August 2011

AUGUST 29  |  AUGUST 21  |  AUGUST 14  |  AUGUST 7  |  AUGUST 1

AUGUST 29, 2011

The newsletter is a day late this week because the weather on some summer weekends here in Oregon are just too beautiful to spend inside working at a computer keyboard.

One of the claims that I see sometimes suggested as a cure for current market practices, and an area where Islamic finance can lead, is the return to the gold standard, most prominently advocated by former Malaysian Prime Minister Dr. Mahathir Mohamad.  I have always thought the gold standard was not the appropriate method for managing international currency markets, but I just finished reading Lords of Finance by Liaquat Ahamed, which focuses on the inter-war period in the US and Europe and features the central bankers of the US, UK, France and Germany as the main characters.

Dr. Mahathir’s primary proposal from what I read is that the use of the Islamic Gold Dinar for international financial settlement between central banks of Muslim majority countries.  This would be a return to the gold standard used by the Western countries until the Great Depression (and then somewhat nominally, under fixed exchange rates, until the 1970s when it was abandoned for good).  The use of the gold dinar–a new gold standard–would, its proponents argue, prevent currency wars and stabilize economies.

The lesson relating to the gold standard from Mr. Ahamed’s book–which I would wholeheartedly recommend as a good financial history of Europe and the US between World War 1 and the Great Depression–is that the goal of remaining on the gold standard (in the case of the UK, at pre-WWI exchange rates) led to dramatically counterproductive economic policies because the demands from the fixed gold exchange rate and the demands of the domestic economy were often at odds.  When unemployment in the UK was running above 10% in the 1920s (PDF), the government was hiking rates to stem the flow of gold out of the UK, which depressed the economy further leading to nearly 2 decades of Depression.

The US avoided some of the problems because it saw inflows of gold from Europe during the 1920s, and despite an economic boom, began cutting interest rates to try and reduce the inflows of gold from the UK (in particular).  Mr. Ahamed clearly believes that this accentuated the speculative stock market rally of the late 1920s, which diverted resources from productive economic activities towards sheer speculation in the stock markets.

On the issue of avoiding currency wars, the gold standard also had a poor record in the 1920s.  After a currency crisis, France returned to the gold standard at an undervalued level relative to the Pound, which had returned to pre-war exchange rates.  This benefited the French economy, but also resulted in strong inflows of capital (i.e. gold) to the Banque de France, which ended up supplementing its reserves with Pounds.  It used these reserves (which represented a claim on a large portion of the UK’s gold reserves) as political leverage.  When the inevitable reckoning came with the onset of the Great Depression in the 1930s, speculators attacked the Pound believing that a fall in the currency were the result of French redeeming their Pounds for gold, which forced the UK to leave the gold standard (even though the Banque de France had not sold a single Pound), leaving the Banque with sizeable losses on its holdings of Sterling.

So much for a gold standard bringing economic stability and preventing currency wars and crisis.  There are much more fruitful ways for Islamic finance to make a positive impact on the global economic environment than trying to re-enact the failed policies of the past.

AUGUST 21, 2011

 Despite the (deserved) criticism of many of the ratings agencies, not everything they say should be tossed to the scrap heap.  In a blog post earlier today (see below) I wrote about S&P’s analysis of some of the challenges facing the takaful industry.  For this newsletter, I want to talk about a few comments from Moody’s relating to Islamic banking, which I think have importance when there is a plan for an Islamic mega-bank based in Bahrain (and possibly also one or a few in Malaysia).  The Moody’s article quoted Christine Kuo, the author of the report saying that:

“Most Islamic banks’ strategies try to achieve asset growth. While this is important, appropriate systems and infrastructure to address risk issues need to be in place to support sustainable growth; therefore, risk management should be implemented first followed by growth”

“When it comes to global comparisons, it is more important for Islamic banks to build strong franchises in selective markets and businesses, and to maintain sound financial profiles as opposed to big balance sheets”

