January 2011

JANUARY 30, 2011

Apologies for the light posting the last week, I was set back a bit by a brief illness, but should be back to normal next week.

Rushdi Siddiqui’s latest column in Gulf News deals with an important topic connected with Islamic finance; the lack of a focused media organization that reports the news, provides data and commentary without merely just republishing press releases and information about who said what at the latest conference.  He writes:

We have been hearing from many quarters about the lack of awareness (and education) about Islamic finance over the last decade, implying the media formula, as part of Islamic finance, has not succeeded. The message we have repeatedly heard about Islamic finance can be said to be more aligned towards “cheerleading”, and less about its functionality.

I fully agree with his assessment; the media formula has not succeeded and it is difficult to find much commentary except for the occasional piece in a broader subject paper like the Financial Times, The National and the articles written by Mushtak Parker in Arab News.  With the network  of most blogs following the same trends of the Islamic finance media (with some exceptions of course) of republishing articles from other sources, there is a lack of good commentary about the Islamic finance industry that balances the positive aspects of the industry’s growth with well reasoned criticism where it is due.

There are plenty of focused magazines that deal with the goings on in Islamic finance and which provide more detailed coverage of Islamic finance, but often these are authored by people within the industry and the number of reporters focused on providing coverage of the industry is limited to the amount of space dedicated to “cheerleading” about Islamic finance, promoting Islamic financial institutions and products.  There are exceptions of course; one that I find the best is the Opalesque Islamic Finance Intelligence newsletter, which is released monthly and connected with the Islamic Finance Resources blog, which has a fantastic database of resources on Islamic finance.

With apologies for some self-promotion, I think that one of the reasons the article is timely is because the inaugural issue of the Islamic Globe is coming out in February (subscribe by clicking through and going to the “Subscribe” tab) and I will be contributing coverage of Islamic finance in the Americas.  I recommend that everyone subscribe to receive the inaugural issue.  I hope that this will not be the only organization that steps in to fill the need for high-quality journalism on Islamic finance. The more that are out there, the better for encouraging better understanding of Islamic finance and moving beyond the platitudes (“Islamic finance was unaffected by the fnancial crisis”), oversimplifications (“Islamic finance is finance without interest”) and mis-statements (“Everything in Islamic finance is backed by tangible assets”).  And certainly there still remains much ground in the blogging world for greater depth providing analysis of the news and commentary on the current debates in Islamic finance.

JANUARY 23, 2011

I was reading a paper on the risk management approaches used by Islamic banks (or which could be used) to increase the proportion of the financing they extend using mudaraba and musharaka and it clearly illustrates the dilemma facing Islamic banks if they want to shift the balance of their assets from shorter-term murabaha, salam and ijara towards longer-term mudaraba and musharaka financing.  I will ignore the debate about whether it is preferable for Islamic banks to shift towards profit-and-loss sharing instruments; it is another issue entirely.

The dilemma is that longer term assets can increase returns to the banks if they are properly vetted to reduce the percentage which must eventually be written off, either in part or in whole.  This should make the bank’s investment account holders happy, not to mention the bank’s equity shareholders.  However, the diligence process that Islamic banks would be expected to perform for these types of products are not typical for bankers.  Bankers are generally focused on credit risk when making lending decisions and the Islamic banking industry is generally filled with people experienced in conventional banking who likely share this mindset.

A closer analogy in the conventional finance industry to banks offering mudaraba and musharaka would be private equity and venture capital.  In fact, the musharaka structure is essentially the same as private equity and venture capital.  The VC/PE generally provides some capital to their portfolio companies, but also takes a direct role in the management of the business.  A mudaraba is similar, but the provider of capital is generally not permitted to play a role in the management of the business, so it is closer to a passive investor who provides only capital and does not take an active role in the management of the business.

The distinction between the banker’s focus on credit risk and the VC/PE industry’s focus on the likelihood of success (i.e. profitability) of the underlying business demonstrates how difficult it would be for bankers to cross over and be comfortable evaluating the risks and prospects of more risky, uncertain investments done through mudaraba and musharaka.  This more than the need to develop of different product structures may explain the predominance of products that replicate conventional lending (where credit risk is the predominant risk) and the limits of profit-sharing lending by Islamic banks.

