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The Social Impact of Islamic Finance

2012-01-25T18:23:00.000-08:00

Farooq Sheikh, a student at the Lahore University of Management Sciences, wrote a 2 part series for SocialFinance, a Canadian blog on impact investing ([Part 1] [Part 2]). In a comment, he clarifies what he meant by 'social impact':

"I am referring to an influence which is beneficial to the society and delivers sustainable social and/or environmental benefits without negatively affecting the social fabric in the area one is operating. It means solving the problems of the society (e.g. Providing equity financing to a project which would spur employment) and at the same time earning financial return on the capital for those who have provided the capital."

I am hopeful that Islamic finance will become more focused on the social impact of their activities, instead of just creating the easiest products for them to get Shari'ah approval and make a profit (while donating any non-permissible income to charity as their 'social impact'). There is definitely a wide range of Islamic financial institutions, so to some degree, statements about their concern about social impact are generalizations, but I think it is clear that most Islamic financial institutions are pre-occupied with acting as much like banks as they can.

As much as it may have been the intent of Islamic economists for "money has no intrinsic value and hence cannot be treated as the subject-matter of trade. It is just a medium of exchange. Islamic financing is always based on tangible assets and inventories, unlike its conventional counterparts." There is a significant question about whether this is the case in most transactions, for example, those based on commodity murabaha or tawarruq. These transactions involve tangible assets, but the assets are involved to create a debt (through sale with deferred payment).

For a while I have argued that this use of commodity murabaha is necessary, both to fit within regulatory requirements, but also in areas like liquidity management where other products do not exist. I think this is the case, but without necessarily disagreeing with the idea for Islamic finance that Sheikh described. This, I think, is a clear area where one can differentiate between different uses of commodity murabaha. While I generally support commodity murabaha used for inter-bank money market transactions (though I have critiqued the use of commodity murabaha-based repo transactions collateralized by commodity murabaha-based certificates of deposit), I have been critical of the use of the same structure for deposits.

The difference, I think, is whether there are alternatives that would work as well that are not commodity murabaha. In the case of Islamic repos collateralized by Islamic CDs, the commodity murabaha structure could be maintained for the repo with the collateral being tradable contracts like ijara. In the case of deposits, there are a number of other deposit products like wadiah, qard and mudaraba which are widely used by Islamic banks. It doesn't necessarily address the social impact of Islamic finance, but it can help to combat cynicism that Islamic banks always take the path of least resistance in terms of diverging from the way conventional banks do business.

Islamic finance complexity (Part IIh)

2012-01-20T20:38:00.000-08:00

It has been a while since I added to the Islamic finance complexity series of posts, but I was reading an article that I thought would provide a return to the series (and also back to the liabilities side of Islamic banks' balance sheets). The IFSB is beginning work on its standards for capital adequacy to incorporate changes in Basel 3, which prompted me to look at one of their Guidance Notes already out there (IFDB-4 [pdf]), which deals with capital requirements around profit-sharing investment accounts (PSIA), which are a large part of Islamic banks' liabilities (equivalent to deposits).

The standard from IFSB provides guidance to regulators to determine the treatment of liabilities (and the assets they finance) for capital adequacy calculations. What is at issue with the PSIA is whether the assets financed by PSIA should be given a risk-weighting in the capital computation greater than zero (i.e. there should be some capital set aside for the assets they finance).

The theoretical proposition with PSIA is that the assets the bank invests the PSIA funds in should not be treated as assets needing capital set against it. The logic is that since PSIA investment account holders (IAHs) are liable as rabb ul-mal (in a mudaraba) or muwakkil (in a wakala) to bear any loss and the bank only gets a share of profits (if any) or a fee, respectively, that are generated by the assets.

However, since most Islamic banks--either by choice or because they are required to by their regulators--set up profit-equalization reserves and investment risk reserves, and also can "[forego] all or part of its Mudārib share of profits on investing UIAH [unrestricted IAH] funds, or donating to the UIAH part or all of the profit on investments financed by shareholders’ funds, so as to enhance the profit payout to the UIAH".

As a result, the bank is bearing some displaced commercial risk from the investments financed by IAHs because they will--to some degree--bear the risk of loss in the funds invested that were provided by IAHs. As a result, while the contracts in their pure form would not expose the bank to possible losses, in actuality the bank has to set aside some capital to pay for these losses. The IFSB guidance note provides guidance to regulators to determine the calculation of what portion of assets financed by IAH depositors should be considered "at risk" (thus needing a risk weighting based on their own structure).

One of the more interesting discussions in the guidance notes was surrounding the status of IAHs, in terms of how the regulators expect depositors to be treated should the bank become insolvent:

"In practice, there is considerable ambiguity in the nature and characteristics of UPSIA, which vary among IIFS and jurisdictions. At one extreme, IAH are highly protected so that UPSIA tend to be deposit-like products where the returns are 'stabilised'".

At the other extreme:

"UIAH have no claim as creditors over the assets of the IIFS (as do conventional depositors). Instead, they have a claim to the assets financed by their funds (including their share of any undistributed profits and less any losses), including their share of assets financed by commingled funds, in respect of which they rank pari passu with the shareholders after taking account of the fact that the latter are liable for amounts deposited by current account holders and other creditors."

One note here is that current account holders are depositors under, for example, qard hasan, who have their principal guaranteed, but are not entitled to profit. Between the two extremes, there are any number of possibilities where depositors are neither treated like current account holders or fully liable to lose the full value of their principal. The qualification of UIAH (unrestricted IAH) is done because a restricted IAH would have specific assets financed using their funds and therefore would have their funds at risk of loss based on the performance of the assets they finance.

The distinction in regulatory treatment of mudaraba and wakala depositors across jurisdictions provides another example of how it is not necessarily as simple as arguing whether Islamic banks' deposits should be fully pass-through (a pure mudaraba) or not. It also highlights the fact that the regulatory environment facing Islamic banks is not uniform and also not necessarily easily transferable to how Islamic banks work.

UPDATE: I just saw an article which describes some of the different factors that affect whether PSIAs will impact Islamic banks' capital requirements, from the IFSB seminar in Malaysia.

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

New country, same story?

2012-01-18T13:30:00.000-08:00

The boom in Islamic finance in Dubai from 2005-2008 was built on the back of the real estate sector and when real estate faltered, it brought down several Islamic finance institutions. So it should bring a bit of caution to see that the Participation Banks in Turkey are concentrated in real estate construction as well. An article in Today's Zaman (ht Islamic Finance Turkey) breaks down the loans from Participation Banks into the uses of these funds:

Business Loans

Construction loans: $8.01 billion
Trade: $3.52 billion
Textile: $2.05 billion
Food: $1.35 billion

Consumer Loans

Total: $3.46 billion
Of which housing loans: $2.03 billion

Adding the construction loans and housing loans gives just over $10 billion (out of $20.6 billion in total loans). Is this too much? Only time will tell if this is sustainable. An IMF paper looking at the exposure of US banks before the credit crisis found that they had a higher level of exposure to real estate (62.4%), although the exposure to commercial and residential real estate combined for just over 50%.

So far Turkey's economy has been growing rapidly--as has its banking system (Participation Banks included)--and hopefully there will not be surprises down the road. But it is never too early to consider whether there might be warning signs, though more analysis than just looking at the share of real estate financing in Participation Banks' loan books is needed.

Gov. Zeti tells it (mostly) like it is

2012-01-16T12:59:00.000-08:00

An article in Arab News describes the prospects for Islamic finance as seen by Zeti Akhtar Aziz, the governor of the central bank of Malaysia, Bank Negara. Included in the article is a quote from Gov. Zeti which I think does an admirable job at describing the ways in which Islamic finance is affected by the global financial crisis and the recession which followed. She said:

"The Islamic finance industry was insulated from the first round of the crisis (the global financial crisis). Islamic financial institutions (IFIs) are more resilient because they are closely linked to the real economy, with in-built checks and balances such as profit-sharing and risk-sharing. As such, there are greater elements of responsible lending. As economies slow down and financial markets experience a correction, these will impact financial institutions including IFIs. That is why it is important to have capital buffers, risk management and governance practices that are sound. We are continuing to develop mechanisms, institutional arrangements and financial infrastructures such as greater liquidity management and more so that the Islamic finance industry would continue to be resilient."

There are some things I think are not necessarily true. IFIs do have some elements of responsible lending because they cannot move risk off balance sheet quite as easily (and in opaque ways) as conventional banks through credit default swaps (which the FT Alphaville blog described in two posts earlier today). But, I am not sure that IFIs are any more linked to the real economy than conventional banks (with the exception of situations like before the credit crisis when some banks were loaded up with CDOs created (synthetically in many cases) from subprime MBS. Most (smaller) banks didn't participate in these instruments, but were still hurt because of tightening credit, falling real estate prices and a slowing economy.

