June 2011

JUNE 26, 2011

Since I discussed the UAE central bank Islamic repo facility which will be available soon, I have continued to decide what about it troubles me.  It is a different reaction than I would have expected based on the serious problem that an Islamic repo solves (when backed by a sovereign credit).  I still believe that liquidity management is one of the most important challenges facing Islamic banks, and a sovereign (or central bank-based) solution that provides short term liquidity to banks to act as a source of credit as a last resort, like when private inter-bank markets freeze up like they did during the fall of 2008.

That being said, the system proposed by the UAE central bank represents a cynical view of the Islamic finance industry (talk of differences between it and conventional finance while developing products that mirror almost exactly the conventional system) or a view by the central bank that the problem represents a near-term threat to Islamic banks (which may be some of the mindset since the UAE faced its banking crisis following the housing meltdown).  However, which ever explanation is the case, the longer it is used, the harder it will become to change it.

The specific aspect that troubles me is that both the Islamic CD and the credit provided in the Islamic repo are based on commodity murabaha.  I can’t make a case about whether there are any Shari’ah issues with the product, but the perception will add to the difficulty of explaining how Islamic finance differs from conventional finance.

It would be legitimate at this point to accuse me of wanting to have my cake and eat it too because I have supported using products that replicate conventional products as a way to expand the industry and make it more competitive with conventional finance.  For some reason though I cannot quite accept the idea of using a commodity murabaha that is collateralized by debt representing the outcome of another commodity murabaha.  At what point will the cycle of offering commodity murabahas collateralized by commodity murabahas that are themselves collateralized by commodity murabaha.

Or, maybe I am creating a double standard where some replication is ok and other is not.  The UAE Central Bank has two PDFs describing:
-The Islamic CD; and,
-The collateralized commodity murabaha.

I would be interested in hearing your thoughts.  Am I creating a double standard or is there something about this particular product that crosses a threshold?

JUNE 19, 2011

Mohammed Khnifer wrote an article (the second in a series) that paints a disturbing picture of the job market for graduates, even as the speakers at conferences say there is a huge talent shortage in the industry as a whole.  It suggests that either there is a disconnect between the skills that Islamic financial institutions want and what these programs provide, or there is not actually a shortage in the less experienced jobs available from Islamic financial institutions, and the shortage is at higher levels in management.

Neither is promising for Islamic finance graduates, but the former is more easily fixable than the latter.  However, if the Islamic finance programs are in fact not offering training in the skills in demand (for which they are charging significant tuition), then a cynic would conclude that they only are involved to capture a ‘hot’ area of education in demand and do not have their student’s best interests at heart.

I don’t which one is the case, but it is in some ways a reflection of how the industry works.  Most of the students or aspiring students I have talked to or received emails from are younger, less experienced people–many who recently finished their undergraduate studies–who want to work in the Islamic finance industry, but don’t know how to get a foot in the door and view specialized Islamic finance training as a way to do that.  However, the way the industry works, with a focus on replication of conventional financial products, this is not likely to be an easy way to break into the industry.

A far easier track is there for people with conventional financial experience who want to move horizontally within a firm or from one firm to another.  Their familiarity with how financial institutions work from first hand experience makes them more appealing than someone with less experience but more training.  This presents a dilemma for some people who don’t want to work for conventional financial institutions because there is no substitute for the experience it provides.  By recruiting people largely from within the conventional financial industry, at all levels, there will also be more likelihood that Islamic finance continues to operate in the same way it has for the past several decades and make significant changes to the mix between different products, and business models.

This is the innovation that, if done gradually to avoid disruptions and with enough care to avoid adding too much risk to the industry, will make Islamic finance evolve in a different way than conventional finance.  It will strengthen the industry while at the same time providing a clearer distinction between Islamic and conventional finance.  However, without providing an opportunity for younger financial professionals who are not already traveling down the well worn ruts of conventional finance, this innovation will be slowed.

