September 2012

September 29, 2012

A long-running theme in Islamic finance  is debate about using ‘organized’ tawarruq for liquidity management.  The OIC Fiqh Academy even released a fatwa that condemned the practice (as it is currently being done) as a ‘deception’.

The specific criticism, as articulated in the article I linked to above, is that because tawarruq uses commodities that remain in warehouses throughout the transaction, and the different brokers are able to ‘net’ the purchases, there is not a genuine transfer of the asset and it returns back to the dealer at the end of the transaction.

The counter argument would be: legal title is transferred and there are more than two parties involved (so no bay’ al-inah).  It would just add cost to actually physically move the metals from one warehouse to another.

This is a valid point—why would the product as it is currently used, be any more legitimate if the metals were physically moved between warehouses?  There would be no benefits, just costs.  The alternative (moving back towards ‘classical tawarruq) would lead to the introduction of price risk, which would make the contract more akin to the type preferred by the OIC Fiqh Academy because  it would create a ‘trading’ operation where the parties involved are trying to profit by  selling and re-selling an asset, and the profit would come from movements in the market price of the asset (rather than to LIBOR).

But that would lead to a different product than what tawarruq is used for now, and it would make it less useful, so the benefit from moving to a more ‘authentic’ structure would in practical use, render it almost worthless for short-term liquidity management.

So, what are the alternatives?  The newest alternative is Shari’ah-compliant repo transactions, where a commodity murabaha is combined with collateral in the form of sukuk.  This has its own risks, but for this discussion, it does not add much since it too relies on trade in metals to generate a financing contract (and in the case of the UAE Central Bank Islamic repo, uses Islamic CDs which themselves are based on commodity murabaha as collateral).

The remaining alternative is wakala, which doesn’t rely on trading assets to generate a financing contract, but uses an agency agreement benchmarked to LIBOR instead.  It is not ideal, but there are few other options for short-term liquidity management tools, so maybe the industry should be encouraged in this direction.

September 23, 2012

Reuters reports that the state-owned Irish Electricity Supply Board (ESB) is considering issuing up to €1 billion ($1.3 billion) in sukuk in Malaysia within the next 12-18 months, potentially using its generating plants as assets to attract capital from the GCC and Malaysia as the Euro crisis leads to more difficult access to credit.  (Note: nothing here should be taken as a recommendation to buy anything).

The company has refinanced much of its debt already, but still has €1.4 billion in debt coming due (including revolving credit) during 2013 and 2014, which any financing in 2012 will be primarily used to refinance.  But, the company has significant liquidity needs to fund capital expenditures which S&P expects to be €700 billion in the 12 months following its August report.

With the Irish economy still only slowly growing (electricity usage and economic growth move in tandem) and funding markets in Europe still jittery, there seems like an opportunity for Islamic finance to offer a value proposition for the state-owned utility.  It would be an opportunity as well for the Irish government to demonstrate its commitment to attracting more Islamic finance to the country.

What is the value proposition?  Wouldn’t there be no greater demand for a sukuk than a conventional bond and only a higher cost for the Shari’ah structuring?  That depends.  Future demand for sukuk is in part dependent on oil prices (see link to IMF paper to the left), which are  dependent on global economic growth and a Eurozone debt crisis resolution, which would lower funding costs for conventional bonds, reducing the benefit that a sukuk could provide.

But, so long as demand for sukuk continues to exceed supply, there may be an opportunity for the ESB to get comparable or even lower cost from a sukuk because there are so few large non-Financial European sukuk (in fact, there are none except a very small one issued by a UK-based company).

Offering a sukuk with a different profile and different underlying risk profile that is likely to be differently correlated with the sukuk from the GCC and Malaysia will provide investors with some diversification.  And with no other investment opportunities with similar characteristics available, it could receive greater demand than a conventional Eurobond, and therefore a potentially lower financing cost.

If these expectations come to fruition, it could provide an opportunity for Islamic finance and for Ireland .

September 16, 2012

Islamic banks often with regulatory systems designed for conventional banks.  There are efforts to encourage Islamic finance through ‘equal treatment’ of Islamic and conventional finance and some countries have incentives designed to help Islamic finance grow more rapidly.

While many of these incentives are good, they risk becoming entrenched, (I have discussed in several posts recently).  The first link specifically focused on Indonesia, which is considering offering government support to Islamic finance (based on statements from the head of the central bank).  Around the same time, Bank Indonesia raised down payment requirements for loans, and extended the same rules to Islamic banks.

The head of Bank Indonesia Edy Setiadi, said in that context “The principle of BI also has to make similar regulation for Islamic banks.”  This is important because the argument could be otherwise made that down payment rules for conventional banks are not needed for Islamic banks since their financing products are based on ‘real assets’ and more connected to the ‘real economy’.

