March 2012

MARCH 25, 2012 (PDF)

International Islamic Liquidity Management Corporation (IILM)

Islamic finance has increasingly expanded internationally but has yet to develop the short-term products to manage liquidity and has so far developed patchwork solutions, with many countries having short-term products for their domestic banks.  Internationally, much of the liquidity management is managed using inter-bank money market products, either based on murabaha or wakala.  These products work sufficiently well in normal times offering banks with either excess assets or liquidity needs a way to fill the gap.

The IILM, however, is developing an alternative that will substitute for inter-bank liquidity management.  The necessity of a product like this is not necessarily apparent in the relative calm of the Islamic finance industry, but the recent financial crisis demonstrated how quickly inter-bank lending can dry up.  In times of financial stress, where Islamic banks become concerned about the solvency of other Islamic banks, often the flow of financing between banks will slow or even grind to a halt.

What problems will the IILM address?

If the inter-bank funding market slows or dries up entirely, the banks with excess liquidity will keep it on their own balance sheet as cash, sacrificing the yield it could earn by investing it in an asset (like short-term financing to another bank).  The banks with liquidity needs will either have to find a more costly financing alternative, which may not be available at all, or turn to its central bank.  Most central banks have not developed an Islamic lender of last resort product, but may find an ad hoc solution like the wakala deposits injected by the UAE central bank into several Islamic banks during the Dubai debt crisis.

In the worst case, an Islamic bank with a liquidity shortfall may be forced to sell long-term assets at distressed prices which, if sustained, could turn a liquidity shortfall into a solvency crisis.  The longer the shortfall lasts, the more likely the bank will be at risk of a bank run either in the classical sense (by depositors) or the Lehman sense (by wholesale funders).  As Lehman demonstrated, the doubts of the solvency of one bank can quickly spread to other institutions and exasperate the drying up of inter-bank funding markets.

What solution does the IILM product offer that is currently lacking?

An IILM short-term sukuk (now reported at up to $1 billion, compare to initial plans for $200-$300 million [pdf]) would provide a short-term asset for banks with excess liquidity, denominated in US dollars.  The benefit for an Islamic bank is that it can place some of its cash assets (which yield nothing) in an IILM sukuk that provides some yield and (if successful) would be extremely liquid and high quality (so the principal would be placed at little risk, even in times of financial stress).  Currently the IILM is waiting for its rating, which would affect its desirability for Islamic banks because the higher the credit rating, the lower the capital requirement for banks which hold it (presumably the IILM is aiming for a credit rating high enough so that the IILM sukuk could be held with a zero risk-weighting meaning it would not increase the bank’s capital requirements).

There is very little information out there about exactly how the structure would work, but I have speculated in the past that it will likely be an ijara or istithmaar, based on Dr. Zeti’s comments that they are waiting to “get the allocation of high-quality underlying assets”.  I think an ijara structure is less likely because the IILM’s members are central banks, which have more financial assets than they do physical assets.  The important point if it is an istithmaar is that the central bank members (and multilateral Islamic Development Bank and Islamic Corporation for the Development of the Private Sector) have to ensure that the assets include at least 51% non-debt assets (e.g. non-murabaha, salam or istisna’a).   This would ensure it would be tradable.

For as little detail there is about the structure of the sukuk itself, there is even less detail about how it could provide a source of liquidity for Islamic banks, except by being asset which could be readily sold to meet the bank’s liquidity needs. There is, however, an effort by the International Islamic Financial Market to create a standardized Islamic repurchase agreement (repo), that would provide a way for central banks and banks to offer short-term financing that would provide lower credit risk because it would be collateralized (instead of being unsecured like a typical commodity murabaha or wakala).

