January 2012

January 29  |  January 22  |  January 15  |  January 9  |  January 1


JANUARY 29, 2012

This week, I discussed a little part of an intriguing article called “Is Islamic finance a failure?” (see below). I think that it is not a failure, as does I think the author of that article, Oliver Agha, agrees. There have been some product failures. Some of the real estate-backed private equity transactions in the go-go years (particularly in Dubai) are probably not coming back in the same sizes as they did back then. There was a mooted product by Deutsche Bank that gave Shari’ah-compliant investors access to non-Shari’ah-compliant hedge funds, which attracted a lot of controversy. There were also a number of mudaraba and musharaka sukuk that bent the rules in terms of how the redemption was set up. And, while it has not failed yet, I think there is a good chance that the Goldman Sachs murabaha sukuk will in retrospect be viewed as not a success and few issuers (mostly conventional banks) will think of trying to issue similar sukuk.

That being said, there has been some disappointment in terms of how Islamic finance has developed.  Despite much interest by (in particular) Islamic economists, the products used by most Islamic banks are dominated by murabaha (and other debt-based) Islamic finance products.  There has in particular been a lack of profit-and-loss sharing products.  In the theoretical back-to-back mudaraba model envisaged by the early thinkers on how Islamic finance should work, most of the products should be structured as mudaraba, where the depositors provide capital to the bank (and assume risk of losses, as well as being entitled to profits) and the bank does the same in providing financing to consumers and businesses.

There are many reasons why this has not developed, but I think that one of them is that a bank is not necessarily the best place to push equity risks and returns.  The demand for bank financing, but particularly the demand for deposit products make Islamic banks based on mudaraba and musharaka largely untenable.  Yet this should not be considered a failure either.  There are other places where Islamic finance works very well using mudaraba and musharaka.  For example, stock markets, venture capital and private equity can all be easily fit into the mudaraba and musharaka structure.  Most new companies are set up using similar structures to mudaraba and musharaka with different founders contributing capital, labor or both to the venture, where they are also taking on risk of loss, while hoping to reap their share of the businesses’ profits.

There are also other products like sukuk, of which a large number are ijara sukuk.  When trying to develop products that can meet the needs of investors who are looking for some profit potential (and most importantly a stable source of income), an ijara sukuk provides a good structure.  The investors are exposed to loss if the asset being leased is destroyed, a risk they can mitigate through takaful.  Yet, as long as things go well, they can generate a consistent stream of income comparable to a conventional bond, but without involving lending money in exchange for its return plus interest in the future.

There are, of course, many areas where improvements can be made and I am confident that there is attention being paid where it is merited because if you can develop a product that is demanded you can capture the demand and make a profit doing so.  If it uses a different method that is considered more Shari’ah-compliant or more true to the ideas behind Islamic finance, then there is benefit to the entire industry.  If it is suspect, it will usually be found out and criticized.  If you don’t believe that, I suggest you ask Goldman Sachs.

JANUARY 22, 201

One recent article I saw described the challenges with a sovereign sukuk for the UK government, with another minister coming out and saying it would not provide value for the cost (i.e. it would be more expensive to issue than a conventional Gilt).
This raises a couple issues.  First, we have seen widely that sukuk are more expensive for issuers because of additional structuring costs and these costs are likely to be higher additionally for the UK government (or really any Western government) because they have to manage not just legal but also political issues.  They can’t be seen as giving one set of government bond investors a priority over another unless they want to issue asset-backed bonds.  I don’t know whether or not this is something that governments have done, but I suspect that it is exceedingly rare if it ever happens.
Another potential issue is whether the UK government is considering just the costs of issuance in terms of the yields they will be paying and the costs for the lawyers who structure the sovereign sukuk.  There is reported to be a detailed analysis that the UK Treasury staff prepared, but it has not been released.  At issue here is whether the economic analysis was focused just on the direct costs and how much it benefit it included besides just monetary benefits.
I would be very interested to see whether the UK Treasury’s analysis ever is officially released (chances are pretty good that it will be eventually leaked).  There are arguments to support a UK sukuk (it would assist the UK Islamic banking industry and bring recognition that the UK is supportive towards the Islamic finance industry as it grows in prominence).  However, there are also arguments against (that it would waste taxpayers money by not getting the best cost of financing of government debt, or that it would go against the government’s regulatory approach of creating no obstacles, but also not providing special treatment).
The UK Treasury has been considering issuing a sukuk for several years, as have other countries.  Yet, between the political environment and the difficulty facing European countries with the debt crisis affecting many countries (directly or indirectly), I think that a sovereign sukuk coming out of Europe in the next year or two is remote.  However, I would be happy to be wrong.