However, she is absolutely correct that IFIs are susceptible to a slowdown in the economy, which necessitates a similar level of regulation as other financial institutions. Gov. Zeti is usually a good source for clear statements on the Islamic finance industry and this quote is a good example.

A couple other things in the article caught my eye. First, the 3 applications for Islamic mega banks are not from Western institutions, and are reportedly backed by GCC-based investors, which continues the trend of convergence between the GCC and Malaysia. Second, Governor Zeti is quoted saying: ""The IILM [International Islamic Liquidity Management Corporation] is currently obtaining the required rating, as well as fulfillment of all other parameters for the issuance including high quality underlying assets". This to me suggests that the sukuk will be more likely an istithmaar sukuk, backed by Shari'ah-compliant financial assets from the central banks that are the members of the IILM. Under standard practice, fewer than 50% of these assets will be murabaha and istisna'a if the sukuk are going to be tradable (though I think AAOIFI rules stipulate a cutoff of 33%).

Could Tadawul become a regional sukuk trading center?

2012-01-15T13:41:00.000-08:00

My earlier post on the expected $4 billion sukuk from the Saudi aviation authority GACA seems like it could be of even greater significance if the new rules allowing foreign investors to invest directly on the Tadawul exchange. Currently the Tadawul sukuk and bond market has 7 listed sukuk from 4 issuers with a total size issued of SAR34.5 billion ($9.2 billion).

A sovereign sukuk (the GACA sukuk is guaranteed by the Ministry of Finance) with an issued size of SAR15 billion ($4 billion) would increase the total value of sukuk eligible for trading by nearly 50%. If foreign investors were able to invest in sukuk directly through the Tadawul, and if foreign issuers were able to list their sukuk on Tadawul, it could create additional liquidity for sukuk, which is growing, but is still limited.

UPDATE: The activity on the Tadawul Sukuk and Bond Market for 2011 was very small (see Annual Report 2011, page 45 [pdf]). On average, there was 1 transaction every 5 trading days (49 trades in 248 trading days) and the total volume was SAR1.8 billion ($480 million).

Combining Islamic finance and sustainable finance

2012-01-15T11:47:00.000-08:00

I've been going through the Malaysian Financial Services Blueprint (2011-2020) and there are a number of interesting ideas in there about Islamic finance. Hopefully, I'll get to some of the others in later posts; the first one is on the connection between the Socially Responsible Investing industry and the Islamic finance industry. The report writes:

The demand for Islamic finance is expected to emanate not only from the Muslim population but also from those with affinity for socially responsible objectives and those seeking ethical financial solutions where the central theme is a more equitable model that would foster sustainable growth, whilst preserving the environment and improving the overall socio-economic landscape. This is spurred by the growing significance of global ethical consumer movement where Socially Responsible Investment (SRI) is expected to be an important mainstream asset class by 2015. With this development, Islamic finance has an enhanced growth prospect given its close synergy with ethical finance.

The idea here is worthy and there is definitely a possibility for Islamic finance to attract non-Muslim consumers based on the ethical ideas that underpin Islamic finance. Malaysia is noteworthy in this respect and estimates place the share of Islamic bank accounts held by non-Muslims at around 25%.

The often attributed reason for the take-up of Islamic finance by non-Muslims in Malaysia is that the products are cost-effective or even cost-advantageous, in part due to the government's efforts to promote Islamic finance. This is something which could work in some other regions, but in many countries--particularly those with small Muslim minorities--the idea of favoring Islamic finance over conventional finance is going to be a non-starter.

Without a government-aided cost advantage, Islamic finance will have to offer something new that conventional finance ignores. The most frequently offered suggestion is to move Islamic finance more towards profit-sharing contracts (e.g. mudaraba and musharaka). While this may make Islamic finance more attractive (it is not necessarily certain that this is the case), it is unlikely that, outside of some areas of finance like stock markets, this will be possible in current regulatory environments.

Therefore the suggestion from the report to focus more on activities that "foster sustainable growth, whilst preserving the environment and improving the overall socio-economic landscape" makes sense. This is probably most likely way to tap the "enhanced growth prospect given its close synergy with ethical finance". So far, Islamic finance has concentrated much effort in laying the groundwork and setting up Islamic finance to meet the financial needs in a way that is Shari'ah-compliant.

Now, it should take the next step from expanding the breadth of product offering and focus on differentiation. This need not be an industry-wide shift. There are likely to be plenty of people who just want a Shari'ah-compliant alternative to conventional banking, so not adding complexity will make these services more competitive with conventional financial institutions.

However, there is likely a market opportunity--among both Muslims and non-Mulims--by offering Islamic financial products with a focus on low-income communities, avoiding investments that are not environmentally sustainable, and to add other so-called ESG (environmental, social, governance) criteria to the investment decisions. These may or may not be required to be Shari'ah-compliant, but there is nothing stopping Islamic financial institutions from adding more ethical criteria to their decision-making process.

Largest sukuk ever - does it matter?

2012-01-14T21:35:00.000-08:00

I am not usually impressed with most of the "first" or "biggest" news items relating to sukuk because there is usually more need for more plain vanilla sukuk and less need for overly complicated sukuk. We all remember how the Nakheel sukuk worked out, and one of those was both a "biggest" and a "first". However, the reports from Zawya that Saudi Civil Aviation Authority GACA is on the verge of issuing the first sovereign sukuk from Saudi Arabia, as well as the largest ever with a reported size of SAR 15 billion ($4 billion).

This sukuk is significant because Saudi Arabia is the largest GCC economy and has been less active in both corporate and (of course) sovereign issuance of sukuk. The $4 billion represents almost the entire total issuance for December ($5 billion) and a good portion of the average monthly issuance globally during 2011 ($85 billion total, or about $7.1 billion per month). The sukuk is guaranteed by the Saudi Ministry of Finance, giving it a credit quality likely on par with the Saudi government's Aa3 rating from Moody's and AA- from S&P.

The sovereign sukuk should provide a high quality for investors like takaful providers and pension funds, but not all of it is likely to end up being held-to-maturity and the sukuk, if it listed on the electronic market for sukuk with Tadawul, could provide a boost to the trading volumes in sukuk (e.g. an investor holding a corporate sukuk that wishes to remain invested in sukuk but not exposed to a corporate credit can sell the corporate sukuk and buy a sovereign sukuk, which they are not currently able to do).

Indonesia inter-bank money markets

2012-01-11T22:43:00.000-08:00

It is difficult to tell exactly how the inter-bank money market will work (described in an article from Bisnis Indonesia). The article describes:

"According to him [an unnamed source at Bank Indonesia, the central bank], the underlying asset in the money market may be in the form of sharia commodity futures. Moreover, collateral may use government’s sukuk.

Taking apart the parts of this sentence, I would imagine that the "sharia commodity futures" refer to using a commodity market (for cocoa, cashew or arabica coffee, as the article suggests later) to back commodity murabaha between Islamic banks in Indonesia. A commodity murabaha is a common inter-bank money market instrument in the GCC and Malaysia. The latter has set up an exchange, Bursa Suq al-Sila, to connect palm oil producers with financial institutions that want to use palm oil to back commodity murabaha transactions.

The difference between most commodity murabaha inter-bank lending and the Indonesian plan, from my reading, is that the inter-bank commodity murabaha would be collateralized using government sukuk. Bank Indonesia announced in the first half of 2011 that it planned to issue 3-, 6- and 12-month Sharia T-bills and was scheduled to issue the first 6-month T-bills in early August.

Collateralizing inter-bank commodity murabaha transactions is a good move from a risk management perspective, where lack of confidence by counterparties can lead to withdrawal of inter-bank lending and turn a liquidity crisis at a bank to a solvency crisis. If the inter-bank lending is collateralized, the counterparties to a bank that runs into a perception that it is in trouble will be less hesitant to withdraw funding to that bank (although they will certainly not be patient for ever). This is the reason that repurchase (repo) transactions have become a large source of short-term funding for many banks (with the caveat that the security of repo transactions is only as good as the credit of the collateral; the European debt crisis shows that even seemingly solid sovereign credit can lose their value as collateral very quickly).

The difficulty with developing this type of collateralized inter-bank lending is from a Shari'ah-compliance perspective. The issue of collateralized commodity murabaha was one of the proposals considered by the International Islamic Financial Market (IIFM) (see my initial comments here). It is still not necessarily widespread, but it is a promising way to make inter-bank lending more secure (which prevents funding from drying up as quickly and gives time to deal with troubled banks). However, there are obstacles--about which I cannot speak with authority---that make it more difficult to ensure it is widely accepted as Shari'ah-complaint. But, it adds to the forthcoming International Islamic Liquidity Management Corporation (IILM) as a new source of inter-bank liquidity management tools that will strengthen the Islamic finance industry.