An IILM sukuk could be used as the collateral to support Islamic repo transactions that would allow for greater liquidity management because Islamic banks would be more willing to offer repo financing with an IILM sukuk as collateral than with another sukuk because if the borrower defaulted, the lender (either an Islamic bank or a central bank) could more readily sell the collateral and be less likely to suffer losses if the default occurred in times of financial stress.  For now, there is no connection between the IIFM and IILM efforts, but they both address a similar need, and we will have to wait for more details about both.

Updates from the Americas

Bloomberg launches weekly newsletter

Bloomberg may be trying to capitalize on the niche audience that The Islamic Globe found in its year of publishing with a new Bloomberg Brief, that ”gives global investors and financial advisors critical data and analytics”.  However, the focus on providing “expert insight from the industry’s most influential thought leaders [and] decision makers” likely places it more firmly within the market of current industry publications that avoid ruffling feathers.  Meanwhile, The Islamic Globe has launched a crowd-funding effort to resume publishing. [Disclaimer: I covered the Americas for The Islamic Globe and hope to continue when they resume publication]

IdealRatings adds to service offering

San Francisco-based IdealRatings has teamed up with Egyptian law firm Ibrachy to provide Shari’ah legal and consulting services to Egypt.  The announcement offers the potential for firms in Egypt to tap IdealRatings’ global network of Shari’ah advisory firms.  IdealRatings provides specialized data services for Shari’ah screening, but does not have its own Shari’ah board.

MARCH 18, 2012 (PDF)


Tunisia has set up a working group to study how to facilitate Islamic finance in the country.  While there are a number of priorities likely competing for attention of the government, it is good to see that the working group is being set up and also is not being done in a way that is designed to inhibit conventional finance.  A post-revolutionary country cannot be too picky about where it receives finance and I think it would be inadvisable to look to Sudan or Iran for example (both countries, at least nominally, have entirely Islamized their financial systems).   Tunisia is very sensibly looking towards Malaysia and Bahrain, as well as recent entrants to Islamic finance like Oman and Jordan.

According to the OECD (pdf report), Tunisia is relatively well suited in terms of its economy to try and attract Islamic finance as a way to add diversification to the economy (unlike its neighbor Libya), given its ties to Europe and links with GCC countries like the UAE, Qatar and Bahrain.  To be honest, when I started looking for information on Tunisia’s economy, I expected it to resemble Eastern Europe after the fall of the Iron Curtain with a large public sector trying to shift its focus towards Europe (the transition from communism to capitalism was the subject of my thesis in college).

However, if there is any comparison with Eastern Europe, the most apt comparisons would be to the Czech Republic or Slovenia, and the Baltic countries, which (after an immediate severe decline in the economy) were able to more readily re-orient their economies and political systems to look west instead of east.  For Tunisia, the adjustment should be easier since it had already shifted towards Europe and away from the large public sector that Libya was left with after the fall of Qaddafi.

Returning to the subject of Islamic finance in Tunisia, there will likely be a significant learning curve, since Islamic finance was absent under Ben Ali.  However, the private sector is better developed than, for example, in Libya, which should provide more destinations for finance directed through Islamic financial institutions in the country into real economic activity, which is supposed to be the raison d’etre for Islamic finance.

The priority in Tunisia for Islamic finance is not likely to be the private sector since the country is estimated for see its budget deficit rise from 4% in 2011 to 6% in 2012.  The priority is likely to be a sovereign sukuk to fill the budget gap. Finance Ministry’s director-general Chaker Soltani noted: “Before issuing Islamic bonds, or sukuk, we must put a law in place”.  He admitted that a sukuk issue would be unlikely to come in 2012.

One the legislation is in place for Islamic finance and the first sukuk is issued by the government, the question will be whether there is significant enough demand for Islamic banking services.  With a population of just 10 million people and an established conventional banking sector, Islamic banks will have a lot of competition on their hands for a small population.  However, on the plus side (for comparison sake), the UAE (which has many retail Islamic banks) has a population of only 7.5 million.