JUNE 12, 2011

Continuing on the microfinance theme from last week, I came across a paper by Mahmoud El-Gamal, Mohamed El-Komi, Dean Karlan and Adam Osman which developed and tested a Grameen model and a “bank-insured RoSCA” in Egypt to see whether one was superior to the other in attracting clients and ensuring repayment.  The bank-insured RoSCA (rotating savings and credit association) is a slightly modified form of the traditional RoSCA where each participation contributes regularly and each period, one member receives the contribution.  In the modified form, the bank will collect a premium from the participants and if one of them does not pay the contribution, the bank will step in and make the payment and that participant will owe the bank.  It is viewed by the authors as a simplified credit union.

Their test was focused on determining whether the RoSCA would lead to better, worse or the same take-up by participants, as well as whether it would lead to more frequent repayment.  To do so, they used real money in an experimental setting with participants who shared the same demographics as a typical microfinance client (in a country with a large enough Muslim population that a portion would be expected to turn down the Grameen loan because it required interest payments).  However, they did not include any factors that would affect the return on the investment that participants theoretically made (the investment was predetermined to have a certain return).

The reason for the higher frequency of repayment in the RoSCA model is that the loans between participants is interest-free. It will not benefit the participant to renege when the social cost of default is more than the amount of the loan (in the Grameen model, that tipping point is higher, at the amount of the loan plus interest).  In addition, when the social cost of default (which applies to the single defaulter alone) is lower than the loan amount, the bank (which guarantees the RoSCA, and to whom the defaulter becomes a debtor) can raise the cost of the penalty (which applies to both participants) to a level where default by a participant no longer becomes attractive.

In practice, this was borne out in their field experiments.  The RoSCA attracted greater levels of participation and also had lower probability of default, which is what the game theoretic model predicted.  It creates one data point, albeit under simplified assumptions, for how a RoSCA could be used as an alternative to the Grameen model of microfinance, and perhaps even expanded in the future into larger, more formal financial institutions similar to credit unions.  It will be interesting to see what research develops out of this paper–either from the co-authors or from other researchers.

JUNE 5, 2011

The CGAP Islamic Microfinance Challenge 2010 will hopefully lead to further development of Islamic microfinance.  Following the announcement of the winning projects, the CGAP microfinance blog featured posts by the winner and runners up.  Today’s post (link) features the winning institution, the Al Amal Microfinance Bank in Yemen, whose Risk & Compliance Officer provided the description of their winning product.

They will offer tradespeople in Yemen (tailors, carpenters and blacksmiths, for example) ijara financing to fund the purchase of tools for their business.  The clients will pay a monthly rental fee for a set period until the item has been purchased.  During the rental period, the bank will be the owner of the tools (which creates some risk management issues, as well as potential moral hazard, which are not discussed in the blog post).

The project is made sustainable (from a financial perspective) by financing the leases by raising money from businesses who invest in an investment fund composed of the leases.  Without knowing the structure of the investment fund, the microfinance institution can participate in one of two ways.  It could either serve as the mudarib (manager) for the investment fund (or managing musharaka partner) and receive a share of the profits (not necessarily required to be in proportion to the capital contributed in the musharaka on the upside) or as the wakil (agent) for the fund and receive a fixed management fee.

The reason I like this approach is that it is simple.  It is easy to understand how it works.  It allows the clients to buy tools they need, provides the bank with a source of profits and provides an opportunity for the businesses to invest their surplus cash in a microfinance institution (who will also see their need for donations to fund operations and financing lessened or eliminated).  I am no legal expert nor am I an expert on Yemen, but I would guess that in Yemen and many other countries where Islamic microfinance is going to be demanded, finding a simple way to administer the financing that does not presuppose a strong set of legal rules governing commercial transactions will be the most successful.

Even in countries like the US where the legal system is viewed as predictable, a simple solution is preferable because it will likely cost far more to go through the court system to resolve a dispute than it would be worth to the microfinance institution (i.,e. legal costs are likely to exceed the size of the financing making the legal win even assuming it can be collected a Pyrrhic victory).