November 2011

November 27 | November 20 | November 13 | November 6

NOVEMBER 27, 2011

The big news of the week was ThomsonReuters’ announcement of the Islamic Interbank Rate (IIBR), which I will have more details on in this week’s Islamic Globe, which you can subscribe for free at

The aspect of the IIBR that I have most concern about is that it is initially based on LIBOR through the use of LIBOR by the contributor banks to the index.  They are contributing multiple tenor rates for inter-bank lending, which is based on their own inter-bank lending that is today based on LIBOR.  This is not problematic on its own, because what other rates than the ones they are currently using would one expect to be quoted for the IIBR?

However, the key thing that the IIBR will depend on for its own success will be bank’s willingness to abandon the LIBOR (or EIBOR or SAIBOR, etc.) rates which they have up until now relied on as pricing benchmarks for their inter-bank lending.  If they stick to those rates for determining their own inter-bank lending, then the IIBR will end up as a failed experiment and will be only a number that the perpetually optimistic promoters of Islamic finance turn to as evidence that Islamic finance has created a ‘new paradigm’ or something to that effect.

Despite this fear, I am optimistic that IIBR will catch on, in part because of the European debt crisis, which is likely to (if it has not already) roil the debt markets that the LIBOR is based on.  Furthermore, the IIBR is concentrated in the GCC, with all the banks publicly listed as being contributors being based in the GCC (13 fully Islamic, with 3 Islamic windows, by my count).  The market separation between the IIBR and LIBOR should provide some initial impetus for its adoption, which is a positive, albeit one that could not have been planned since the IIBR has been in the works for over 2 years.

While I do believe that the IIBR will catch on and become an Islamic benchmark, I don’t think it will serve its function long-term and I think it will end up closely representing a basket of conventional interest rate benchmarks of the countries where Islamic finance is most prevalent.  I would be happy to be proven wrong here, but with Islamic finance being such a small part of the global financial markets, and the tendency of the financial markets as a whole to engage in arbitrage, I think the IIBR is overall a neutral development for the industry.  We will hear a lot about it, but it won’t in the end make much of a difference.

The only impact I think it will make is either neutral or negative to the industry.  The arbitrageurs, which are ever-present, will move funds in and out of the Islamic banks to capture whatever spread there is between the conventional and Islamic interest rate indices (again, with IIBR being a weighted average of the markets where the contributor banks operate).  The potential negative scenario from this is that it will introduce ‘hot money’ into inter-bank lending, where the arbitrageurs will place money with Islamic banks when that rate exceeds the alternative rate and pull those funds out as soon as the relationship shifts the other way.

So long as this movement of money is small, it will not be impactful, but if it becomes significant, then it could make the Islamic banking industry less stable.  My analogy from recent history in this regard is the heavy reliance that banks in Georgia (the US state) had on brokered deposits, which were hot money in search of the best yields.  As the US banking environment deteriorated and these flows disappeared, we were left with a disproportionate share of bank failures coming from Georgia as banks were unable to replace those funds and, as their assets were hit, became targets of the FDIC.