There are certainly international Islamic banking companies eyeing the market.  For example, the working group includes Bahrain-based Al Baraka Banking Group.  For a country like Tunisia without a history of Islamic banking, the first movers will likely be companies like Al Baraka, who can bring in their experience in other countries to develop the Islamic banking industry.  Once they become established, de novoIslamic banks or Islamic windows of conventional Tunisian banks (or windows of global banks) will follow.

This is a long road for Tunisia, and while a moderately Islamist government would probably prefer to jump start the Islamic finance sector more rapidly at the expense of conventional banks, this would be unwise.  Having a working group lay a solid framework using international lessons (which is the approach they seem to be taking) will not immediately bear fruit, but it will be more successful in the long run.  The worst case would be for the Islamic finance market to quickly grow domestically which would likely lead to failures (and perhaps a few fraudulent schemes by unsavory players looking for a quick buck) which would dampen interest among the public for Islamic finance.  That would be a shame.  Just head east to Egypt for examples of how the failure of so-called Shari’ah-compliant financial institutions can hurt the prospects for future developments.

Updates from the Americas

Last weekend, I had the pleasure of speaking at the Islamic Finance Conference: East Coast organized by students at the University of Maryland in College Park.  I would like to thank them for putting together an interesting day of speakers with much less commercialism/sales pitch-ism than many other conferences I have attended.

My presentation, which is available on my website now (I believe my talk will be available on the conference’s website shortly) was on the potential for Islamic microfinance to expand into providing financing for cleaner and/or renewable energy financing, particularly in rural areas.  Feedback is welcome from newsletter subscribers, many of whom have been working in Islamic finance for many more years than my 5½ years.

Website update

This weekend I was able to finish uploading the back issues of the newsletter to the Sharing Risk website.  I started writing the newsletter back in May 2010, so there are quite a few issues that I have addressed over the nearly two years I have been writing the newsletter.  If you go to the website, the newsletters are arranged by month under “Newsletters”.  There is not a search feature on the website, but to search for a specific issue, you can always go to Google and enter your search followed by “”.

Thanks to all the subscribers for the providing feedback on previous issues, and I look forward to more feedback now that the back issues are available on the website.  Please feel free to forward on this newsletter to others who might be interested.  They can subscribe either on the blog or by emailing me.

MARCH 12, 2012 (PDF)

MENAdrill (an Esam Janahi production)

MENAdrill Investment Company (MIC), an investment company “principally promoted” by Bahrain-based First Energy Bank  announced that it had issued $130 million in 3-year limited recourse Islamic debt financing to First Energy Bank and Gulf Investment Bank, which arranged the financing.  The debt is structured as a murabaha and will finance the MENAdrill 1 rig which was delivered in November 2010 and began drilling work for PEMEX, the Mexican national oil company in shallow water offshore of Mexico.  The MENAdrill 2 rig was delivered in March 2011 and has been transported to Mexico where it is expected to be put into service next month.

The two rigs cost a total of $364 million (other sources say over $400 million) and were ordered in late September 2008 by the then-chairman Esam Janahi (who is also chairman of Gulf Finance House, which launched FEB) who was replaced in February 2011. When MIC was launched in 2008, First Energy Bank expected MIC (founded with $1 billion paid up capital) to have over 20 rigs operating within 3-5 years (it will have 2 operating as of next month).

Updates from the Americas

Arcapita’s Atlanta-based Chief Investment Officer, Charles Ward, jumped ship to return to the conventional private equity world joining the New York office of Perella Weinberg.  Arcapita is currently in talks with its creditors who are concerned about the firm’s ability to repay a $1.1 billion murabaha coming due at the end of March.  Ward’s departure comes shortly after I reported in The Islamic Globe that J. Jill, a women’s apparel retailer, saw its debt downgraded from B3 to Caa1 by Moody’s.  J. Jill is the lone private equity holding that was acquired during Ward’s tenure, and the only holding acquired since the financial crisis hit in 2008.

MARCH 4, 2011 (PDF)

Are sukuk more expensive than conventional bonds?