JANUARY 16, 2011

A few articles this week have highlighted the needs for long-term sukuk for takaful companies to invest their assets to match durations with their long-term liabilities.  However, I think the problem is more fundamental than just a lack of long-term sukuk for takaful funds.  There are far too few sukuk of all maturities for takaful funds to invest in.

In a presentation by Geert Bossuyt (using some figures from the Ernst & Young World Takaful 2009 report), the difference in asset allocation is stark:

  • GCC takaful companies are invested in approximately 30% deposits, 20% sukuk, 10% real estate and 40% equities
  • Malaysian takaful companies are invested in approximately 20% deposits, 45% sukuk, 5% real estate and 30% equities
  • Conventional insurers are invested in <5% real estate, 35% equities, 45% bonds, 5% deposits and 10% other investments

When I looked at one mutual insurer. the difference was even more stark.  It was invested 88% in fixed income (81% investment grade), 5% in private equity, 4% real estate and 3% equities.  Even using the numbers on the presentation from Mr. Bossuyt and the numbers from the World Takaful Report, there are far too few investment opportunities for takaful funds in sukuk.  A much larger share of the non-equity component is held in deposits than sukuk (compared with the ratio of deposits to bonds for conventional insurers).

The investments of the mutual insurance company that I looked at also revealed diversification across types of fixed income investments that takaful funds would have trouble replicating.  40% of the portfolio (fixed income plus other assets) was corporate bonds, 6% was sovereign (U.S.) debt, 3% municipal (state and local governments) bonds and the remainder was in asset-backed bonds, residential and commercial mortgage backed securities (RMBS and CMBS) and individual commercial loans.  Of the credit qualities represented, 90% of the fixed income portfolio was investment-grade; only 10% was high-yield.

The significance of corporate bonds and mortgage-backed securities (and other asset-backed bonds) in the mutual insurers portfolio would make it difficult for a takaful fund to match the asset allocation of conventional insurance (particularly in the GCC).  Malaysia’s sukuk markets have a greater diversity of sukuk issuers, which is reflected by the higher share of investment in sukuk compared with deposits than the GCC.

It is certainly true that the maturity profile of sukuk issued by all issuers worldwide is too compressed in the 3-to-10 year range.  However, there are also too few corporate issuers (particularly outside of Malaysia).  There are also too many “asset-based” (i.e. unsecured) sukuk compared with asset-backed sukuk.  On this latter point, I think the potential for the International Islamic Financial Market (IIFM) to create a master agreement for asset-backed sukuk is definitely important and may be more significant than expanding the maturity diversification of sukuk.  

JANUARY 9, 2011

I am always hesitant to raise issues of politics as it connects with Islamic finance, but there are times when politics and finance connect in an indirect way that necessitates some observation.  Islamic finance has become one front in a war of words with critics alleging that it is part of a nefarious plot; one critic described “Sharia[-compliant] finance is jihad with money”.  The rhetoric has been heated for years with many of the same (debunked) arguments used for why Islamic finance is somehow dangerous to the West and the United States in particular (perhaps I see a disproportionate share in the US because that is where I am based).

Efforts to place Islamic finance on level ground with conventional finance in France and South Korea have faced hurdles placed by critics of the industry (or the politicians who share their views).  In the US, one group even sued the US government for its bailout of AIG because of AIG’s takaful unit.  However, the rhetoric against Islamic finance has stayed as just rhetoric.

With the recent tragic assassination in Arizona, however, I think the Islamic finance industry–particularly in the West–needs to consider how to improve its outreach and better explain what it is and why it exists, lest the overheated rhetoric combined with general ignorance lead to an attack on Islamic finance.  I hope that this message can soon be written off as just my response to a shocking event, but the general political rhetoric that is receiving a second look in response to Arizona is not too far removed from some of the “anti-Islamic finance” crowd.  They insinuate that Islamic finance involves financing of violence and even claim that it is part of a religious war, creating an “us-versus-them” mentality that we see can lead to tragic results.

