June 2012

June 24, 2012 (PDF)

An IMF working paper (PDF) that examines the differences between Islamic and conventional finance in Malaysia provides some interesting results about the differences between Islamic and conventional banks, which contrast with the “conventional wisdom”.

For example, prior to and during the financial crisis, Islamic banks had higher capital levels (measured by capital adequacy ratios), while convention banks had higher capital after the crisis.  Also, before the crisis, Islamic banks were able to generate higher returns on equity (ROE) than conventional banks but have lagged since.

One possible explanation for the flip-flop in the higher levels of capital from Islamic to conventional banks before and after the crisis is that after the conventional banks glanced over the edge into the abyss during the crisis, they adopted a more conservative capital buffer afterwards.

Islamic banks, in contrast, had higher capital levels before the crisis, in part because they were growing faster than they could lend out the deposits which were flowing in.  Not having faced the same brush with death as conventional banks, they were more willing to diminish their capital buffer to support their continued rapid growth when the clouds of the crisis parted.

As for the return on equity, it is a bit more surprising to see Islamic banks ROE suffer as their capital declines (both relative to conventional banks).  In general, it would be normal to see ROE increase with a decrease in capital because the returns generated by the bank’s assets would be spread over a smaller equity base.

The authors suggest two reasons—both which should be troubling for Islamic bankers—about why Islamic banks’ ROE declined relative to conventional banks.  First, although Islamic banks’ net interest margins were higher than conventional banks due to higher exposure to auto and personal loans, the quality of these assets were lower, resulting in higher levels of non-performing loans.  Second, the authors cite Hassan & Dridi (2010) who also found that Islamic banks globally lagged after the crisis, which they attribute to “weak management practices”.

The basic result from this paper, which mirrors the results from Hassan & Dridi (using data from Malaysia, Turkey and the GCC) is that Islamic banks have underperformed conventional banks since the crisis ended.  It is, therefore, time to stop celebrating that Islamic banks did better during the crisis, and start asking why they have done worse since.

June 17, 2012 (PDF)

After hearing a speech from the recent AAOIFI conference by Mufti Aziz Ur Rehman (presentation slides), I think that Shari’ah audit is a critical area where expanding the depth of qualification for Shari’ah auditors could help the industry avoid future problems caused by unqualified Shari’ah auditors.

This is not to say that I think that most Shari’ah auditors are not up to the task or there are questions about Shari’ah auditors working to hide Shari’ah-compliance problems.  As Mufti Aziz noted, there are just too few experience requirements in the current system of certifying them.  “No conditions for eligibility and entitlement” and “No experience and pre-education required”.

A study by PwC (pdf) in Malaysia have found little coordination between Shari’ah boards and Shari’ah auditors, and that Shari’ah auditors are active mostly in an operational rather than consultative role.  Other studies (also focused on Malaysia) have found that most Shari’ah auditors have accounting and auditing backgrounds, rather than backgrounds in Shari’ah.

These two conclusions—and there are probably differences between the institutions surveyed in Malaysia and other IFIs around the world—support the development of a more robust training and certification program for Shari’ah auditors, particularly with regards to the interaction of Shari’ah risk within the overall risk management of IFIs (an area where few institutions surveyed by PwC said there was involvement by the Shari’ah auditors).  ­

The Shari’ah auditor role should be one that is independent of management and serves as a more hands-on internal check for the board of directors who are ultimately responsible for the effectiveness of internal controls for Shari’ah-compliance just as they are for the accuracy of the financial statements.  Shari’ah auditors are not Shari’ah scholars, and they should interact with the Shari’ah board to ensure they have a full understanding of the conditions laid down by the Shari’ah board to ensure compliance of the products.

Shari’ah board members provide the ground rules for the products offered by the IFI, but they need to be able to be able to verify management assurances about internal compliance with the fatawa they provide.  Otherwise, they cannot have confidence in the Shari’ah-compliance of the institution when they sign off on its annual report.  It is in everyone’s interest for internal Shari’ah auditors to be well trained in their responsibilities to avoid costly errors that will affect the industry as a whole, not just an individual institution.