JANUARY 15, 2012

The prospects for sukuk are bright coming out of a strong 2011 with significant issuance in the pipeline like the GACA sukuk from Saudi Arabia, which will be the country’s first sovereign sukuk (it is guaranteed by the Ministry of Finance), expected to be up to SAR15 billion ($4 billion).  Malaysia continues to be leading in sukuk issuance, but there could be prospects for more sukuk issuance out of the GCC.
The World Bank, in a report from 2011 ([pdf], page 7), broke down the financing sources of companies in the MENA countries (further separated into GCC and non-GCC countries) between bank loans, equity markets and bond markets (measured as a percentage of GDP).  Bank loans amounted to a bit more than 50% of GDP (70% in the GCC), while equity markets accounted for 10% (about 15% in the GCC).  Private bond issuance was almost negligible, with a slightly higher (but still very small) amount in the GCC.
The reliance on bank debt is in large part due to the lack of development of the bond markets (and to a lesser degree, equity markets).  In the absence of the latter two, companies are reliant upon bank debt to provide their necessary financing.  An article from Reuters quotes Morgan Stanley executives stating that they expect the reliance on bank debt will fall in 2012 after a strong year last year for bond issuance (conventional and Islamic).  They also note the fall in bank debt as a result of European banks pulling back from the region in the wake of (or more appropriately, intensification of) the European debt crisis.
The move away from bank debt, particularly when equity markets are unsettled, should provide a natural area for growth in the bond markets and within the MENA region, the sukuk market should be a large beneficiary (it will benefit sukuk issuance in other parts of the MENA region, but less so because the sukuk markets are just developing in many non-GCC MENA countries).
Using the approximate share of GCC GDP from bank loans, equity and bonds (those percentages were from 2010) and backing out the 36.8% drop in bank loans in 2011 to $39 billion (giving an estimate of $61.7 billion in bank loans in 2010), this corresponds to approximately $4.4 billion in corporate bond issuance in 2010 (close to an estimated $4.6 billion in sukuk issuance in 2010 reported by Emirates Business 24|7).  Corporate issuance grew strongly in 2011 (the same EmiratesBusiness article reported $14.6 billion in corporate issuance of sukuk in the GCC in the first 9 months of 2011).  On the back of strong growth from 2010 to 2011 coupled with expectations that bank loans (particularly from European banks in the region) will not strongly increase their lending, 2012 could be a strong year for sukuk coming from the GCC.
While the estimation method I used is far too rough to estimate a total value of sukuk for 2012, it does appear that–as long as a widespread recession is avoided–sukuk issuance from the GCC could continue its rapid growth and increase the total share of sukuk issuance coming out of the GCC (as a percentage of the worldwide total).  As companies are able to tap the bond markets increasingly for financing, it should create a virtuous circle; as issuance grows, the market deepens, liquidity grows and sukuk becomes a more attractive form of financing.

JANUARY 9, 2012

I have not really weighed in yet on the Goldman Sachs sukuk program, except for my post on tawarruq generally.  I am unable to decide whether or not Goldman’s sukuk was permissible or not.  That is just above my pay grade.  However, the controversy around it raises a number of issues that I think are worth exploring in a little detail.  There are two issues that I think are at the forefront of the controversy (and I think these have been floating around for some time, but the Goldman sukuk program pushed them into the media spotlight:

1) Is commodity murabaha (or tawarruq or murabaha, or whatever the structure actually is) a useful tool for financing in Islamic finance and is this the face that Islamic finance wants to present to issuers who are considering using Islamic finance?
2) Is it ok for companies to issue debt that is Shari’ah-compliant when the underlying companies themselves are not Shari’ah-compliant for equity investments?  Is there a difference when the use of capital is earmarked for Shari’ah-compliant business areas?

On the first issue, I think that murabaha is a perfectly acceptable tool for Islamic finance (I’m not weighing in on whether Goldman was using murabaha in a proper way or not; again, beyond my pay grade).  It meets a financial need and has been widely accepted by Shari’ah scholars for certain uses (including by Islamic banks tapping the inter-bank money markets).  Commodity murabaha and tawarruq are different, some may say cynical, types of murabaha, but they are also accepted widely and widely used by financial institutions.  However, I think that using murabaha (particularly in a sukuk) is not a good way to introduce new issuers who are not necessarily focused on Shari’ah-compliance as the primary reason for engaging with Islamic finance.   For one, it brings up strong emotions and there are pitfalls that a new issuer like Goldman (whatever their level of sophistication may be) can trip over.  An ijara sukuk is much more of a good way to ease a new issuer into how Islamic finance works.  First, its benefit to the industry is much less debated.  Second, it is easy to understand for issuers who are not otherwise familiar with Islamic finance (it’s similar to a financial lease).