In the end, we will have to wait and see what the final regulations around collateralized inter-bank Islamic lending from Bank Indonesia. However, I think that the development is positive and could help Indonesia be an area of growth for Islamic finance and banking in 2012 (more in terms of being rapidly growing; not necessarily having a large quantitative impact on the size and growth of Islamic finance as a whole). One area where it does not have much impact is in moving Islamic finance away from murabaha. However, it is probably better for Islamic banks and financial institutions to move other parts of their balance sheets away from murabaha and towards profit-and-loss sharing instruments before the inter-bank money markets are shifted away from murabaha.

Islamic banking growth in Indonesia

2012-01-07T14:24:00.000-08:00

One of the regions I see continued growth for Islamic finance in 2012 is Indonesia, which is geographically close to Malaysia where Islamic finance is as developed as anywhere in the world. There are also links between the two countries banking systems, with several Malaysian banks with Islamic windows (e.g. CIMB).

The central bank, Bank Indonesia, reported that (ht IF Indonesia for translating the article) in November 2011, Islamic bank financing had risen 45% over the same period in 2010 to Rp. 31.9 trillion ($3.5 billion). For the fourth quarter Islamic bank financing was Rp. 102 trillion ($11.2 billion), 45%. At the same time, non-performing loans fell from 3.12% to 2.85%, indicating that the increase in quantity has so far not come at the expense of quality.

However, the Islamic banking industry in Indonesia is tiny compared to the overall banking system, representing between 3.8% and 3.9% of the total banking system. This small size and rapid growth, represents an opportunity to expand, which I think it will in the next year.

There are also developments in how the central bank interacts with Islamic banks, with the launch of repo transactions on Islamic Treasury Bills, which I discussed in an earlier post.

Tawarruq

2011-12-26T10:51:00.000-08:00

There are almost as many opinions on tawarruq as there are people who know what the term means. With questions being raised about whether a recently launched Goldman Sachs murabaha sukuk was a tawarruq or not, the issue has been thrust into the forefront of discussions within Islamic finance*. A discussion of some of these issues are available from Camille Paldi (posted as a PDF).

This article had a link to a page from ISRA, which listed a number of different fatawa from different Shari'ah boards about the permissibility of, and structure of, tawarruq transactions. I, of course, cannot say whether a tawarruq is permissible or not. However, reading Paldi's article, and the Shari'ah opinions about tawarruq, there are some points which I find noteworthy about tawarruq.

The basic structure of a tawarruq (as used in the financial industry) is that the bank will buy a commodity (e.g. nickel from the London Metal Exchange). Once ownership transfers to the bank, it will resell the metal the the customer for the price paid, plus a profit, with repayment either in installments or as a lump sum. In either case, repayment will occur in the future. The customer then takes ownership of the metal and sells it to a metal broker to get cash.

In terms of economic outcome, neither party owns the metal, but the customer has X dollars in cash, with an obligation to repay the bank X + p dollars (p is the profit). In this example, the bank and the client can be switched for a tawarruq-based deposit product. During the entire transaction, the only time the metal involved makes an appearance is in the initial purchases and sales. One fatwa said: "It is compulsory to base this practice on the purchase of assets, which are then sold to the party who desires financing, i.e. the customer. The customer will then sell it to another party at a price that is agreeable to both parties. The delivery and payment is concluded on the spot".

When the final sale is completed, another fatwa reads: "One of the conditions of a legitimate tawarruq contract is that the bank must not guarantee the customer a specified price in the market but sell the goods at the best price, in accordance with the forces of supply and demand at the time of sale." One of the issues raised by multiple fatawa was avoiding instances where the bank (or its broker) is both selling to the bank and buying back.

These Shari'ah issues are interesting--I cannot offer an opinion about what they mean for the Shari'ah-compliance of any individual product--but they do raise a few issues on the financial side (e.g. if one were looking at the way transactions were actually carried out). First, the basis of the organized tawarruq product relies to some degree on ensuring that the price paid for the commodity is equal to the price at which it can be sold. The commodity markets on which these tawarruq transactions are based can be volatile, even on an intra-day basis, so an Islamic bank acting on its own behalf to buy the metals and later as agent for the customer to sell them, is exposed to the risk that the price of the commodity rises or falls.

Theoretically, I assume that the bank is supposed to pass that price risk on to the customer, who owns the metals between the initial purchase and the final sale. However, many customers, particularly retail customers, will not want to assume the price risk of the underlying commodity. There may even be regulations that limit the ability of the bank to change the effective profit rate after the contract is signed (the effective rate would change if the markup is fixed and the price realized is different than the original cost of the metals; if the price fell, the rate would increase while if the price rises, the rate would decrease). Yet, the bank cannot guarantee the price realized on the sale of the commodities lest it become both the seller and the buyer (as an intermediary).

Besides the operational issues with tawarruq, there are more theoretical arguments about its use. Initially, tawarruq was used for short-term inter-bank financing, where there was no other alternative available (there still are only a few, which was the rationale for forming the International Islamic Liquidity Management Corp.). Then the product became a consumer financing product. Now it is being used to structure deposits. The theoretical question is whether tawarruq ties the hands of Islamic banks to structures that (at slightly higher cost) replicate conventional banks.

I am generally in favor of Islamic banks using products that meet a banking need from Muslims who would not otherwise engage in the financial system. I think that makes sense. However, I also believe that creating an exact replication of the conventional financial system, or even the banking system, albeit with more transaction costs, is not the best goal for Islamic banking. There is a middle ground between making products available to meet consumer need and turning the entire exercise into a problem-solving exercise for clever bankers and lawyers.

There is, I think, a valid place for tawarruq in the development of Islamic banking. It is a useful tool where other tools are not yet designed. For example, there are few products available for education financing from Islamic banks and the benefit from providing this type of financing to people who will not use interest-based financing is high, both for the individuals and for society as a whole. This is the proper role of organized tawarruq (in my opinion) within Islamic banking. It is a fine tool, but Islamic bankers should not let tawarruq be the only tool (as the expression goes, when all you have is a hammer, everything looks like a nail).

* I wrote an article on the sukuk for The Islamic Globe, which was followed by a critical article about the sukuk program, which was followed by another critical article with a rebuttal by the firm which provided Shari'ah consulting services to GS.

Bank Indonesia reverse repo

2011-12-23T18:27:00.000-08:00

Bank Indonesia (BI) extended its reverse repo operations to government sukuk on December 1st. The structure of the transactions are not clear, but based on another article and a BI regulatory document (which is not available in English, so I had to rely on GoogleTranslate) it looks like a wa'd-based repo transaction. In the past, the sukuk issued by BI were based on ijara (mitigating concerns about the Shari'ah-compliant of trading at prices different from par if it were repo on sukuk based on commodity murabaha).

However, the repo concept has been tricky to synthesize in a Shari'ah-compliant way, so the BI reverse repo would be a novel transaction. It appears that the structure is based on wa'd, a unilateral undertaking to purchase or sell. In the repo transaction (which the article said would be with a 1 month maturity, although that may only be used as an example), BI would sell a sukuk to a bank for the market value (assume for simplicity this is par, 100). The bank would make a unilateral undertaking to sell the sukuk bank to BI in one month for 100 plus a spread based on a repo rate of 4.6% annualized.

I think, although I am not familiar enough with the Shari'ah-compliance rules on wa'd to say for certain, that because it is only a unilateral promise, it is permissible to specify a price for the transaction in the future. If there were two unilateral promises (one by the bank to sell and one by BI to purchase), it would not be permissible. Presumably since BI is originating the transaction and is the central bank, it is virtually assured that it would purchase the securities without needing to give a binding promise.

One area where difficulty would arise is if the sukuk rose in price during the repo, for example to 120. The rules for the reverse repo transaction stipulate that if the bank decides not to honor its unilateral promise to sell, BI will charge the bank a penalty of the difference between the market price (i.e. 120) and the amount that the the bank bought the sukuk (i.e. 20). This appears to me to be a sticky point for Shari'ah-compliance, although it could be mitigated if the penalty were stipulated to be donated to charity. Anyway, with the penalty being stipulated as being the profit the bank would realize by not honoring its unilateral promise (removing the financial incentive for the bank to default), it is unlikely that this would ever occur in practice.

I think this is an interesting idea and I would like to see more documentation about how it works and also the logic by which it was approved by the Shari'ah board advising BI. I would appreciate any reader comments on the structure, since I am trying to piece together the structure from limited information, some of which I had to base on imperfect translations.