The article describing Moody’s article also summarizes:

“While size is important because diversification is harder when an institution is small, those banks which enjoy dominant positions in smaller but more favorable markets may have a higher franchise value (which could translate into greater earnings stability) than a bigger bank with a highly price-sensitive customer base operating in a competitive market”

I think that these points very accurately capture the challenges of an Islamic mega-bank, particularly one that is a greenfield effort (rather than one accomplished from organic growth or acquisitions).  The capital is out there if the will is there for investors to capitalize a $100 billion Islamic bank, but after one raised that kind of money for an Islamic mega-bank that has the size needed to compete with the international financial institutions around the world, the question would come: how do you manage that type of bank and deploy all of its capital in an efficient way with all the risk management that would be needed for what could become a systemically important institution (both to the home country and to the Islamic financial system).

A bank of that size would have linkages with almost every other Islamic bank in the world, if for no other reason than it needs to deploy the capital to generate a return and the market for Islamic finance (on the demand side from companies and individuals) is limited unless a large portion of the funds were loaned out to other Islamic banks for short-term finance.  Otherwise, shareholders would likely become impatient that a large portion of their capital was earning little or no return.  In order to find a home for that capital, there would inevitably be a push to deploy or die and the riskiness of those receiving financing would almost certainly increase.

For the industry, that bank would be a curse as well as a blessing.  On the one hand, it would have the capital free to grease the wheels of the inter-bank money markets, lowering the costs across the industry.  However, that would only serve to accentuate the need to take greater risk in the other operations to offset the decline in the (already low) inter-bank markets due to low interest rates across much of the world.  This increase risk, while it would please the bank’s shareholders by generating returns to the equity holders, would set up a systemic crisis if (or when) the bank’s high-risk lending started to deteriorate in quality and loans began to go bad.

This would be a true nightmare scenario for the Islamic finance industry.  If the solvency of the mega-bank (or the quality of the loans on its books) came into question, it could freeze up markets across the world (in Islamic finance) and likely also in countries where the bank was based.  Both Bahrain and Malaysia (where the mega-banks are expected to launch) are highly competitive in Islamic finance and that further erodes the profitability of the bank and could force it to move ever more quickly into more risky markets.  While the bank would initially begin as a creditor in the inter-bank money markets, it would probably on any given day be both a creditor and a debtor.  Without transparency about exposure for other Islamic banks (transparency that is still largely lacking in the conventional financial market), fears of large loan losses at the mega-bank could precipitate a funding crisis for many other banks with investors and depositors concerned about how exposed other banks were to the mega-bank, should it fail.

All of this takes a few steps of extrapolation from where we are today (without any Islamic mega-banks), but I think the risks are real enough (based on experience in the last financial crisis) to consider before the meg-bank becomes real (and entrenched).  If there is any prescription that flows from this idea, it is that it is better to construct a mega-bank from smaller banks through a combination of organic growth and mergers/acquisitions.  At least that way, there is a chance for risk management to develop as the institution grows (although that is not a panacea, using the example of Bank of America, which has acquired and acquired without a compensating growth of sound risk management practices).

AUGUST 14, 2011

 A few weeks back I wrote critically about the UAE Central Bank’s structure for repo transactions using commodity murabaha with Islamic CDs as collateral.  I remain unconvinced that this is the best way for an Islamic repo transaction to be structured.  However, my opposition to that structure does not extend to the idea of making collateralized commodity murabaha a structure for Islamic repos.  National Bank of Abu Dhabi and Abu Dhabi Islamic Bank recently announced that they had executed an Islamic repo transaction that seems very similar to the UAE Central Bank structure.

The press release describes:

NBAD and ADIB jointly embarked on this initiative to formalise the Master Collateralised Murabaha Agreement (MCMA), thus enabling Islamic banks to utilise their holdings of sukuk.

The MCMA offers a Sharia-compliant alternative to the repurchase arrangement, which conventional banks and financial institutions (FI’s) use to lend and borrow at extremely low risk.

