February 2011

FEBRUARY 27, 2011

One aspect that I did not touch on when discussing the Grand Mufti of Dubai’s ruling that charging profit on the period of construction delay under a forward ijara lease is whether this practice is consistent with the general belief that Islamic finance is concerned with fairness between the two parties.  On its face, the idea that you could be forced to pay rent on something that is not constructed seems unfair to the renter.  However, if there were a stipulation that if the leased unit were not available, the lessor (the bank) had to substitute a comparable unit, it would seem more fair a deal.  To be clear, I don’t know whether or not a substitute rental unit was made available by the bank and the comments from people with the contracts made it appear that the rental for the period from the original delivery date to today was being requested now with no previous requests.

However, the way I understand the forward ijara contract (and I may be incorrect; please correct me if I am), the reason the lease payments start on the anticipated date of completion is to avoid the uncertainty that would be created if the lease payments started vaguely “when the leased unit is completed”.  This would open the contract up to much more doubt that would likely favor the lessor (who could decide when the unit is completed) and be able to unilaterally determine when lease payments began.

The contract is designed to remove one type of imbalance between the two parties by providing certainty about when the lease payments would begin.  However, if the lease payments begin on the date specified in the contract and the asset being leased is not constructed at that point, then there should be some benefit provided to the lessee who is making payments (a lease payment is made in exchange for the benefit from the use of something).  If I understand it correctly, then as long as the lessor provides a replacement property so that the lessee can realize the benefits, then it is fine for the lease payments to begin before construction has been completed.  In this case, it doesn’t appear that this was done and so the Grand Mufti’s judgment that the contract is not Shari’ah-compliant (based on how it was executed) makes sense.  However, as I said in the post, I don’t have enough information or expertise to say anything definitively, and there will likely be more developments in the future to clarify the real issues at the heart of this situation.

FEBRUARY 20, 2011

The market for Islamic derivatives products is nascent, with a few products available, and a few standard contracts available (most notably the International Islamic Finance Market’s Tahawwut master agreement).  However, even with the master agreement, there are uncertainties that remain about what uses of Islamic derivatives are permissible.  This will be one focus of new rules developed by the International Shari’ah Research Academy (ISRA) in Malaysia for Bank Negara Malaysia.

The ISRA rules for Islamic derivatives are in part motivated because of questions around Shari’ah-compliance that are in part caused by the purpose of Islamic derivatives: “hedging” or “speculation”.  The head of ISRA’s research affairs Asyraf Wajdi is quoted: “Islamic derivatives is still a controversial instrument even though the objectives where the instrument was introduced are clear and noble to hedge against potential risks [...] What is the difference between speculative trading and hedging? We have to define clearly what is hedging.”

This raises a couple of questions in my mind.  First, if an institution uses the product for a “non-hedging” or “speculative” purpose, what will be the ramification?  Will they be forced to treat any income (or losses prevented) as non-permissible income?  Will the Shari’ah board mention this if it is frequent in the Shari’ah report that is presented to shareholders?  Will it create other sanctions for Islamic financial institutions in countries, like Malaysia, that have national Shari’ah boards?

If non-hedging uses are prohibited for both parties, then there will need to be 1) equal volumes of people wanting to take each side of the contracts for hedging purposes; and, 2) there will need to be a way for the parties to meet one another.  The other alternative if one side of the derivatives transaction can be done for “speculation” (more specifically, as part of a financial institution’s business where it does not have a need to hedge a specific risk) is for conventional banks to act as counterparty in the transactions.

The conventional banks would not be concerned with the Shari’ah issues in a transaction and could play an important role in the market by filling the role of counterparty when there is a mismatch between the volume in demand of Shari’ah-compliant institutions wanting to hedge against a given type of risk.  However, it would be controversial if these institutions were involved in a large share of the market for Islamic derivatives and it is an open question whether Shari’ah scholars would approve the transaction if one side were essentially engaged in “speculation” while the other (from within the Islamic financial industry) had a legitimate “hedging” purpose.

If both parties were required to have a risk to hedge, it would probably keep the market small and underdeveloped (much as it has remained for years).  If one party that doesn’t have a requirement for Shari’ah-compliance can step in as a counterparty, even without a hedging need (where it could hedge itself with other Islamic derivatives or conventional derivatives), it would encourage the market, but it would undoubtedly attract criticism.

FEBRUARY 13, 2011

Last week in the newsletter, I provided some of my first thoughts about the Qatar Central Bank directive forcing conventional banks to close their Islamic windows.  As a few more details were released during the week, I added a few posts on my blog (see below).  However, there have been few additional details released since then, so this newsletter will cover another topic that I have covered in past newsletters, the regulation of Shari’ah boards to mitigate their perceived conflicts of interests.

As a bit of background, Funds@Work has released several publications analyzing the relationships between different Shari’ah scholars in terms of educational background and their affiliations (and the connections through these affiliations with other Shari’ah scholars).  The data has been compiled and made public through a subscription service (www.ShariahScholars.com) in collaboration with Zawya.  While the full database is limited to subscribers, there are some limited data freely available.  It is one unique source of transparency in an industry lacking many quality sources of data.