June 10, 2012 (PDF)

At the end of May, Bank Negara Malaysia, the central bank, announced the introduction of the collateralized murabaha product, which it says will serve as a “low credit-risk financial instrument that enables collateralised interbank transactions in the Islamic Money Market”.

In essence, BNM introduced a version of the Islamic repo mentioned in an International Islamic Financial Market (IIFM) report on potential structures for that product.  The first Islamic repo was introduced using the same collateralized murabaha in August 2011 with a $20 million deal between Abu Dhabi Islamic Bank and the National Bank of Abu Dhabi (collateralized with Malaysian and Abu Dhabi government-related entity sukuk).

This is a good tool for Islamic banks to have because it strengthens the inter-bank market by providing a liquidity management instrument with less counterparty risk than an unsecured inter-bank murabaha.  In the inter-bank market, the unsecured murabaha could lead to more rapid liquidity problems if a bank’s solvency comes into question because there is nothing but the full faith and credit standing behind the inter-bank loan.

The Islamic repo product adds some level of security that should stem the drying up of liquidity, but only if there is a market for the sukuk to be sold if there were a default.  Even now in relatively calm times (and I use that word loosely).  However, the benefits from collateral depends entirely on the ability of the counterparty to liquidate the collateral at near the value of the murabaha financing extended, which will almost certainly be absent in a crisis where it would be most needed.

However, as the failure of MF Global highlighted (described in a recent NY Times article), a repo, potentially an Islamic repo, could take advantage of accounting rules that would lead it to be an avenue for abuse (caveat: this loophole is likely to be closed due to MF Global). MF Global entered into repo-to-maturity with the European sovereign debt it purchased, and treated the repo as a sale for accounting purposes and recognized the profits of the trade at the repo date.

Since Islamic financial institutions operate using similar accounting rules to conventional banks (with modifications developed under the auspices of AAOIFI), unless the rules are changed, a similar accounting arbitrage could be profitably exploited by an Islamic financial institution on arguably more risky fixed income (e.g. corporate sukuk).  And, unlike European sovereign debt, there is a much lower chance that if the murabaha had to be unwound there would be a liquid market into which it could be done.

June 3, 2012 (PDF)

During the past 2 weeks, the Arcapita bankruptcy case has been focused on the recently passed deadline for Arcapita to make a $30.4 million inter-company loan, to fund a periodic land purchase payment for their residential real estate golf community, owned through a joint venture with Barwa Real Estate Company.

The payment is required to maintain the current ownership in the joint venture, which Arcapita asserts has significant value.  The request for court approval includes a hint that the use of the land could “change in a way highly beneficial to [Arcapita] based on ongoing developments in connection with the selection last year of Qatar as the site of the 2022 World Cup”.

The payment request—which Arcapita made 2 weeks before the June 1 deadline—was initially questioned by Arcapita’s unsecured creditors, who initially viewed the request “with a jaundiced eye” as a result of the financing transaction itself.  Two weeks before Arcapita filed for bankruptcy, the company tapped Qatar Islamic Bank for financing by entering into a sale-and-leaseback of the Lusail joint venture.

Arcapita committed to pay the remaining land purchase agreements (for both itself and its investors in the property), as well as semi-annual $10 million lease payments to QIB, and a $20 million option premium when they repurchase the shares in the Lusail joint venture (which they can do any time through March 2015.

The initial scrutiny of the QIB transaction was due to the timing (2 weeks before the bankruptcy filing) and the presence of a shared board member at QIB and Arcapita.  The unsecured creditors maintain that they are still reviewing the propriety of the transactions, which Arcapita insists were made without independently, and with disclosure of his position on the boards of both institutions.

After meeting with Arcapita, the unsecured creditors committee recommended that the payment be approved by the court, which it was on May 31, because it will increase the value of Arcapita for the benefit of the unsecured creditors.  The decision was made in part, according to a court filing by the creditors, because the first $10 million semi-annual lease payment due in September 2012 will require separate court approval that will “serve as another checkpoint with respect to the Debtors’ management and potential monetization of the Lusail Joint Venture”.