The only reasonable response to this rhetoric is rational explanation of Islamic finance to educate people about what it actually is because that is the only antidote to the spread of incendiary falsehoods in any situation.  It is our responsibility as people working in, researching and writing about Islamic finance to educate those we come into contact with about Islamic finance.  As Mushtak Parker described, there are three types of people involved with Islamic finance: the diehard optimist, the fairweather fans and the hard-working pragmatists “who believe in Islamic finance not merely because of their faith traditions (not only Islam) but because they believe and have proven that Islamic finance is eminently workable, here to stay and a force for good in economic development, shareholder value and wealth creation and effecting socio-economic justice.”

Most of the people with whom I speak with about Islamic finance fall into that third group.  They work behind the scenes largely within the Islamic finance industry.  But now, I think, there has to be a broader focus.  Continue to work within the industry to improve it, but also educate the people who respond with a puzzled look when you mention Islamic finance.

JANUARY 2, 2011

Happy New Year!

With the new year, it is time for the predictions for the upcoming year, so I’ll offer a few of my own.  Please feel free to email this newsletter to others.  If this gets emailed to you and you would like to subscribe, just email me at blake@sharingrisk.org or enter your email on my blog:http://investhalal.blogspot.com

1) The focus of Islamic finance will shift back from Malaysia to the GCC as rising oil prices create excess liquidity to finance infrastructure projects
In the immediate aftermath of the credit crisis, the impact was not felt as much in the GCC as much as it was in Malaysia, with a sharp drop in sukuk issuance, for example.  However, the crisis spread to the GCC leading to the Dubai debt crisis caused  investor nervousness about the etire region while Malaysia rebounded quickly.  This has led to GCC corporates issuing sukuk in Malaysia.  However, despite having a more developed secondary market for sukuk, Malaysia is a much smaller market and cannot absorb all of the sukuk that GCC issuers will want to issue.  This will force issuers to turn back to the domestic markets, which will be boosted as the troubled investment banks and government-related enterprises finish up their restructuring or cease to do business entirely.  While secondary market liquidity will still be limited, the new sukuk from issuers who have weathered the crisis, supported by continued sovereign issuance, will lead to a more liquid secondary market.  International issuers like GE Capital will return to the market, which will increase confidence among investors and regional issues.

2) The International Islamic Liquidity Management Corporation will begin issuing USD-denominated sukuk but the impact of these sukuk will be limited by the lack of a structure for an “Islamic repo”.  This will concentrate the interest of investors on the shortest maturity sukuk
The ILMC will issue its sukuk with maturities of up to 1 year.  However, as liquidity management tools, only the shortest maturity (less than 3 months) will see widespread demand because the development of a secondary market will be slower than expected.  Without the ability to undertake repo transactions bcause of Shari’ah-compliance issues with the structure of the repo transaction and little difference in rates between the 4 week and 52 week sukuk, financial institutions will have a preference for short maturity sukuk, even at nearly zero return.

3) There will be a few larger Islamic banks launched, but the hope for a ‘mega-bank’ will continue to be an elusive dream
It has been a consistent theme over the past several years that a ‘mega Islamic bank’ will help Islamic finance can create competition with the Islamic windows of conventional multinational banks.  However, whether a dispute over the location of the headquarters or difficulty raising capital, the dream has proven to be elusive.  The current plans for an IDB-sponsored mega bank and the mega-bank awaiting approval in Malaysia will be launched, but will not start with the capital sufficient to compete with multinational banks.  Their growth will be hampered by too few investment opportunities and lower demand for credit among the companies who have recovered their health in the wake of the global recession.

I always doubt that any of the predictions rolled out at the start of each year are likely to happen, and I don’t have any more confidence in my own predictions.  But it provides a couple of things for readers to think over.  If you disagree or have predictions of your own, email them to me and if there are enough, I might put them up with my own predictions on my blog.  When you email me, let me know whether or not you want your comments and predictions to remain anonymous, and if so, how you want to be described (e.g. investment banker in Qatar, etc.).