June 2010

JUNE 27, 2010

I have generally focused less on retail banking and more on investment and wholesale banking, mostly because I am not a banker myself.  However, during the last week an article from Junaid Bhatti was published calling Islamic banking in the UK a ‘flop’.  Mushtak Parker, a journalist who writes in Arab News returned with criticism of the original article, but also of the Islamic Bank of Britain.  Without wading into the debate about the IBB, it has led me to think more about the general lack of retail Islamic banking in the US.  There are a few banks (and one credit union in New Jersey) that provide retail Islamic banking in the US.  They are primarily focused on their local communities, although some offer home finance products nearly nationwide.  This is in part due to the regulations in the US and the geographical distribution of Muslims within the US (concentrated in New York, Washington, DC, Chicago, Los Angeles and parts of Michigan and Texas).  The state-by-state regulation of banks makes it difficult for small banks, who are so far the only ones offering Islamic banking, to have a wider footprint (it was not possible for banks to have interstate branches until the mid-1990s).

With the US in mind as an example, what is the best way to provide Islamic banking services in the West?  The large banks have little interest in expanding into what is a very niche market based on the size of the Muslim population.  Small banks remain localized and there are few credit unions offering Islamic banking.  Far from being a sign of weakness, I view this as a strength for Islamic banking.  If the basis for Islamic banking is to finance activities in the real economy, retail banking needs to be connected with and focused on the economies in which it is providing financing.  Based on the advertising from conventional large banks, they are trying to project an image that they are focused on retail banking and local communities, even if their actions say the opposite.  Most are owned by large bank holding companies that leverage the deposit base as a cheap method of financing and make most of their money on fees.

There have been attempts by groups concerned with the high concentration of deposits in these large banks to convince people to switch to credit unions and some local governments have also made the change from large to local banks and credit unions.   This should provide Islamic banks and credit unions with an opportunity to expand, particularly in cities like Los Angeles, New York, Washington, DC and Houston with sizable Muslim populations (compared with other cities) and few or no banks offering Islamic retail banking.  The difficulty for banks tapping this opportunity will be finding a broad enough customer base to become profitable (existing Islamic financial institutions have said that it took them nearly 10 years to reach profitability).  One way to shorten the time to profitability would be to reach out as more than just an ‘Islamic’ bank and appeal to non-Muslims who share the same ethics which guide Islamic banking.  There are probably more people out there that want to move away from the large mega-banks towards a more ethically-focused bank.

JUNE 20, 2010

There have been two areas where I have stressed that Islamic finance needs to improve in order to retain its strong growth rate (it appears that Islamic finance has returned to strong growth since the worst of the credit crisis, although reliable data are hard to come by).  These two areas are: inter-bank money markets for liquidity management and longer-dated sovereign sukuk to provide a pricing benchmark for corporate issuers.

There are finally some indications that these are becoming priorities within some countries.  Pakistan’s central bank says it is developing Islamic money market instruments, which follows the announcement the week before last that the UAE central bank is developing Islamic certificate of deposits as well.  The last newsletter focused on securitization as a way for Islamic banks to increase profitability while retaining their high cash levels by moving assets off their balance sheets and transferring the risk to the sukuk investors (with of course a healthy warning to avoid the abuse of off-balance sheet SPVs by conventional banks that sparked the credit crisis).  The development of inter-bank money market instruments alleviates the drag of cash in excess of regulatory minimums and along with careful securitization can make Islamic banks competitive with conventional banks, which will make them more likely to be used by non-Muslims as well as Muslims who prefer Islamic banks, but only if they are cost competitive with conventional banks.

The second area where progress is being made is in longer-dated sukuk.  Conditions in the financial markets may force a change to the plans of Indonesia to issue $500 to $600 million in 7-10 year US dollar global sukuk in October.  If the conditions allow for this issue, it would be a significant development because it would provide a benchmark for Indonesian firms looking to issue longer-dated sukuk.  If this occurs, I would imagine that the first corporate issuers would be higher-grade corporates.  However, if there were several high-grade corporate sukuk with maturities between 7 and 10 years, it would eventually provide enough pricing information (assuming the global economy does not head into a double dip recession) for lower rated corporates to join in issuing sukuk.

JUNE 13, 2010

There were two news items that I mentioned on the blog this week that I think are important for the Islamic finance industry generally: the planned UAE central bank’s Islamic CDs, which could be approved as early as next week, and the latest twist in The Investment Dar’s case against Blom Bank over a wakala the bank claimed was ultra vires in an English court because of non-Shari’ah-compliance.

The Investment Dar (TID) is involved in a court case in English courts regarding a wakala placement from Blom Bank, a Lebanese bank, which was supposed to return principal plus a 5% profit to Blom Bank.  The funds were invested alongside TID’s other investments and following TID’s financial difficulties, it petitioned an English court to rule that it did not have to repay Blom Bank principal and profit because the contract was not Shari’ah-compliant.  English courts have in the past ruled that Shari’ah-compliance is not an issue it will adjudicate so TID took a different tact arguing that the non-Shari’ah-compliance of the product made it outside of the permissible activities under TID’s corporate charter (ultra vires).  The court took a skeptical view of this defense and ruled that TID could appeal if it first paid the principal due to Blom Bank.