NOVEMBER 20, 2011

I was just reflecting on the types of deposit products available from Islamic banks and there are generally four: qard, mudaraba, wakala and murabaha.  There are costs and benefits associated with each, both from a theoretical perspective as well as in practice.
In much of the theory of Islamic banking, the mudaraba deposit product is widely viewed as being superior because it is a profit-and-loss deposit.  On similar lines a wakala deposit also requires the deposit to bear losses on the investments for which their deposits are used to fund.  A qard deposit is also in theory perfectly acceptable because no return is provided on the funds in exchange for the safety of the principal amount.  A murabaha deposit would be viewed in this light as being inferior because it replicates a conventional time deposit where principal is guaranteed (at least as far as the bank stays in business) and a return is provided to the deposit.
However, the way Islamic banks operate change the equation.  The qard product is not affected; it works the same way with no return and safety of principal, and is not too different from how many demand deposit accounts function today with the global zero or near zero interest rate environment.  In a more normal situation, the qard deposit product would probably be viewed as less competitive because of its zero return and would not provide a sustainable funding base for Islamic banks because it would be hard to gather qard deposits except from people who want to have a safe place to keep their money and don’t want to engage with a conventional bank (it is a great deal for the banks who receive a free source of funding, apart from the potential liquidity management issues that it creates).
As things work, a mudaraba and wakala account does not function in the way it was envisaged because depositors are unwilling in general to bear risk of loss of their deposits.  Islamic banks have therefore used reserve accounts to even out the profit payments and protect the depositors from loss.  There is also an informal (as far as I know it is informal) promise by shareholders of the bank to subordinate their claims over profits to the depositors, so that any shortfall in profits would come out of the profits accruing to the bank to keep the deposit rates competitive in comparison with conventional banks.  There is, therefore a deposit product that is designed to be profit-and-loss sharing but in practice works more like a conventional deposit account where principal is protected and returns are stable over time.
In contrast, a murabaha deposit account is not viewed as theoretically preferable, but in practice may be superior to mudaraba or wakala because the theoretical idea of murabaha (at least of a commodity murabaha) bears more similarity to how the murabaha deposit account works in practice.  Depositors lend money to the bank through a purchase and re-sale of commodities with repayment on a future date (which could be daily, weekly, monthly or any other frequency to meet the depositors’ desire for liquidity).  However, the position of the depositors as creditors and the bank as debtor is much more similar to how Islamic deposit accounts actually operate than the more appealing (to many) wakala and mudaraba deposit.  However the same problems arise with murabaha in deposit accounts as in the rest of Islamic finance because it becomes more and more a replication of conventional banking products rather than a new way of thinking of the banking relationship.
The picture is slightly different when there is an Islamic deposit insurance system, which I described in a blog post earlier today (see below), where the deposit insurance can take away the tail risk of large losses for mudaraba or wakala depositors and make these more appealing than murabaha deposit products.
For those of you who are not subscribers to The Islamic Globe, here is my latest article, which was on the UM Financial situation.  I would recommend you subscribe (it’s free) to get the articles as soon as they are released.

NOVEMBER 13, 2011

I have not had time this weekend for the reflection on Islamic finance that usually results in an idea for a newsletter because I have been hard at work on some interesting articles for The Islamic Globe (you can subscribe for free at  However, next week, I plan on returning to the Islamic finance complexity series (the latest is below; the full series is available from my blog where there is an index of the posts).

As always, I welcome your input on the posts, particularly when they are as open-ended as my Islamic finance complexity series.

NOVEMBER 6, 2011

Appologies for the 2-week absence of the newsletter. I was traveling the weekend before last and last weekend I was finishing up writing a chapter on Islamic microfinance, which will appear in a book about Islamic finance more generally to be published some time early 2012.

Recently, I have been trying to look at the Islamic finance industry from a different perspective, to try and see if there are areas where the Islamic finance industry can better serve people’s financial needs, rather than just create an Islamized version of the conventional financial system. The initial impetus for the exploration was a critique of the Islamic finance industry for being too complex (see below, towards the bottom of the posts).

This complexity is due, in my estimation, mostly to the way that the industry was created. When Islamic finance was first brought into practice 35 years ago, the primary concern was creating an alternative to the conventional banking system that would be viewed as permissible by the consumers. The idea of creating Islamic versions of conventional banking and finance products was perfectly natural. It is very difficult to start a banking system anew, and the conventional system was not developed in one fell swoop. It evolved over centuries into its current form. It continues to evolve, in the wake of the financial crisis, and most of that evolution is being driven from the bottom up (although regulatory changes are spurring on some of the evolution).

Just as conventional finance did not spring up fully formed (and is continuously evolving), so is Islamic finance. The changes, I think, will be driven from the bottom-up as individual Islamic financial institutions see a better way to serve their customers. The Islamic financial institutions that focus on their own profitability and make products that pay high fees but are too complex for consumers to fully understand will eventually lose out. But, there are not well formed ideas about what areas of the Islamic financial industry are most in need of changes, which prompted me to look at the industry piece by piece.

I don’t expect to come to a definitive conclusion; the series of blog posts are more of a thought exercise and I welcome input from the readers of my blog and my newsletter. Change will come to the Islamic finance industry only incrementally, but incremental change will only happen if there is some introspection about the current state and direction of the Islamic finance industry.