April 2011

APRIL 24, 2011

No newsletter this week.  The next issue will be emailed next week.

APRIL 17, 2011

I have continued to think through the arguments I made in my last post (see below) about the distinction between form and substance being more appropriately discussed as a pragmatism versus idealism.  The argument is valid I think, but a few ideas that might not have been clearly enough made in the blog post are called for.

First, while I stick to my belief that there are plenty of ways outside of banking where profit-and-loss sharing are used and are more appropriate, I want to reiterate that the point of the post was not to malign the critics who want Islamic finance to do more than replicate conventional products.  The distinction in my eyes is to focus on what the purpose of different products is and to be wary of the replications that create Islamic versions of products which benefit the banks at the customers expense.  Those types of ‘innovations’ represent the most cynical aspects of Islamic finance; financial institutions reaching to maximize their own fees while providing products that are of dubious benefit to customers.

Even those products that are viewed as being the most cynical–like tawarruq–are not necessarily always bad for Islamic finance use.  For example, there is no way that I know of for an Islamic finance product to provide an education loan because how would that fit into the other products used.  It is not a tangible good that could be financed using ijara or murabaha.  It is not a good fit either for a profit-sharing product because it would be extremely difficult to measure the “profit” to be divided between the financier and person receiving finance.  And yet, education is something which provides a social return on investment, as well as to the person getting more education.  It is clearly beneficial (and in demand) and so the use of even a controversial product will provide benefit to both parties.

The main perspective of the blog post was not on this individual level, but on a more macro level.  Is it possible–as the world works today–to expect a bank (to use one example) to shift its product mix away from debt-based products and towards profit-and-loss sharing products?  Are banks capable of handling that type of risk?  Are the regulations in place to allow it to be done in a way that protects the financial system?  Will depositors actually demand a product (deposit accounts) in which they directly bear the risk of these types of investments (however it might be minimized by using profit-equalization reserve accounts)?

My answer is no.  I don’t think any of these questions can be answered affirmatively.  That doesn’t mean that there can’t be other financial entities that offer a profit-and-loss sharing product that consumers will demand, that the offering institution will be able to manage and that regulations will fit the types of products being offered.  It just won’t be a bank as we (as consumers and financial professionals) and regulators view banks today.  This is the main point at which I define the problem as pragmatic versus idealistic (and align myself with the former).  The idealism that banks should change their product mix towards profit-and-loss sharing is in my view misplaced.  There are many other areas where a preference for profit-and-loss sharing can be materialized and I think that “forcing the square peg into the round hole” with PLS in a banking context is misdirected energy.

APRIL 10, 2011

Since I am still in Berkeley and travelling for most of the rest of the day, I will just make this newsletter short.  I spoke at the Berkeley Islamic Finance Forum yesterday.  I posted my speech up on my blog (which is also below).  Regular blogging should be back next week.

APRIL 3, 2011

When I was running through the headlines, one story caught my eye: “Indonesia’s finance ministry plans to issue 3-month, 6-month and 12-month sharia T-bills starting from the end of the second quarter this year, said sharia director at the debt office.”.  It reiterates plans by the Indonesian government to start issuing 3-, 6- and 12-month sukuk T-bills to complement their other sukuk issuance (and to replace T-bills which were stopped to “reduce volatile capital inflows”.  There were few details available to illuminate the structure they planned to use, but it is likely that it would be based on salam or ijara (like the Central Bank of Bahrain) or murabaha (like most other short-term liquidity management tools used by Islamic financial institutions.  I have spent many words throughout the past few years about how essential it is to develop alternatives to the inter-bank lending market to strengthen the industry’s resiliency in the face of future liquidity crises (like what conventional finance faced in 2008, when interbank money markets nearly shut down entirely).

The Indonesia sukuk T-bills would probably resemble CBB’s short term issuance (which has continued despite the protests in Bahrain, albeit at elevated yields).  Both are short-term, local-currency denominated and thus aimed primarily at the local market.  This is how it should work–there is no benefit to a central bank trying to be the source of liquidity for all Islamic banks around the word.  This is much better facilitated through multi-lateral organizations like the International Islamic Liquidity Management Corporation.

Bahrain presents a good example of the product structures for short-term instruments.  They have the 3-month salam and 6-month ijara sukuk.  The former, representing a debt receivable (in the form of a commodity), are not tradable (except at par), but with a short maturity, that is probably not problematic.  The same trading restrictions would be placed on a short-term murabaha or tawarruq sukuk, it that were used in Indonesia.   Issuing the 6-month sukuk using ijara (which does permit trading) alongside a non-tradable shorter-maturity sukuk does allow for some benchmark rate to be determined in the market.

This is useful for Islamic financial institutions and adds a new dimension to the creation of a Shari’ah-compliant, sovereign yield curve, which should help more efficiently price sukuk given local market conditions that would not be picked up using a benchmark like LIBOR.  Specifically, in previous government sukuk auctions, the yields demanded by investors has been higher for sukuk than conventional bonds of a similar maturity.  There may be no inherent difference in the economic outcome from a government bond and a government sukuk, but that does not mean they should be priced identically if the secondary market for one is more liquid than the other.  This illiquidity premium is also probably meaningful when pricing corporate sukuk in Indonesia because the secondary market for corporate sukuk is probably equally as illiquid and the “illiquidity premium” attached to government sukuk can be used as a measure of the illiquidity premium for a given corporate sukuk of similar maturity.

While I strayed from the initial subject of the post, the development of liquidity management products through short-term government sukuk issues, I think it demonstrates that one can not always look at one problem in isolation.  Developments to help alleviate one problem can also work to improve the industry in other areas.  In this specific case, a short-term government bond developed to help Islamic banks manage excess and deficient liqudity can also broaden the Shari’ah-compliant yield curve to new maturities and help market participants better price in liquidity risks to sukuk markets.