This is the key to the difference with the commodity murabaha backed by another commodity.  The NBAD/ADIB structure is focused on using sukuk–which are only rarely structured using murabaha because of the difficulty of making them tradeable.  Instead, this Islamic repo transaction is designed to faciliate short-term lending and borrowing at low risk, effectively replacing the inter-bank unsecured commodity murabaha with a secured commodity murabaha that is secured by an asset that is (in some ways at least) more than just another receivable on another counterparty.

This is important systemically because the failure of one institution would force the liquidation of a chain of inter-bank loans and could more easily spread across the Islamic banking system.  As the troubled institution heads towards insolvency, the inter-bank markets would become harder and harder to access (because of concern by other banks of becoming unsecured creditors of a potentially failed bank).  The difference with a commodity murabaha secured by a sukuk is that the cost of a counterparty failing is reduced (particularly if the collateral is high quality).  All other things being equal, this would keep the lending channels open as long as the collateral is viewed as high quality.  This is an area where increased supply of high-grade sukuk from sovereigns and multilateral institutions (e.g. Islamic Development Bank, International Finance Corporation, International Islamic Liquidity Management Corp, etc.) is critical.

The high quality collateral can serve as a backstop to keep inter-bank money markets open even in a crisis because the failure of an institution would not have as much of a spillover effect onto its counterparties.  They could keep lending so long as they were provided with good enough, unencumbered sukuk as collateral knowing that if the counterparty failed, it could recoup the principal amount loaned by liquidating the collateral.

It doesn’t matter–strictly speaking–that the structure be secured commodity murabaha backed by non-commodity murabaha-based products.  This is more of a personal opinion that to keep the industry from sliding too far into the realm of cynicism by creating over-complicated exact replications of every aspect of conventional finance.  But, the development of Islamic repo products, particularly for interbank money markets to replace or supplement unsecured commodity murabaha, should make the industry more robust for the next crisis.

AUGUST 7, 2011

 Rereading my posts from last week, the ideas I started discussing in a blog post on Islamic T-bills in Indonesia can be extended further in terms of the benefits from having multiple Islamic short-term sukuk available for Islamic banks and other financial institutions.  Consider an Islamic bank that has operations in many countries around the world and also accepts deposits (in local currencies) in these same countries.  A conventional bank could use short-term money markets or repos denominated in one currency (e.g. the US dollar) and currency swaps or forwards to hedge their exposure to currency fluctuations in the short-term liabilities against their assets denominated in a local currency in the markets in which they operate.

However, Islamic banks do not have readily available currency hedging or repos and very limited short-term sukuk and so would be exposed to fluctuations in currencies (which would cause a mismatch between the value of their assets and liabilities as the currency exchange rates fluctuate).  While there are some early discussions about creating standardized structures and contracts for currency hedges and for Islamic repos (the first Islamic repos were just introduced by the UAE central bank), they have not become commonly available in all of the different currencies that an Islamic bank would need (Ringgit, Rupiah, Dinar, etc.).

Instead, if the IILM introduces USD and EUR short-term sukuk, that can provide liquidity management tools for Islamic financial institutions that operate in countries where those currencies are used or where the local currencies are linked to those currencies (e.g. the GCC where the currencies are pegged to the US dollar).  In other countries, like Indonesia, Islamic financial institutions can still use the USD or EUR sukuk, but will have to manage the currency risk that is built in to their balance sheet with assets denominated in Rupiah and the liabilities denominated in US dollars.  Their other alternative–and one that the Indonesian government is helping with–is to use Rupiah-denominated Islamic T-bills to fund their operations against their Rupiah-denominated assets.

So, while the benefits from a multilateral organization like the IILM developing short-term sukuk denominated in USD and EUR, it will not remove the benefit that can come from individual countries developing local currency short-term sukuk (not to mention the diversity of structures that can improve the sukuk market overall which I mentioned in my post). It will also make the development of standardized Shari’ah-compliant currency swaps more beneficial because IILM sukuk will be denominated in non-local currencies for many Islamic financial institutions.