One of the running debates in the Islamic finance industry is the issue of cost of Shari’ah-compliant products versus conventional products.  Whether it is an Islamic mortgage, Islamic structured product or a sukuk, the conventional wisdom is that there is a premium associated with Islamic finance (which I discussed last December in a blog post).

However, a story from Bloomberg, quoting the VP at SJS Markets Ltd., Samer Mardini, puts a figure on this premium: 120 basis points or 1.2%.  The estimate from Marini estimates the coupon required to sell 5-year sukuk at 5.5%, significantly higher than the yield on conventional bonds of the same maturity according to Bloomberg.

Perhaps this also puts some context behind the UK Treasury’s decision to again decide sukuk don’t offer value for the cost.  In an era where debt levels are rising and there is heightened attention paid to the sustainability of debt, few Western sovereign issuers are going to opt for a more expensive option, especially if the spread over convention debt exceeds 100bps.

The question then follows: where is the spread coming from and is there a way to reduce it?  The answer to the first question, is two-fold.  Many people would immediately point to the additional legal and financial structuring fees, and this is a contributing factor, but I think that investors demanding extra yield is probably a more significant factor.

I place a lot of responsibility at the feet of the secondary markets and the lack of development of liquid markets for the additional cost.  This was attributed as the cause of several Indonesian sukuk auctions back in 2010, despite the rapid growth in the economy of Indonesia. Due to illiquidity in secondary markets, investorsdemanded a spread of 50bps over conventional bonds, which are more liquid.  The article linked above quotes a fixed income analyst at Mandiri Sekuritas: “The main problem in sukuk auctions is liquidity”.

The liquidity issue is a difficult one to resolve, but changing conditions in sukuk primary markets (where sukuk issuance has surpassed pre-crisis levels) may indicate that at least one piece is fitting into the puzzle: supply.  If there is sufficient supply of new issues, then investors may be more willing to part with the sukuk in their portfolio because they know they can replace it with a different sukuk, deepening liquidity in secondary markets.

While this does provide some hope, there are still other obstacles blocking the path to a narrower spread between conventional bonds and sukuk.  Even if one excludes the legal costs for structuring a sukuk, it will still be more costly for investors because each sukuk is different and the prospective purchasers will have to spend more time reviewing the structure, rather than focusing on whether the issuer is risky or not.

There are likely to be cases where a custom sukuk is the only way to go, but there will be many more instances where it will just add cost and complexity to the issuer and to the purchaser.  I like the idea that was proposed for IIFM and Hawkamah of creating a template for an ijara sukuk.  IIFM has experience in the past creating standardized contracts (some of which have been more successful than others), and ijara sukuk are probably the most common structure for issuers.

There is no guarantee that either a template for an ijara sukuk, nor a more liquid secondary market would lower spreads to zero, but better to tread down these paths and see if it makes an impact than to keep marching forward down the current path.

Updates from the Americas

  • The Malaysian subsidiary of Bellingham, Washington-based fund manager Saturna Capital, manager of the Amana Funds, wasselected as the portfolio manager for the Crescent International Equity Fund.  The fund—which will be launched later this year by Australia-based Crescent Wealth—represents a new area for Saturna and its Malaysian subsidiary it acquired in 2010.  It also represents the first fund Saturna manages outside of the US.
  • South Dakota’s state House of Representatives passed a law on February 14th that was subsequently passed by the State Senate on Wednesday and passed on to the governor that would prohibit the courts and state government agencies from enforcing “any provisions of any religious codes”.  The law follows a failed attempt in 2011 to amend the securities laws to ban Shari’ah-compliant products, though that law was attacked for its vagueness and potential unforeseen consequences. The current bill was introduced at the end of January, nearly the same time as the legislature passed a non-binding measure encouraging South Dakota public schools to provide academic instruction on the Bible.  The irony is apparently lost on the supporting members of South Dakota’s legislature.