Islamic finance media

2011-12-22T18:55:00.000-08:00

Back in January, when I took the offer to cover the Americas for The Islamic Globe, I agreed not to write for other publications, which at that point, was primarily the magazine Business Islamica, where I wrote the "Expert Opinion" column for a couple of years. I told them of my intentions, and thanked them for the opportunity.

However, recently someone sent me an "Expert Opinion" column from the magazine that was posted on their website that had me listed as the author. I didn't remember writing that particular article for Business Islamica, so I did a search for some of the article's text only to realize that it was content I published on my blog in June, well after I stopped writing for Business Islamica.

I contacted the magazine, and they promptly removed the article from their website and I moved on. However, when speaking with other bloggers in the Islamic finance industry, I now realize that they do this with other people's work. They will find content on a blog and reproduce it in their magazine as if it were written for inclusion in their magazine. This does not seem right to me in the context of Islamic finance, which is focused on operating ethically. It also troubles me as a blogger.

I write ~~things~~ posts for my blog without editing them as carefully as I would if I were writing a formal article, so if my blog posts are appearing without my knowledge in a magazine, I am both being associated with that magazine without my knowledge or consent, but if I make a mistake or ~~write unclearly~~ do not make my point clearly enough, my reputation could be harmed because readers will assume the article was written for a magazine, not for a blog (where I could return to clarify or correct mistakes). When I do make mistakes on my blog and return to clarify or correct them, I like to add as a note, and not change the original text.

I hope that other magazines in the Islamic finance industry are not also engaging in this misappropriations of people's writings, whether they originally appear on a blog or in another publication. It is unethical and reflects poorly on the magazines doing it, while potentially also being damaging to the writers whose writings are being taken. While most writers do want to get additional eyes on their work, it has to be on their own terms, and with their consent, to ensure we have control over the content we produce.

Are sukuk cheaper than conventional bonds?

2011-12-13T23:02:00.000-08:00

I was thinking about sukuk tonight and it occurred to me that sukuk might not have an advantage compared to conventional bonds in a way that I had not thought. The basis for this idea is how sukuk work in practice, not how they work in theory. I am also thinking more about mudaraba or musharaka sukuk than ijara sukuk, since the former cannot have clauses stipulating repurchase of the underlying assets at par like the latter can (according to the AAOIFI guidance issued in 2008).

In a mudaraba or musharaka sukuk (I will focus on an unsecured mudaraba sukuk because the analysis is simpler), the issuer becomes the mudarib and will manage the funds provided by the investors, to fund a particular business. These types of sukuk are often used by banks to fund their lending, for example, to fund ijara contracts under which funding is provided to acquire a real estate asset.

The sukuk are structured so that the bank sets up an SPV to issue the sukuk and the SPV funds the bank, which issues the financing, secured by the real estate. The bank finances the ijara contracts to receive a higher rental income than the required coupon on the sukuk. The mudaraba stipulates that the rental income is split 99% to the investors and 1% to the mudarib, with the income used to pay a coupon to the investors anticipated at 5%, while the rent is set to generate a 7% return.

The excess return (2% in the example) generated is placed in a reserve account, to cover shortfalls in the future from non-payment or late payments of rents, which will be paid out to the mudarib as an incentive fee if left at the maturity of the sukuk. However, if there is a shortfall at the redemption date, the investors are required to bear the loss. In this case, where the mudaraba is based on these specific assets, the investor would be worse off for a given coupon on the sukuk compared to if it were an unsecured corporate bond, backed by all the assets of the company, except for those used to issue secured debt. As a result, they would demand a higher coupon to compensate for the risk compared to a conventional bond issue.

Of course, this is not how these sukuk work in practice. In one that I was reviewing recently, the bank that issued the sukuk (and managed the mudaraba assets), non-performing assets could be swapped out for performing assets of the same type. The sukuk is also set up to be pari passu with the bank's other creditors, and so the assets backing the sukuk are not the only ones whose performance will determine ultimate repayment of the sukuk. In this case, the investors would likely demand a similar coupon to conventional bond investors for the same issuer and maturity of bonds.

In neither case would the issuer find a sukuk to be a cheaper alternative than a conventional bond. There are of course market considerations, like relative demand for conventional bonds versus sukuk, that could make the issue of a sukuk cheaper than a conventional bond. Yet, the sukuk is not on the basis of its structure, cheaper than a conventional bond because, even where the risks are limited to put them on par with a conventional bond, the upside is returned to the issuer as an incentive payment, while the downside is limited to the same downside as for conventional bond investors.

If the goal of Islamic finance is to create financial products that Muslims (or companies run to be Shari'ah-compliant) who avoid conventional finance are willing to avail themselves of, then this is not problematic. If, however, the goal is to design a product that is different in its risk and return profile from a conventional bond (as the rhetoric suggests, especially relating to mudaraba and musharaka), then all the mudaraba sukuk described above has done is to create a mudaraba that functions like an ijara, without any ownership of the underlying asset and cloaked in the mudaraba structure. It has essentially been stripped of its risk and return sharing that is supposed to make mudaraba an 'optimal' structure for Islamic finance.

Islamic finance complexity (Part IIg)

2011-12-03T21:12:00.001-08:00

I have covered the structure of the liabilities section of the Islamic bank's balance sheet in earlier posts, and I plan to return to the liabilities in the context of its interaction with the income statement and the maturity mismatch that is a function of banking. However, that is best done with reference to the asset side of a bank's balance sheet because the income statement deals both with the income earned on assets and the costs of funding the assets. Therefore, I am going to move onto the asset side to describe the 'stocks' of the asset (the maturity mismatch and the income/expense are included in the 'flows' arising from the 'stocks' of assets and liabilities).

Before going into the asset side of the balance sheet, I want to reiterate that this whole Islamic finance complexity series (maybe I should have come up with a better title for the series) of blog posts is a thought exercise to come up with interesting areas of how Islamic finacne works that are not always part of the day-to-day discussion of how Islamic finance works in practice. Most of what is out there is either new products offered by Islamic finance institutions, the financial results of their activities or theoretical discussions of how Islamic finance should operate, or why it is 'superior' to conventional finance. There is definitely a place for new developments and discussions of how the industry should operate, but I have found that the latter is done in generalities (including within a lot of my own writing).

Apologies in advance if my in depth discussion becomes dull or is too simplistic, but I think that if a discussion of the Islamic finance industry (and an analysis of how it has diverged from what it is 'supposed to be') is to be undertaken in a comprehensive way, it has to be a bit dull at points and include a simplistic analysis of the data that is put out about Islamic banks, which are largely contained in financial statements. However, I hope that there is some value in the insights that come out of this analysis. As always, I welcome comments on the blog posts or by email at blake@sharingrisk.org.

Moving into the balance sheet, there are a number of categories of assets held by Islamic banks and for a sampling, I delved into the balance sheet of a large UAE-based Islamic bank to provide a set of assets to go through. It's not important which Islamic bank was selected, because the focus should be on the types of the assets on the balance sheet.

The assets can be divided into a few categories:

Cash
Inter-bank lending
Islamic financing and investment
Investments
Receivables
Property, plant & equipment
Goodwill

Cash

Islamic banks, like all other financial institutions want to have a liquid supply of cash available to meet depositor withdrawals, payments to their vendors, money held with their central bank to meet reserve accounts, and any other needs that arise in the course of their business. One thing that I have seen repeated widely (including in my blog) is that banks hold higher cash balances than conventional banks. As a rough test of this idea, I compared the Islamic bank with one in the US that has similar total assets (I picked the US bank because it was easier for me to find a bank with comparable assets in the US).

The US bank had 2.7% of its assets in cash (either in non-interest-bearing or interest-bearing instruments) while the Islamic bank held 6.4% of its assets in cash. I accept that this is a highly unscientific analysis, but with a cash-to-assets ratio of the Islamic bank more than twice the conventional US bank, it seems probably that Islamic banks do hold more cash than conventional banks.

The problem for Islamic banks when dealing with their cash balances is that it is harder for them to make a return on the balances sufficient to offset the cost associated with their funding and so higher cash balances should all other things equal lower the return on the bank's assets. A mitigating factor is that the Islamic bank was able to place a large proportion of its cash balances in profit-paying instruments with the central bank (the UAE has an Islamic CD available starting in 2010 for Islamic banks in the country). However, the remainder is either cash on hand, held in a current account at the central bank or held against the bank's reserve requirement with the central bank.

The Islamic CD offered by the UAE Central Bank was significant for the bank I looked at. Between the end of 2009 and the end of 2010 (i.e. before and after the Islamic CDs were offered), almost all of the drop in cash on hand and current account deposits with the Central Bank were offset by deposits in the Islamic CD (representing about 30% of the total cash balances of the bank). Banks are responding to the opportunity to place funds with the central bank and generate a return on these assets, even if it is low.

