July 2011

JULY 24, 2011

There are reports that with the increase in the capital of the Islamic Corporation for the Insurance of Export Credit and Investment (ICIEC), part of the Islamic Development Bank Group, the ICIEC will offer third-party guarantees for sukuk.  It appears from first glance that this could be an example of Islamic finance leaning into the wind rather than following on the latest and greatest product developed in the conventional financial markets.
My understanding of conventional bond markets, especially the common practices, is not great, but there are two areas in the US where bond insurance has been less successful than envisaged at the outset.  The first is the practice of providing an implicit government guarantee for the debt of the quasi-governmental entities Fannie Mae and Freddie Mac.  When the guarantees were needed and the institutions were weighed down by losses, the government stepped in and essentially took control to keep them from failing.  The second area where bond insurance is common is in municipal bonds where there are several bond insurance companies (e.g. FGIC, AMBAC, MBIA) that ran into significant financial difficulties during the financial crisis.  However, in this case, the intended market for their bond insurance were not the cause of most of the financial problems; instead, they faced large losses on mortgage-backed securities they insured.

When I say that the ICIEC appears to be leaning into the wind, I mean that as a complement.  Bond insurance is seemingly discredited with the failure of Freddie and Fannie and failure or near-failure of the bond insurers, however, their initial purpose did not lead to their failure but they were doomed by overextending themselves into areas where they did not have enough knowledge to adequately price the risk (and charge a sufficiently large enough premium.

If the ICIEC sukuk insurance plans move forward, it will be important that the insurance be targeted towards sukuk whose risks are more easily determined and not towards the structured products, which could come with tail risks that aren’t able to be built into the pricing of the risk ex ante.  This shouldn’t be a problem because there is unlikely to be a shortage of sukuk for the ICIEC to insure (and ensure that their growth meets the expectations of the ICIEC/IDB member countries).  There is also unlikely to be much competition from other insurers that will drive down the cost of insurance below the cost needed to cover losses from default without forcing the ICIEC to go to the IDB or IDB member countries cap in hand looking for a bailout.

JULY 17, 2011

The Consultative Group to Assist the Poor (CGAP), the microfinance arm of the World Bank had a competition focused on Islamic microfinance last year and after it concluded, they had a series of blog posts highlighting the successes in Islamic microfinance programs that were in the competition.  They recently posted a summary of the points from the earlier blogs, which I found interesting.  There were two points in particular, about which I have some comments.

Savings: Wherever regulation allows, savings should be a core element of an Islamic microfinance business model. As in conventional microfinance, it is believed that more Muslims would benefit from savings than from loans². Since the majority of savings accounts Muslims have access to earn interest, there is a disincentive for Muslims to hold bank accounts. Also, having Shariah-compliant savings accounts will help mobilize deposits and instill a culture of savings as well as contribute to economic development.

The role of microfinance (note it is microfinance, not microlending) in promoting savings is important, both on the conventional side as well as Islamic, because it can serve as insurance in some ways if the clients have access to the funds for unexpected or large expenses like medical care or education, both of which will benefit the clients as well as the microfinance institution (by limiting the likelihood of default caused by illness of the client and by increasing the prospects for the children of the client who will be more likely to avoid poverty if they are able to finish more education).  However, the benefits from savings could be limited if there is a significant possibility that the client’s deposits are not secure if there is no deposit insurance (as there is unlikely to be).  If Islamic microfinance adopts more profit-and-loss sharing instruments like mudaraba and musharaka, where the prospects for losses are likely to be higher and the MFI is not part of a wider network of MFIs that could provide an opportunity for some mutual insurance even absent a government-based deposit insurance program, then the savings product will not be used and clients will keep their savings elsewhere.

If clients do not use the savings product because of fear of loss if the MFI becomes insolvent, then the MFI will be hurt as well because deposits can provide a much more stable and cheap source of funding for expanding the financing side of Islamic microfinance compared to external funding.  It will also keep more of the profits locally (compared with for-profit microfinance investment from external sources).  If more of the profits are kept locally, it will provide greater benefit to clients who will benefit both as savers generating a return on their deposit, and as borrowers who have greater access to financial services.  For this reason, the credit union model of microfinance, as used by the World Council of Credit Unions in Afghanistan or the model being tested by Mahmoud El-Gamal et al. in Egypt makes more sense than either a non-profit or (especially) a for-profit MFI.  That is not to condemn either of the latter two; institutional diversity can bring benefits, but a client-owned institution does have some benefits that the other two lack.

However, in all cases, inclusion of a savings program alongside financing programs is beneficial.  However, the issue of safeguarding the deposits against MFI insolvency will have to be addressed.  A mutual deposit insurance program (organized either by a government or an apex organization) can benefit in this regards by setting up a deposit insurance pool (e.g. using a takaful model) and managing the risks and setting the premiums for the deposit insurance to compensate for expected losses.  When designing this, it will be important to get enough diversification for the deposit insurance pool, perhaps more so than for banks, because the events that create insolvency could be particularly widespread and not only based on changing economic conditions.  For example, a drought or natural disaster could hit a wide area and will not necessarily be specific to one country.

Less likely to have over-indebtedness problems: Such a model would require a more thorough investigation of the client, especially because Sharia compliant models do not use any kinds of guarantee except against negligence behaviors. Moreover, the MFI will have to make sure that its funds are going towards economic activity/enterprise development. In fact, the MFI will be the one who will buy those assets in most of the cases. Due to this set-up, it will not be possible for an MFI to make profit and to flourish while its clients are suffering, as was the case in Andhra Pradesh in India, for instance.