In the latest Funds@Work report (link is available from Islamic Finance Resources), Murat Unal raises a number of questions, but there were three that I thought I could offer a few of my own thoughts on (and as always I welcome your feedback on the questions as well as my responses).

“What is the optimal  number of board memberships [and] if we accept that Shari’ah scholars have different capabilities [...] why don’t we leave the optimal number to the IFIs?”

I am not sure it is possible to determine the maximum level of boards any given scholar can sit on and arbitrary limits will generally not help unless these board seats are taken instead by younger, less recognizable scholars working with at least one senior scholar. In fact, the limitation could lead to a bias towards the better funded institutions (particularly multinational financial institutions). For example, Citigroup, which has a tiny Islamic finance subsidiary has three very prominent scholars on its board (not to pick on any one institution, but I happened to be looking at their website recently). If these scholars are able to only choose 10 institutions, then they will likely choose only the ones that either have the best compensation or that have the highest “prestige”. The other Islamic financial institutions will either be forced to bid up the cost of their services or suffer a competitive disadvantage of having a less recognizable board of Shari’ah scholars. It will also reduce the interaction between the senior scholars and younger or less recognized scholars if the few institutions that can attract the most recognizable scholars (and do not also have other scholars that can benefit from working with the top scholars). That will slow the diffusion of knowledge from the older to younger generation of scholars and ultimately hurt the potential for growth in the industry.

“Why is remuneration of Shari’ah scholars not made public specifically in the case of listed companies where shareholders have a specific right to ask for greater transparency?”

I do not know why this is not already the case.  It is not necessary for every employee of a publicly-traded company to have his or her salary released to the public in the regular financial statements of a company, but it is common practice for the officers and directors (which includes the top management and corporate board) to have their compensation released in financial statements.  The Shari’ah board plays an equally important role in these institutions to the corporate board of directors (and perhaps even greater because they legitimize the institution’s products).  It would benefit shareholders to determine whether the quality of the board merits their pay and to benchmark the compensation (both amount and structure) with other institutions to assess the corporate board’s job acting as fiduciaries for shareholders.

“We know from prior research that changes in board structure increase the board’s monitoring and control capacity and can be beneficial to innovativeneess.  Should limits (in years) to board memberships and rotation be institutionalized?”

I think that this is a much more tenable solution to the Shari’ah scholars perceived/potential conflict of interest issue and also encourages the spread of knowledge among Shari’ah scholars by changing the composition of boards periodically thus creating greater diversity of personnel who work together on Shari’ah boards.  Similar rules were put in place following the Enron scandal with the partners responsible for auditing a given firm rotating every five years.  A similar rotation would be beneficial for Islamic finance because it would reduce the potential for Shari’ah scholars to become too close to the firms they are overseeing in order to make sure they remain on the Shari’ah board.  It would also cut down on the accusations of “scholar shopping” because if a product is offered continuously by an institution, it would be reviewed anew by each permutation of the Shari’ah board (who have to certify that all the institution’s products offered in the past year were Shari’ah-compliant).  This would be more effective, although more time consuming, if the members of the Shari’ah board had staggered rotation periods (so that every 2 years, one board member was replaced, for example).
FEBRUARY 6, 2011
Reuters is reporting that the central bank of Qatar has told conventional banks that they must close their Islamic windows by December 31st, “amid worries of overlap between the two”.  On face value, the move is good for Islamic banking because it reduces the questions about the sources of funds used by Islamic windows and their commingling with (or origin as) funds from interest-based banking.  It also could be viewed as positive because it will reduce the excess supply of Islamic banking products from too many lenders in some countries.

However, I think this is somewhat short-sighted for Islamic banking because it reduces the competitive pressures from conventional bank’s Islamic windows which force all Islamic banks to adopt best practices that multinational financial institutions use to efficiently offer their banking products.  Without the competition from these institutions, it could lead to higher costs for consumers if their only option is wholly Islamic banks, which may have deployed less technology in their businesses.  This might be the case not because the Islamic banks are inherently any less efficient than conventional banks, but because they are generally younger institutions and have not had decades of experience (in most cases) from which they can learn how to deliver financial products in the most efficient way possible.
On the other hand, there could be some benefit to the Islamic banking industry if the wholly Islamic banks are able to increase their market share and thus also increase their size.  Many Islamic banks have been less efficient because of their relatively small size compared to conventional banks.  This means that there are fewer customers across which they can spread their fixed expenses.
It will be interesting to watch how conventional banks in Qatar push back against rules that force their divestiture or closure of their Islamic windows and whether any decide to either spin off their Islamic units into stand-alone Islamic banks or sell them to wholly Islamic banks.  If they choose to do the latter, it could speed up the growth in the size of the acquiring Islamic banks and, if the acquisitions can be integrated in quickly, could speed up the growth in Islamic banks.  One potential pitfall will be if the conventional banks with Islamic windows are able to avoid the impact of the rule change by separating their Islamic windows from the rest of the bank without divesting or closing them.  This is always a possibility and in the world of finance, many institutions will take whatever means they need to in order to avoid the impact of new regulations.  This will pose a challenge to the central bank to ensure that the spirit of the new rules are implemented, not just their letter.