I will return to the Islamic bank's assets in a future post. See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

Islamic finance complexity (Part IIf)

2011-12-01T22:27:00.001-08:00

One of the ideas of Islamic banking that is most often repeated is that the Islamic banking system is based on profit-and-loss sharing products. However, the theory and practice diverge significantly on this at least on the asset side of the balance sheet. The liability side (e.g. deposits and equity) are done more along the lines of the theoretical model of mudaraba. However, a recent working paper published by the IMF (pdf) found that the profit-and-loss sharing of Islamic banks did not translate into a significant difference in the profit rates paid on deposits.

The study examined Malaysia and Turkey from 1997 to 2010, which included 2 crises (1997/98 for Malaysia, 2000/01 for Turkey, and 2008/09 for both). This should provide some evidence that Islamic banks operate differently from conventional banks by not focusing exclusively on a smoother period, or a crisis period. However, the results of the econometric tests showed that the deposit rates on Islamic and conventional deposits moved together and tests for causality showed a significant causality from conventional deposit rates to Islamic deposit rates, but did not find evidence of causality in the other direction. The data used in the study were for 1-year deposits, although the authors indicate that tests using 1-month and 3-month deposit rates gave similar results.

The authors of the study do not test to see why this relationship exists, but they do hypothesize on a few possible explanations. One is that Islamic banks have to compete for deposits with conventional banks and therefore have to pay depositors competitive returns on their money in order to attract deposits. This is accomplished in most Islamic banks by using Profit Equalization Reserve accounts that allow the bank to save up excess profits to cover shortfalls from the market rate of deposit interest/profits.

Another explanation is that the profitability of an Islamic bank is determined, in large part, by the assets on its balance sheets. Given that the products used by most Islamic banks are debt-based products like murabaha, ijara, and istisna’a, which generate returns that are benchmarked to LIBOR or another conventional interest rate benchmark, the profitability of the bank will be in large part based on interest rate movements.

This explanation does make sense, but is less obvious an explanation because, while deposit rates do move in line with other interest rates, like LIBOR, there is not necessarily an automatic relationship between one and the other. If the changes in Islamic bank deposit rates were driven by changes in rates on assets (e.g. LIBOR), the causality flowing from conventional bank deposit interest rates to Islamic bank deposit profit rates would probably not be there. Islamic banks as they work today should not have significant differences in the breakdown of their assets compared with conventional banks, so the transmission of changes in LIBOR to changes in deposit profit rates should not occur with a lag compared with conventional banks (there should not be causality from conventional rates to Islamic rates on deposits).

The evidence, at least from this one study looking at just two countries, suggests that the more probable explanation is that Islamic banks manage their deposit profit rates using Profit Equalization Reserve accounts to follow conventional deposit interest rates. The reason for this is relatively simple: if they offer lower rates, they will have trouble attracting deposits. Alternatively, if the rates are highly variable, with some period where Islamic deposit account returns are significantly higher than conventional deposit rates, but also periods of significant underperformance, it will also discourage depositors from moving to Islamic banks because depositors are not likely concerned with the average deposit rate over a period of time alone, but want this return to be of lower variability.

What are the lessons from this? First, Islamic banks are not independent of conventional banks and (based on the data in this study) compete directly with conventional banks. Second, Islamic banks do not operate based solely on the theoretical construct of profit-and-loss sharing, even on their liability side. As long as this relationship continues to hold--and there are valid consumer demands that Islamic banks must meet, and regulatory environments which make Islamic banks look like "banks"--the idea that Islamic banks are more resilient or even somehow unique in their response to economic changes should be dismissed. There may be areas where they could be, but even on the side of the balance sheet where profit-and-loss sharing is at least theoretically entrenched, the data shows a strong relationship between Islamic banks and their conventional competitors.

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

German bond auction failure could not be 'cured' with sukuk

2011-11-29T22:01:00.001-08:00

An Arab News article from Mushtak Parker begins:

"Sovereign Germany might be disappointed that its recent Eurobond offering was not fully subscribed. Perhaps in hindsight, had it instead opted to issue a debut Eurosukuk for the same amount, the story might well have been different.

Sukuk issuers, whether conventional entities such as HSBC Middle East or Goldman Sachs (both of which tapped the sukuk market in 2011, or Islamic banks, agree that market conditions in the sukuk space is more favorable than in the conventional space. And this confidence and appetite for Sukuk is backed by rising demand from big institutional investors in the Middle East and Asia.

Despite a difficult global financial climate and the continuing euro zone sovereign debt crisis, sukuk issuance has shown a remarkable resilience over the last year or so, with origination - both sovereign and corporate - gaining a second wind over the last few months if not weeks. Investors in sukuk in general are proving to be all-weather friends with their healthy appetite for such instruments, rather than their fair weather counterparts in the conventional bond market."

The story of Germany's 2 billion euro auction, where 35% of the issue was not subscribed would not have been any different if it had been a euro-sukuk. There is nothing special about Islamic finance or sukuk that make it more likely for investors to buy a sukuk from an issuer than they would a conventional bond because, when the economic structure of the transactions are examined, there is not much difference between sukuk and conventional bonds. The only caveat to this statement is that some investors are constrained to only invest in Shari'ah-compliant instruments, but those buyers make up a relatively small portion of the total funds available to purchase in the primary markets.

The idea that Islamic finance can run to the rescue where conventional finance 'fails' is just as silly an idea as the idea that was all too common 3 or 4 years ago when people asserted without justification, that Islamic finance was 'immune' to the crisis. This proved false, and it is equally as false to say that if Germany had gone with a sukuk instead of conventional debt it would have filled the full offering of its bonds.

Right now, Islamic finance does not offer a different product, it just is in a different form. Sukuk are economically identical in most cases to conventional bonds, in order to re-structure the bond into a trade-based form. This is not a value judgment on sukuk; they are in demand and are giving some companies new capital markets they can tap, but they do not change the underlying economics of the transaction. In Germany's case, the bond issue failure was not a question of demand for German debt--if it were, the yields on bunds would have spiked (they haven't). It was likely an isolated incident reflecting general debt market stress within the Eurozone.

Bringing a sukuk instead of a bond does not change the underlying situation in Europe and, if anything, would probably lead to lower demand for the bonds because of the difficulty of educating investors on how sukuk work. Regardless of the issuer, however, it is unlikely that an issuer of any kind could bring a 10-year, 2 billion euro ($2.7 billion) sukuk to market.

The resilience of the sukuk markets during the eurozone crisis has more to do with the relative absence of direct exposure to Europe, where there are very few issuers, and is a reflection of the continued strengths of the GCC and other emerging and frontier markets where the economies are still (for the moment) strong. In addition, a high oil price keeps the liquidity flowing in these regions giving investors the capital needed to invest in sukuk. If the oil price slips because of the euro crisis and developed markets' economies (and/or China) slip, it is highly unlikely that the sukuk train will keep on rolling.

We have seen the connections in the global financial markets and how financial market disturbances in markets disconnected from Islamic finance can spill over into Islamic finance through slower economic growth. This was the story in 2007/08 when the subprime mortgage crisis in the US led to financial markets freezing up and a widespread economic downturn leading to a near-collapse in the sukuk markets. It is a waste of time to try and promote the idea that Islamic finance is somehow a panacea to all the financial market ills.

Islamic finance complexity (Part IIe)

2011-11-25T20:17:00.001-08:00

After thinking a lot about how products are structured, I am moving onto some real-world breakdown in the actual balance sheet balances of some Islamic banks to translate the ideas of how they design their products into how they are actually represented in terms of the bank's liquidity profile. To do so, I picked one country (the UAE) to limit the differences between banks caused by different countries, different regulatory environments, etc, and focused just on the "Liabilities" items in the balance sheet at one point in time (December 31, 2010 for all except for Ajman Bank, which only had annual financial statements through the end of 2009).

The liabilities section is, in rough form, broken into three categories of liabilities: deposits, inter-bank borrowings and other liabilities (e.g. longer term liabilities like sukuk). In general, deposits made up the vast majority of the Islamic banks' liabilities that I looked at, ranging from 76% to 85%. Within the deposits, there were a few main types (current accounts, savings accounts and investment accounts). Most of the banks had just one type of investment account, which I am guessing is almost universally mudaraba-based profit-sharing accounts. Two banks (Al Hilal Bank and Emirates Islamic Bank) which had another category of deposits, wakala. The banks in general used "investment accounts" as their primary funding source, representing around 60% of total liabilities (three-quarters of the deposits), although this wasn't universal.