I take some issue with the idea that Islamic microfinance will be less susceptible to over-indebtedness and that Islamic microfinance should take only fund “economic activity/enterprise development”.  There is a significant role to funding economic activity rather than individual purchases, but limiting Islamic microfinance to just that area ignores the impact that a purchase for household use can have on economic activity, even if the financing does not directly go towards a micro-business.  Funds used to enroll children in school, get basic medical care or make household purchases can have benefits that take time to accrue.  One example is providing funding to switch from wood burning ovens in homes to gas burning ovens.  In addition to the change in cooking method, this can have benefits to the family by lowering the incidence of respiratory problems from the smoke created by a wood burning oven.  Improving the household’s health will not directly create economic activity, but it can increase the ability of the members of the household to engage in business because they will spend less time sick.

The other issue with this point is that there is nothing inherent in Islamic microfinance (or macrofinance) that prevents over-indebtedness.  Excessive debt creation is a function of how the microfinance institutions are regulated and how they make financing decisions, including the information they have on clients’ overall debt levels.  If there is no sharing of information, it is quite possible that a client could receive financing from several microfinance institutions and become overindebted.  It may be structured differently from conventional debt, but the amount of borrowing–conventional or Islamic–relative to the ability of the client to service it on current income (and pay for food, housing etc.) and the occurrence of unexpected events, will determine whether the client becomes overindebted and I have no reason to believe that Islamic finance can forestall overindebtedness.

JULY 10, 2011

In the last week, I have written–first in the newsletter last week and followed up with a couple posts on the blog (see below)–about istithmar sukuk and securitization.  However, I don’t know if it is all tied together as well as it could be.  The underlying motivation for this discussion is that Islamic banks are relatively small and while the growth rate is rapid (according to the published estimates, for what it’s worth), the Islamic banking assets are dwarfed by conventional banks by a huge amount.  There are markets where Islamic banking is relatively common, but even there, the uptake is modest (for example, Malaysia’s share is 20% after a decade of promotion).

One method of speeding this growth up requires finding new capital to come into the Islamic finance industry to fund the growth of outstanding financial contracts, even if it does not result from directly increasing the size of bank’s balance sheets.  The method for this would be to increase the very, very modest level of securitization across the industry.  The benefits would be two-fold.  First, banks could transfer their assets off balance sheet, freeing up the capital now tied up in these assets for new loans.  The way that conventional financial institutions have done this is through securitization.  The assets are packaged together and sold to an SPV, which issues bonds whose return is paid from the cash flows of the entire portfolio (this is the simple explanation, it can get much more complicated with tranching of the portfolio for different types of investors).  As the assets in the portfolio make payments (principal plus interest), the cash flows are passed along to the investors, with the bank or an external servicer doing the legwork of collecting payments and managing the assets (for a fee).

For the Islamic investment market, this provides a benefit of creating new tradable assets: the bonds issued by the SPV.  These bonds will represent different types of loans (mortgages, business financing, etc.), or can include some of each category.  The investments (sukuk al-istithmar) will be much easier to create in size because the contract can be standardized and the same institution will be issuing them (easing the standardization even if a global contract is never developed).  Another benefit from repeat sukuk from several issuers is that the learning process by the issuer will not have to be repeated (i.e. if GE figures out how sukuk work and issues one, there is no transfer of that understanding to, say, the World Bank).

Issuance of sukuk by securitizing assets from bank balance sheet using istithmar can free up additional capital on banks balance sheets while providing a much larger level of issuance for investors who have shown a reluctance to sell sukuk in the secondary markets without the confidence that they would be able to find a sukuk to replace the one just sold.  There are pitfalls that have been well discussed with reference to the conventional securitization market about the quality of assets and the incentives that securitization provides to issuers.  That will be something requiring work to minimize these pitfalls (e.g. requiring banks to hold 5% of the bonds created).

Overall, however, the istithmar sukuk securitization process has the potential to spur on the growth of Islamic finance.

JULY 4, 2011

On June 20, 2011, the Malaysian central bank, Bank Negara, unveiled its newest liquidity management product, although few details were offered.  In the first auction on the following day, Bank Negara sold RM500 million.($165 million) of the 1- to 3-year sukuk.  The product itself is based on the istithmar structure, which combines other receivables from murabaha as well as ijara transactions.  In general, under AAOIFI rules, the portfolio must have at least 33% ijara sukuk in order to be traadable, although in many cases, a more conservative interpretation is used where 51% of the portfolio must be ijara.

It is always interesting to see new Shari’ah-compliant liquidity management products come out with different structures (istithmar, commodity murabaha, salam and ijara are the ones I have run across).  However, beyond the liquidity management space, the istithmar structure is becoming more widely used with institutions like the Islamic Development Bank.  The International Finance Corporation used a similar wakala (agency structure) which securitized a portfolio of other contracts.

The thing that I find about this interest in istithmar sukuk is that it (and/or wakala) have potential to replace mudaraba and musharaka sukuk, which were used (and misused) extensively before the financial crisis and the AAOIFI ruling clarifying the rules around the buyback clauses used at maturity of those sukuk.  There may be less concern about misusing structures (or misapplying their rules) in an istithmar sukuk (compared with a mudaraba or musharaka) because the former type is designed to be specifically an investment portfolio, where latter is commonly associated with venture financing (either providing financing from one party in mudaraba or through a joint-venture financing in a musharaka).

It will remain to be seen how much uptake their is in the istithmar sukuk structure but they are likely holding many ijara and murabaha assets on their balance sheets that could be securitized.  It weill likely depend on whether they have sufficient ijara assets to match up with murabaha to get to the threshold to make their sukuk tradable.