The second issue is more tricky because there are many ways for a non-Shari’ah-compliant issuer to approach the Islamic finance industry.  On the one hand, a conglomerate could have a perfectly acceptable (on Shari’ah grounds) business that is using a sukuk to raise financing for expansion or to replace conventional debt financing.  The conglomerate overall may not be acceptable for an equity investor, but the business that is issuing the sukuk may not have those same issues.  Another situation would be a non-compliant business raising money to finance Shari’ah-compliant assets.  One example would be GE Capital’s sukuk.  GE Capital is a conventional financial institution, yet the sukuk was not financing (at least directly) the company’s interest-based business.  It was being used to purchase conventional aircraft leases and to effectively convert those leases into ijara by stripping out non-Shari’ah-compliant income and payments.  There are arguments about whether this sukuk (as I hinted earlier) might be actually funding the working capital of a conventional financial institution and only using the aircraft leases as an asset to separate the sukuk investors from the financial institution’s interest-based business.  Finally, an institution like Goldman Sachs could tap sukuk markets for its general working capital needs directly, using an uncommon sukuk structure that happens to most closely resemble an interest-based loan.  These three types are just examples and there is a spectrum that spans the entire range.  There is not really a cut and dry distinction of what will go over well and what will not.

I think it is positive that these issues are out in mainstream discussion and hopefully the discussion continues after the news cycle moves on from the GS sukuk.

JANUARY 1, 2012

My local basketball team’s announcers prepare for each game with a look at the challenges and opportunities for each game, which gave me the idea to do a similar thing for Islamic finance for 2012.  Given the global economic uncertainties, and regional political uncertainties in the Middle East and North Africa, I see a high level of uncertainty that makes it more unlikely that my analysis turns out to be different from what happens in the coming year.


By far the biggest challenge facing Islamic finance in the coming year is the ongoing debt crisis in Europe.  Within the Islamic finance industry, there is a lot of activity coming from Islamic windows at global financial institutions, particularly those headquartered within the EU.  The impact of the EU debt crisis on their prospects figures to have a large impact on the Islamic finance industry if they pull back from emerging and frontier markets where Islamic finance is most prevalent.  There is also a risk that the EU debt crisis spills across the world if it leads to a widespread recession across Europe.  This would depress demand for products from the emerging markets, whether those are raw materials or manufactured goods.  As oil markets recover from supply disruptions caused by the Arab Spring–and particularly if the slowdown in China persists–a recession in the EU could lead to further declines in demand for oil, which could lead to a lower price.  This would have a knock-on effect to the GCC where much of the liquidity flowing into the Islamic financial system are based on the price of oil.  Lower oil prices could slow the recovery in Islamic finance in the GCC, further shifting the industry eastward towards Malaysia and Indonesia.


There continues to be strong growth in sukuk markets, with the bulk coming from Malaysia.  However, Indonesia’s government is continuing to issue sukuk and has begun to include their Islamic Treasury bills in open market operations by the central bank through reverse repos.  As the market becomes more and more saturated in Malaysia, there is a huge opportunity within Indonesia, where Islamic finance is at a much earlier stage of development.

Across the MENA region, and particularly in North Africa, the Arab Spring has opened up the possibility for Islamic finance in countries (e.g. Egypt) where it was to some degree suppressed for political reasons.  A recent report from the African Development Bank highlighted the low degree of penetration of Islamic finance in North Africa (and elsewhere in the continent where it has been growing recently).  Africa could also become a new frontier for Islamic finance, particularly with a lower connection between the economies in Africa and Europe than in other emerging markets (e.g. China).

There is always the opportunity for the US and Canada to become more involved with Islamic finance, but it continues to be unlikely in my opinion that either country will grasp that opportunity.  In the US, most of the Islamic finance goes on under the radar because it is a small part of the financial industry, as well as due to political opposition to Islamic finance.  More activity, in my opinion, will come from offshore locations (e.g. Bermuda, Cayman Islands) where many funds and takaful companies are domiciled and as a jurisdiction where SPVs for sukuk can be set up.  There is an outside possibility for Islamic finance (e.g. a sukuk issuance) from South America, but it is likely to be small and the development of Islamic finance in South America is likely to grow even slower than it has in North America.

If you agree, disagree or think I have missed something, please let me know.

Best wishes for a Happy and Prosperous New Year!