The real difference between the banks (only two banks offered this detailed breakdown, unfortunately) came with the maturity of the deposits. Dubai Islamic Bank had more (about two-thirds) of deposits in short-maturity or demand deposits, while Al Hilal Bank had more mid-range (3-6 month) deposits (about one-half) compared with the remainder split between longer-term (>1 year) and short-term funding (<3 months). The split between short- and longer-term deposits is more of a business decision, than it is something that goes to the heart of how Islamic banking differentiates itself .

However, with the limitations on Islamic deposit insurance, the maturity of deposits can be a factor in how resilient an Islamic bank is to future banking system problems (longer maturity giving more protection against runs on the bank becoming destabilizing). The offsetting factor (for the bank) is that longer-term deposits are more expensive than short-term deposits, and that will be true whether the bank is Islamic or not because in practice, deposit accounts are not entirely pass-through, and also must offer rates of return that are competitive with conventional banks.

The other two areas of liabilities on Islamic banks' balance sheets varied bank to bank to fill the remaining 15-25% of the liabilities with some having more in inter-bank financing while others had longer-term liabilities like sukuk or the Central Bank wakala financing that was provided to banks during the Dubai debt crisis. However, in general, the larger the bank the less reliant on inter-bank financing, although the three largest banks (DIB, ADIB and Emirates Islamic Bank) all had wakala financing from the UAE Central Bank, which skews the relative shares.

Removing the wakala financing from the Central Bank (assuming it was replaced with inter-bank financing) removes the previous relationship between longer- and shorter-term other (non-deposit) liabilities between larger and smaller banks (the smaller banks being Sharjah Islamic Bank, Al Hilal Bank and Ajman Bank; Noor Islamic Bank does not put financial statements on its website). The ratio of short term to the sum of short- and long-term non-deposit liabilities is the metric I looked at (moving wakala financing from long- to short-term) ranged from a low of 29% to a high of 87%.

The sample I chose was purposefully non-representative to try and limit the fluctuations due to country-specific factors, but a few trends emerge. First, most banks have deposits as the largest source of their funding, which is probably good because it is lower cost than sukuk and less volatile than inter-bank financing. The one exception to the stability of bank deposits is in a banking crisis and the UAE Central Bank did what central banks are supposed to do in a crisis: they lent freely on more costly terms than they normally would (the wakala is convertible into equity).

In the non-deposit liabilities, the wide range of splits between inter-bank financing (short-term) and longer-term financing like sukuk was mostly explained by the difference between banks that had sukuk outstanding and those that didn't. The banks with sukuk outstanding had lower reliance on inter-bank financing than banks that did not issue sukuk. This suggests that one way to mitigate the reliance of banks on short-term inter-bank financing is to further develop the sukuk market, especially finding structures that don't require physical assets, but can fund longer-term assets on the balance sheet with longer-term funding.

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

Islamic finance complexity (Part IId)

2011-11-20T22:01:00.001-08:00

From my newsletter (subscribe on the left side of my blog):

I was just reflecting on the types of deposit products available from Islamic banks and there are generally four: qard, mudaraba, wakala and murabaha. There are costs and benefits associated with each, both from a theoretical perspective as well as in practice.

In much of the theory of Islamic banking, the mudaraba deposit product is widely viewed as being superior because it is a profit-and-loss deposit. On similar lines a wakala deposit also requires the deposit to bear losses on the investments for which their deposits are used to fund. A qard deposit is also in theory perfectly acceptable because no return is provided on the funds in exchange for the safety of the principal amount. A murabaha deposit would be viewed in this light as being inferior because it replicates a conventional time deposit where principal is guaranteed (at least as far as the bank stays in business) and a return is provided to the deposit.
However, the way Islamic banks operate change the equation. The qard product is not affected; it works the same way with no return and safety of principal, and is not too different from how many demand deposit accounts function today with the global zero or near zero interest rate environment. In a more normal situation, the qard deposit product would probably be viewed as less competitive because of its zero return and would not provide a sustainable funding base for Islamic banks because it would be hard to gather qard deposits except from people who want to have a safe place to keep their money and don't want to engage with a conventional bank (it is a great deal for the banks who receive a free source of funding, apart from the potential liquidity management issues that it creates).

As things work, a mudaraba and wakala account does not function in the way it was envisaged because depositors are unwilling in general to bear risk of loss of their deposits. Islamic banks have therefore used reserve accounts to even out the profit payments and protect the depositors from loss. There is also an informal (as far as I know it is informal) promise by shareholders of the bank to subordinate their claims over profits to the depositors, so that any shortfall in profits would come out of the profits accruing to the bank to keep the deposit rates competitive in comparison with conventional banks. There is, therefore a deposit product that is designed to be profit-and-loss sharing but in practice works more like a conventional deposit account where principal is protected and returns are stable over time.

In contrast, a murabaha deposit account is not viewed as theoretically preferable, but in practice may be superior to mudaraba or wakala because the theoretical idea of murabaha (at least of a commodity murabaha) bears more similarity to how the murabaha deposit account works in practice. Depositors lend money to the bank through a purchase and re-sale of commodities with repayment on a future date (which could be daily, weekly, monthly or any other frequency to meet the depositors' desire for liquidity). However, the position of the depositors as creditors and the bank as debtor is much more similar to how Islamic deposit accounts actually operate than the more appealing (to many) wakala and mudaraba deposit. However the same problems arise with murabaha in deposit accounts as in the rest of Islamic finance because it becomes more and more a replication of conventional banking products rather than a new way of thinking of the banking relationship.

The picture is slightly different when there is an Islamic deposit insurance system, which I described in a blog post earlier today, where the deposit insurance can take away the tail risk of large losses for mudaraba or wakala depositors and make these more appealing than murabaha deposit products.

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

Islamic finance complexity (Part IIc)

2011-11-20T12:40:00.001-08:00

Wakala and murabaha deposits

Reading through the previous posts, I realized that I focused on only two of the four types of Islamic deposit products (qard and mudarba). The other two--wakala and murabaha--should also receive a quick discussion. The wakala deposit product is very similar to the mudaraba, except that the profit accruing to the bank is determined differently. In mudaraba, the bank receives a share of profit as mudarib, while in a wakala, the bank charges a fee for serving as the wakil (agent). In both cases, the losses are supposed to be borne exclusively by the provider of funds (rabb ul-maal under mudaraba and muwakkil under wakala) but in most Islamic banks, there are reserve funds to preserve depositors principal to remain competitive with conventional banks and also to limit the likelihood of a run on the bank.

The other product, murabaha, is a more recent development and is often a commodity murabaha. On the one hand, a murabaha is a useful product because it is not ambiguous like a mudaraba or wakala, in that the deposit is directly exposed only to the credit risk of being a creditor of the bank, rather than existing in a middle ground of being exposed to the risk of the investments made by the bank, but in practice, relying on the bank prudently creating a reserve fund to protect depositors funds. On the other hand, the use of murabaha in deposit accounts further entrenches the product which is seen by many as less than desirable because it further enforces the idea that Islamic banks develop products that replicate conventional bank products.

Islamic Deposit Insurance

However, the main issue I have not yet addressed is Islamic deposit insurance. The idea of deposit insurance is at first glance anathema to an Islamic banking system that is based (at least in rhetoric) on profit-and-loss sharing. There are benefits to making rewards related to the risks, but in a bank, putting risks on depositors shoulders when those banks are competing with conventional banks is likely to hurt their competitiveness when there are no protections to depositors like deposit insurance (or to a lesser degree reserve accounts).

Depositors are generally focused on safety of their deposits and immediate access to their funds on demand, with returns (to keep pace with inflation) being secondary for most depositors with current (demand) deposit accounts. Time depositors sacrifice immediate access to their deposits for some return to offset inflation, but generally are not focused on high returns, especially if those returns put their principal at risk. For both demand and time depositors, the safety of their principal is important and without some form of Islamic deposit insurance, a proportion of these depositors would move to conventional banks that can offer deposit insurance.

Without deposit insurance, the security of depositors' money is reliant on their faith in the solvency of the bank and its ability to properly accumulate enough reserves to offset the losses of funds that are invested on behalf of the depositors. However, the confidence in the bank and its reserve accounts are likely to be highly correlated with depositors' faith in the solvency of the bank and if one is put at risk, there is a possibility for a bank run to start, which will turn doubts of confidence into a self-fulfilling prophecy (in some, but not all, cases). Thus the need for deposit insurance.

There is limited experience with Islamic deposit insurance. Most of the Islamic deposit insurance programs (detailed in a survey by the International Association of Deposit Insurer's (IADI) Islamic Deposit Insurance Group (IDIG) conducted in 2009) are either part of a conventional deposit insurance program entirely or are done with small changes to be Shari'ah-compliant. The only fully Islamic deposit insurance program is Sudan because the banking system is (or was at the time) fully Islamic.

