low.  However, if these banks are able to expand their more profitable assets, the banks that remain when the global economy picks up should be stronger; in part because they will face less competition than during the height of the most recent boom when Islamic (retail) banks were facing more and more competition from conventional banks expanding into Islamic finance by opening windows.  Having once entered the market and then left, they may be more hesitant to re-enter providing a window for Islamic banks to grow with less competition.  However, at that point, their success or failure will be determined by whether they can move their balance sheets towards longer-term, more profitable products without compromising their underwriting standards in a race for yield.

AUGUST 1, 2010

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.

There may not be a newsletter issue next week and the following week because I will be travelling.  If there is not, the next issue will be August 22.