AUGUST 1, 2011

 This week’s newsletter is a day late because I was traveling this past weekend.  While I was away, I was pointed to a New York Times article about David Yerushalmi, one of the leaders of the “anti-Shari’ah” movement in the United States.  While it generally focuses on the politics behind the movement, it does include a mention of Islamic finance:

Mr. Yerushalmi also took aim at the industry of Islamic finance — specifically American banks offering funds that invest only in companies deemed permissible under Shariah, which would exclude, for example, those that deal in alcohol, pork or gambling.

In the spring of 2008, Mr. [Frank] Gaffney arranged meetings with officials at the Treasury Department, including Robert M. Kimmitt, then the deputy secretary, and Stuart A. Levey, then the under secretary for terrorism and financial intelligence. Mr. Yerushalmi warned them about what he characterized as the lack of transparency and other dangers of Shariah-compliant finance.

In an interview, Mr. Levey said he found Mr. Yerushalmi’s presentation of Shariah “sweeping and, ultimately, unconvincing.”

For Mr. Yerushalmi, the meetings led to a shift in strategy. “If you can’t move policy at the federal level, well, where do you go?” he said. “You go to the states.”

For anyone not familiar with the anti-Shari’ah movement, it is primarily a fringe conservative idea that Muslims are focused on “imposing Shari’ah” in the United States (and citations of some of the American crowd by the shooter in Norway suggest that it may also have appeal beyond the US).  The “movement” uses flimsy or non-existent evidence to support their arguments and the arguments are often composed of the same three or four people using each others’ “research” as evidence for the “plot”.

When it comes to Islamic finance, the theory goes that Islamic finance is “jihad with money” and so promotion of Islamic finance–or even toleration of Islamic finance–equates to support for the plot to “impose Shari’ah”.  If the proponents were not given serious consideration in some press outlets and were not successful in getting anti-Muslim laws passed (including one in South Dakota, which tried to ban sukuk), they would hard to read with a straight face.

However, they are impacting the political environment in the United States (and in Europe, Nigeria, South Korea) and actually making it more difficult for Islamic financial institutions to operate in these countries.  This is to the detriment of the Islamic finance industry as well as those countries.  If Islamic finance were more understood and common in the US, particularly on Wall Street itself (rather than through foreign branches of the big financial institutions), it could add a very efficient, capital rich hub to the global Islamic financial industry.  While the banks on Wall Street are convenient (and not altogether deserving) punching bags, the US capital markets lead the world in many areas and have many experienced people working for them who could make a contribution to improving the efficiency of Islamic finance if there were not such a stigma attached in the United States that may dissuade some of them from becoming involved.

This is a loss to the industry, but the stifling of Islamic financial institutions that cater to the portion of Muslims who refuse to use conventional banks is a much greater loss to society, to these individuals and to non-Muslims who could find a new type of finance available if Islamic banks could easily set up shop in markets where they cannot survive on only the population of Muslims who refuse conventional banks.

I don’t know what can be done to minimize the anti-Shari’ah folks–perhaps it will just take time for the fires they light to burn out–but it remains a constant reminder that Islamic finance is still a very small, misunderstood part of the global financial world.  If it is to continue what has been reported as rapid growth (hard numbers about growth rate of the industry are imprecise), the broader financial markets will have to come to recognize Islamic finance as an important source of sustainable growth.  Currently, the large centers of global finance are located, for the most part, outside of the countries with large Muslim populations and one of the largest is located in a country (the US) with an active movement hostile towards Islamic finance.

Further reading:

I have written in the Islamic Globe about David Yerushalmi and the proposed South Dakota sukuk ban.

Professor Haidar Hamoudi, who is much more qualified in legal topics than I am, wrote a blog post on the South Dakota proposed sukuk ban and its unintended consequences.