Two deposit insurance programs which I looked at were Bahrain's (run by the Central Bank of Bahrain) and Malaysia's (run by the country's deposit insurance agency PIDM). The deposit insurance systems are different. Bahrain's covers deposits, not including mudaraba deposits or other deposits not involving safekeeping or custodianship where the depositor would be entitled to share in profits and losses. It is post-funded (i.e. deposit insurance assessments are only collected from banks when there is a failure) so there are no issues with how the deposit insurance premiums are invested (although the CBB website does indicate that a new deposit insurance program is under construction that would shift it to being pre-funded raising the issue of investing the premiums collected by the Central Bank).

PIDM, in contrast, does both collect premiums (it is pre-funded) and does cover mudaraba depositors in addition to deposit contracts based on custodianship or safekeeping (e.g. wadiah). The deposit assessments are calculated in a similar way to conventional banks, but the premiums are held in a separate fund from those collected from conventional banks and are invested only in Shari'ah-compliant government investments (e.g. bonds, notes, bills issued by the Government or Bank Negara Malaysia, the central bank).

Since PIDM's deposit insurance program does cover mudaraba, it would be natural to assume that it limits the profit-and-loss nature of mudaraba deposits, but the deposit insurance program does not cover regular losses that would accrue to mudaraba depositors. It only comes into play when a bank that is a member of the deposit insurance fund fails. In order to not place return-generating accounts above those that do not generate a return for depositors, the wadiah and qard depositors are placed ahead of mudaraba depositors in the seniority of creditors of a failed bank.

The deposit insurance issue should be more aggressively developed now that the Islamic finance industry has the experience of surviving a global financial crisis. It is probably luck more than just about anything that there were no bank runs on Islamic banks during the crisis, and in part also due to the ad hoc interventions by governments. A deposit insurance program (operating under kafala bil ujr, a guarantee provided for a fee, like Malaysia's) is essential if Islamic banks want to compete with conventional banks while also avoiding being covered by conventional deposit insurance programs (which may lessen perception of their Shari'ah-compliance).

As the Malaysian program shows, deposit insurance programs do not offset any profit-and-loss sharing of mudaraba deposit accounts, except if the bank fails. This is probably prudent because while depositors are likely willing to risk small fluctuations of their deposits in rare occasions (where the reserve accounts are not large enough), they are unlikely to accept the total loss of their deposits, and will move to conventional banks if that possibility is shown to be real by the failure of an Islamic bank somewhere in the world.

The existence of Shari'ah-compliant deposit insurance (deposit takaful?) will, I think, increase, rather than decrease, the profit-sharing nature of Islamic banks by taking the 'tail risk' away from mudaraba depositors. They will still have to have faith in the bank adequately maintaining a reserve account (something that the bank regulators should focus on), but it will make the returns generated from a mudaraba account seem worthwhile, even if small, because the unlikely event that they suffer a large loss has been removed. For proponents of a profit-and-loss sharing bank system, this should be a priority, especially before murabaha deposits become the norm rather than qard, wakala or mudaraba that prevail today.

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

IILM delays first sukuk issue

2011-11-15T21:47:00.001-08:00

The International Islamic Liquidity Management Corporation (IILM) has delayed its first sukuk issuance according to Zeti Akhtar Aziz, the chairwoman of the IILM and head of Malaysia's central bank. She said that the first issuance would come in the next six months, while previous statements had said issuance would occur before the end of 2011. However, progress is being made with a rating forthcoming. The first issuance would be small, with follow-on issuance in the range of $2-$3 billion per issue in several currencies to meet demand, although in the past the IILM has stated that issuance would begin in US dollars and be followed by Euro issues with other currencies added as they were demanded by Islamic financial institutions.

The key function that the IILM provides is short-term sukuk, issued by a body with a high credit rating to meet the liquidity needs of Islamic banks. Banks generally take in short-term deposits and use those funds to lend long-term. To remain in business, they need to have sufficient liquidity (i.e. cash) on hand to meet withdrawals by depositors. The rating on the short-term assets they hold is important for meeting their minimum capital requirements under Basel and local regulations. The short-term sukuk provide an investment option that will generate some yield without exposing the banks to the counterparty risk that would emerge from inter-bank murabaha, for example.

There is also the potential, particularly if the IILM extends the maturities of sukuk it sells, for these sukuk to form the backbone for repurchase agreements (repos). A repo is a secured short-term (often overnight) loan between banks and in the conventional world operates using high quality bonds as collateral like US Treasuries. In the Islamic form of repos in use today in the UAE, the collateral is commodity murabaha-based certificates of deposit issued to banks by the UAE central bank, of which I have been critical. The International Islamic Financial Market (IIFM) has laid out other alternatives, none of which are optimal, for Islamic repos, which I described in an earlier post.

The next piece of information that will be interesting will be the assets that are used to back the issuance, and Zeti said they are working to "get the allocation of high-quality underlying assets". The most likely structure will be istithmaar or ijara, both of which would probably be done using an asset-based structure. The assets would likely be contributed by IILM members, most of which are central banks from OIC countries, although the Central Bank of Luxembourg is a member. The central banks are not likely to risk that their assets could be taken by sukuk holders should the IILM default or otherwise fall apart.

It is good to see the IILM move towards beginning operations, however late its development is. The biggest need it can fill is to provide a source of short-term assets for Islamic banks that do not have the risks associated with lending their surplus funds to other Islamic banks. When an Islamic bank lends its funds to another bank--even for a short period--it subjects itself to the risk that the funds would be lost or tied up if that bank failed. For the Islamic banking system as a whole, this provides a powerful mechanism for contagion, where the fears about an Islamic bank's solvency could be transmitted to other institutions which have lent money to it.

Islamic finance complexity (Part IIb)

2011-11-06T23:20:00.000-08:00

After my summary of the ideas behind the deposit accounts of Islamic banks, I went and did a very unscientific survey looking at two Islamic bank's deposit accounts (Dubai Islamic Bank and Meezan Bank) to see how they actually operate in practice. As I expected, the deposit products are similar to what one would find in conventional banking. There are a mix of demand deposit and savings products offered by each bank.

In the case of Meezan bank, the deposit accounts offer a mix of demand deposit accounts based on qard, where "the Bank is liable to pay your money back on demand". One interesting point is that, in contrast to the mudaraba deposit accounts, the qard accounts does not discuss the conditions in which the depositor could lose his or her money, even though there is no one would expect depositors placing their money under qard to be below those placing them under wadiah to be in a lower position in the bank's capital structure.

The Meezan savings accounts were all based on mudaraba, which one would expect from an Islamic banks and all stipulated that the deposits would be invested in Shari'ah-compliant contracts like murabaha, ijara, istisna'a and musharaka to generate a return, although "in case of a loss, as per the rules of Mudarabah, the Rab-ul-Maal shall bear the loss in the ratio of their investment".

When I looked at the Dubai Islamic Bank's products, the descriptions looked much more like conventional bank accounts. Some accounts had profit-sharing features, while others did not. The contracts under which the accounts operated were not specified, so one can reasonably assume that the ones providing profit-sharing were based on mudaraba while the ones which did not were based on wadiah or qard.

One troubling feature of the DIB accounts was that in neither case of the mudaraba or wadiah/qard was the prospect of loss presented. When I searched the DIB website for 'loss' or 'lose', the only page that I found was an FAQ page describing in general terms how Islamic finance works without presenting any risk statement that one would expect from a bank (especially one of the oldest Islamic banks in the world).

My survey was not representative in any way, but it did find a troubling lack of disclosure of the risks associated with Islamic deposits from one of the banks I surveyed. When a consumer looks to place funds with a bank, as I discussed in an earlier post, there are three key things he or she expects: safety of the deposits, a return on deposits to offset the costs of inflation, and access to the money deposited.

Both banks provided good access to funds for their depositors, with the note that some products offer limited access by design (similar to conventional Certificates of Deposit). In terms of a return in excess of inflation, it is unclear. Not all of the products offered concrete terms or histories of the accounts in terms of whether the deposits were paid returns in excess of inflation, but this is to be expected in Islamic banking.

However, with regards to the safety of the deposits, one bank offered clear disclosure that the account holders could lose their deposits if the investments made with those funds were money-losing. The other bank did not make any reference to the potential for losses. Perhaps this lack of disclosure is due to a leniency of regulations in one country versus another, but if Islamic banking is to use mudaraba as a means for raising deposits, there is a clear moral imperative that the costs and benefits of the product be clearly disclosed.