The latest twist is that TID’s Shari’ah board, which approved the wakala product in the first place, has stood by its ruling and asked TID not to use a defense relying on a products non-compliance without consulting the board first.  This is important not just for TID, but for the industry, in my opinion.  The Shari’ah board has an ingrained potential conflict of interest because it is paid by the institution it “regulates” for Shari’ah-compliance.  However, in this case the board has placed its own reputation ahead of TID’s interests by reaffirming the Shari’ah-compliance of the product that TID claimed was not Shari’ah-compliant in the English court.  This provides one data point where a Shari’ah board has stood up to the institution it regulates, which have been few and far between (at least publicly).  It also to some degree discredits allegations of widespread fatwa shopping; the practice may still occur, but as I have maintained in the past, most Shari’ah scholars are acting with good intention and are not willing to sell their reputation to the highest bidder.  For this reason, it is good to see this disagreement happen publicly.

The other news item which I thought was notable (and positive) was that the UAE central bank is planning to issue Islamic certificate of deposits that can be used by Islamic banks to manage their surplus liquidity, as well as for the central bank to use in monetary policy operations. From the perspective of Islamic banks’ liquidity management needs, this is significant because it adds another country to a short list of countries (Malaysia and Bahrain) where there are short-term, government (or central bank) issued securities for Islamic banks to invest their excess capital.  Government bonds are typically given a 0% risk weighting in the calculation of risk-weighted assets to determine minimum capital requirements, which makes them ideal instruments for Islamic banks to buy to generate a return without an additional capital requirement.

The lack of liquidity-management instruments like short-term government debt has led many institutions (particularly banks) to hold excess cash to avoid the risk of a ‘run’ on the bank.  Islamic banks are particularly susceptible to problems caused by holding longer-dated assets that are funded with short-term or demand deposits because they cannot easily liquidate assets to meet withdrawals of deposits beyond their cash holdings.  They are also generally not able to turn to a lender of last resort (i.e. a central bank) to meet the short-term liquidity needs and a liquidity problem can quickly become a solvency problem.  Anything that aids the development of greater liquidity management will reduce the risk in future crises of systemic instabilities within the Islamic financial system.

JUNE 6, 2010
This week’s posts included one on the Sun Finance (Sorouh) sukuk that securitized receivables from plot sales to sub-developers and has held up despite the financial crisis (it was issued in August 2008).  A contemporary overview of the sukuk from Moody’s is available here. The securitization probably could have had either the positive outcome it has seen so far or a negative outcome if the property market problems in Dubai had spread to Abu Dhabi.  However, the specifics of that transaction are less important than the potential application of Islamic securitizations elsewhere in the Islamic finance industry.

While securitization has become somewhat of a dirty word in the past three years because of the sub-prime securitized mortgages which triggered the financial crisis in the US, the concept should not be ignored by Islamic finance.  Securitization can provide a benefit to the Islamic finance market.  Islamic banks generally take a cautious approach to lending and the lack of inter-bank money markets (outside of Malaysia) has led many Islamic banks to hold excess cash on their balance sheet (excess referring to the amount they could hold and still have sufficient capital to meet regulatory minimums) and this curtails their profitability because that cash does not create any returns for the bank’s shareholders.

A securitization could increase the amount of business the Islamic bank could do without necessarily threatening its stability or forcing it to reduce the amount of cash on hand to meet liquidity needs.  It would also create a larger supply of sukuk for investors (pension funds, takaful funds, mutual funds).  The primary lesson from the financial crisis regarding securitizations is that the originate-to-distribute model can lead to reductions in the quality of the loans being made and this should be considered by regulators before Islamic banks are able to securitize the loans they make.  There are also Shari’ah considerations; for example, for a sukuk made up of many different financing transactions to be tradable, it generally must have at least 51% of contracts that would be tradable at values besides par: ijara, musharaka, mudaraba, for example.  The remainder can be non-tradable contracts like salam, murabaha and istisna’a.  The model for a sukuk structured like this is the Islamic Development Bank sukuk, which was backed by a portfolio of ijara, murabaha and istisna’a contracts.

For Islamic banks, who do not have the high ratings of a sovereign or mutlilateral institution like the Islamic Development Bank, and those that do not want to have the sukuk affect their capital position, the securitization method makes sense (see, for example, the IFSB standard 7 (pdf), which covers the impact of sukuk on an Islamic bank’s capital position).  The sukukholders would have no recourse against the bank if the asset’s performance is impaired–their return is based on the performance of the portfolio of Islamic financial contracts that are securitized.  While there could be problems from Islamic banks securitizing their assets, it could also provide a way to reduce the impact of Islamic banks holding significantly larger cash reserves than conventional banks while also creating additional investments for investors.