The principal that Islamic banks should have equal treatment from regulators is important and, while substantive differences in Islamic banks’ products should receive different treatment from conventional loans, it is important for Islamic banks to face similar regulation on products that have the same economic effect as conventional loans, even if this slows their growth.

The case of the down payment rules are illustrative because, while the contracts may be structured differently so an asset is bought and leased to a customer, or bought and resold for a customer, the economic outcome is the same as a conventional loan.  Islamic banks should not be put in a more favorable position compared with conventional banks, which would amount to an incentive, even if it were over time designed to converge with the rules for conventional banks.

It would create an opportunity for regulatory arbitrage, as well as an interest group that would later lobby against the convergence of regulatory standards.

And, more importantly, allowing Islamic banks to operate under looser standards would make them less sound and subject them to greater risks down the line of failure if loans started going bad.  And widespread failures of Islamic banks would be devastating to the future of Islamic finance.

September 9, 2012

There is a tension within Islamic finance between what is viewed as ideal—Islamic finance being different from conventional finance—and what is possible with the real-world constraints of investor preference and regulations (e.g. Basel capital requirements for banks).  A paper by Omar Salah about the effect of the AAOIFI ruling on equity-based sukuk shows how structures can change to move practice closer towards ideal by looking at pre- and post-ruling examples of mudaraba sukuk.

Salah describes the theoretical structure of mudaraba sukuk with the important feature that “sukuk holders do not receive a fixed return and [bear the] risk that [they] will not receive the expected return in case the underlying projects do not perform”.  He then describes several pre-AAOIFI ruling sukuk that mitigate these risks through interest-free loans from the originator and purchase undertakings to redeem the sukuk at par upon maturity, two features which AAOIFI’s Shari’ah board said were not allowable.

The solution—illustrated using the post-ruling Saudi Hollandi sukuk—replaces the purchase undertaking with a call option for the originator if the assets are valued in excess of par and subjects the periodic profit payments to final settlement upon maturity, forcing investors to realize a loss if the mudaraba loses value in excess of the value of the reserve account.

The underlying problem facing mudaraba issuers (which explains why so few have been issued post-ruling) is that it attempts to fit a square peg into a round hole.  Investors want a fixed income-like instrument while the equity-based structure demands loss sharing.  The creative solution from the Saudi Hollandi Bank sukuk accommodates this requirement to a degree, but there remains the problem of valuing the underlying assets, which is more art than science.

Valuation problems are common in banking and finance (e.g. the discrepancy between the trading price of Arcapita murabaha pre-bankruptcy with the values of assets on its balance sheet).  This makes fixed duration mudaraba and musharaka sukuk difficult because redemption on maturity has to occur at a valuation determined ex post, without reference to the par value.

This will always be difficult unless the sukuk assets can be valued with reference to market prices so perhaps mudaraba and musharaka structures are more useful in equity markets, rather than sukuk, since by their nature it is difficult to replicate the risks and returns of fixed income.

September 2, 2012

Few studies empirically test the effectiveness of Islamic microfinance, since it is only a small niche within the broader microfinance sector.  However, a study written by M. Mizanur Rahman, a Director at Islami Bank Bangladesh Ltd, studied the effectiveness of that bank’s Rural Development Scheme and comes away with interesting results.

After controlling for a household’s asset (its land holdings), the number of family members involved in income-generating activities, the proximity to an IBBL branch, the borrowers age and education and a measure of piety (e.g. reading the Qur’an, wearing hijab, fasting), Tk120 in higher income (significant at the 1% confidence level) for every Tk100 in financing.  The number of family members involved and the age (whether the borrower was over 40 years old) are also significant at the 5% level.  The measure of piety falls just short of the 5% confidence level, but also has a positive coefficient.

The author suggests that a “clients’ ethics and morals had positive and significant influence on the household income” but there is always of danger in extrapolating relationships identified by regression analysis, particularly a sample of 1,020 clients within the Islamic microfinance progarm who share similar degree of piety.

The result with piety might be picking up unobservable individual differences between clients who are using Islamic microfinance.  For example, the increase in income for client exhibiting greater piety could be separating out those clients who believe most strongly in the value of Islamic microfinance from those who are using it because they are unable to receive conventional microfinance.

The IBBL microfinance program is mostly based on bay’ muajjal, which is similar to murabaha (and in economic form to conventional microfinance).  The study does not show whether an alternative profit-sharing microfinance product would work better, and that is understandable since the real world experience with mudaraba and musharaka microfinance is so scant.

However, what the study does show is that Islamic microfinance can attract clients who will use the financing to increase their income.  Further research is needed to determine whether or not this is due to the program itself, or whether it can attract higher quality clients than conventional microfinance, because demand for Islamic microfinance likely outstrips supply.