This is especially the case for a bank like DIB where the financial statements for 2010 report a provision against the depositors, albeit one that is outweighed by a far larger transfer from the profit equalization reserve account. The fact that a bank pays returns based (somewhat loosely) on the returns from its own assets funded by the deposits and shares the risks from those investments with depositors should be clearly stated. This should be even more pressing an issue for a bank like DIB which still holds a wakala liability to the UAE Ministry of Finance from the recent bank bailouts in Dubai.

Leaving aside the institutional differences between the banks surveyed above, I see a few lessons. First, Islamic banks should disclose the full risks of their products, including the position in the capital structure based on the type of deposit. Second, Islamic banks should provide full disclosure that the profit paid on their deposits are totally based on the return on those investments and that they are liable to bear the loss on those investments unless there are funds available in the profit equalization reserve to cover the losses.

It is commendable for Islamic banks to smooth the returns on mudaraba deposits to essentially store up reserves so that depositors can not worry that they will lose their deposits. However, it is essential that they be fully aware that the reserves put aside to safeguard their deposits may run out and they could lose their deposits.

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

Islamic finance complexity

2011-11-03T23:41:00.000-07:00

The issue of Islamic finance complexity is a common theme of criticism of Islamic finance from people who view the industry as creating nothing of value beyond what the conventional industry can provide. After proposing a "back to basics" approach, I have been working through how the industry is designed or imagined to work and the products that are actually offered to try and ascertain where the industry is satisfying legitimate financial needs of consumers and where it is developing products that suit its own profitability. I will update this post as an index to the other posts where I look at specific items (in chronological order, with the most recent posts at the bottom of the list).

Can Islamic finance return to the basics?
Overview of the thought experiment (Part I)
How should Islamic financial institutions develop products (Part Ia)
Islamic financial product disclosure (Part Ib)
Islamic banks - depositors (Part IIa)
Islamic banks - deposit accounts (Part IIb)
Islamic banks - deposit insurance (Part IIc)
Islamic banks - deposit products (Part IId)
Islamic banks - composition of banks' liabilities (Part IIe)
Islamic banks - empirical evidence on deposit rates (Part IIf)
Islamic banks - cash holdings (Part IIg)
Islamic banks - profit-sharing investment accounts (PSIA) and capital requirements (Part IIh)

Islamic finance complexity (Part IIa)

2011-11-03T23:31:00.000-07:00

The goal of this thought exercise is to understand whether Islamic banks meet the financial needs of their customers and structures products that are both readily understandable to customers and competitive in price to conventional alternatives (where they exist). The first, and most basic, need among consumers is to have access to a safe place to put their money that can earn a return, as well as a place they can turn to for a loan (whether a consumer or a business). This is a bank.

On the most basic level, a bank is an institution that collects savers' money and invests these funds into loans that earn a return sufficient both to pay a competitive return for depositors and at the same time keeping the depositors' funds safe. The function of the bank is to turn short-term deposits into long-term loans--to manage the maturity mismatch between the liquidity needs of depositors and the need for long-term funding for borrowers. In addition to the depositors' money and the loans provided, the bank holds some degree of equity, that for regulatory purposes is separated by how much it is able to absorb losses so they do not need to be passed onto depositors.

Depositors

For depositors, the underlying need is for a safe place to store money with the requirement that they be able to access their money when they need it, that they can earn a return sufficient to offset the effects of inflation and to provide depositors a way to use their money.

The theoretical idea of an Islamic bank where depositors place their deposits under mudaraba conflicts with the idea of safety of the deposits from loss, which (among many reasons) is probably why a pure mudaraba is not used in Islamic banking today. However, the alternative--wadiah--does not succeed in generating a return sufficient to offset the costs of inflation of deposits by reducing the purchasing power of the deposits held at banks. Abstracting from the mechanics of how a debit card works, which may not fully comply with the current standards of Shari'ah-compliance, the issue of accessing the funds is not any different between an Islamic bank and a conventional one.

The solution to two needs (protecting depositors from losses and still providing a return necessary to offset the costs from inflation) that Islamic banks have adopted is that the mudaraba accounts are made liable for losses of the bank, but the profits accruing to equity (who would in theory be on par with depositors) are voluntarily made subordinate to the return of depositors' principal. In addition, through reserve accounts, the depositors' profit is 'smoothed' by setting up reserve accounts where excess profits are stored to maintain profit payments when the profits generated fall below the market interest rate on deposit accounts.

The arrangement is not optimal because the equity investors are basically making their investment as a mudaraba (they provide the capital and the bank provides the management expertise to generate a return on that equity). Therefore they should not have to 'voluntarily' sacrifice their return in order to prevent losses on other mudaraba capital, although when the they can capture additional upside from higher profits than depositors can, where excess profits beyond the deposit rate are stashed away in reserve accounts, there is at least the potential for equity investors' return to be higher than depositors, in compensation for the additional risk they are taking.

The wadiah account holders are essentially sacrificing one goal (protection from returns against inflation) to promote the other goals (safety of principal and ability to use their money when they need it). Their principal is guaranteed, even if inflation erodes the purchasing power of the deposits, and through checks, debit cards or wire transfer, is able to use their deposits as they see fit.

On a basic (and grossly oversimplified) analysis of the depositors position, the basic Islamic banking model does make sense, although there are trade-offs, which could arguably be used as evidence that Islamic banking both does not suit the needs of both depositors and equity investors in the banks. However, there are always trade-offs between risk and return and linking risk and return is often described as a key feature of Islamic finance. While it is not optimal to have mudaraba depositors implicitly subsidized by (mudaraba) equity holders, the potential higher returns for equity investors should assuage some criticism that they are forced to bear greater risk than depositors than they would in a theoretical mudaraba-based Islamic bank.

This analysis does not necessarily cover the actual products offered by Islamic banks for depositors, but that will have to wait for a later post.

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

Islamic finance complexity (Part Ib)

2011-11-02T22:31:00.000-07:00

Another link I posted earlier on Twitter took a lesson from microfinance. The article describes studies about transparency and disclosure in microfinance, particularly relating to disclosures on interest rates, costs and the outcome if things go wrong (i.e. default). Any issue on disclosure and transparency (with regards to consumer disclosure) is common across any financial products targeted towards the broad consumer market because so many disclosures are essentially pointless for consumers because they are written in legalese and are usually too long for consumers to bother reading through in their entirety. One example of overcoming this legalese is the efforts in the US by the Securities & Exchange Comssion to bring "plain English" into disclosure statements for companies and financial institutions (which is accompanied by an 83-page handbook on writing in plain English (pdf)).

However, there is more to the issue of disclosure and transparency than just the disclosures presented. The CGAP article mentions specifically that consumers understand much more clearly fees when presented as dollar amounts, rather than in effective interest rates. Consumers also are not familiar with "recourse" impacts of financial products (i.e. what happens when the s*** hits the fan).

The analogy to the Islamic finance industry is two-fold: cost and complexity. On cost, the Islamic financial products are generally more expensive than conventional financial products. Most Islamic financial institutions would prefer not to convert their fees into an annual percentage rate (APR) because of its roots in conventional finance referring to interest rates. However, in most regulatory regimes, disclosures are required to include an APR. As the CGAP study found, this may not be the most useful number to have included in the disclosures and so Islamic banks that want to embrace transparency should add additional disclosures that detail the fees of their products in a separate schedule. It will both inform consumers better and also give an alternative to the (mandatory) disclosures of APR, as long as it is not deceptive in terms of the actual costs of the product.

The complexity issue is more interesting to me and has fewer requirements imposed in terms of disclosure from a regulatory perspective. How many consumers can explain how the Islamic financial product they choose actually works? In some Islamic financial products it takes hours for even people who read prospectuses for a living to understand exactly how an Islamic financial product works, even if the goal of the whole process is relatively simple. This has attracted the interest of regulators like the Dubai Financial Services Authority, who criticized excessive complexity, citing the Nakheel sukuk. Unfortunately, the article is subscription only so I can't read it all, but the Nakheel sukuk is a perfect (if extreme) example of an excessively complex sukuk.

If Islamic financial products are complex, can consumers understand them? Do consumers of the Islamic financial products know what happens in a default on the products they use and how they differ (or even if they do differ) from conventional products? I would suspect that few people do. Part of that is an education issue. Consumers should learn how these products work, but financial institutions have a responsibility as well to not use overly complex structures. The key should be meeting a financial need, but if the financial need requires elaborate structuring to re-create a conventional financial product, then perhaps Islamic banks should just take a 'pass'.

All in all, the Islamic financial industry should ensure that its products are understandable and understood by consumers of the product (I hold out little doubt that they will produce any clearer disclosures to consumers than conventional financial institutions) and that the fees are both comparable, fair and understandable.

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html

Islamic finance complexity (Part Ia)

2011-11-02T22:05:00.000-07:00

Earlier tonight, I posted an article on Twitter from CGAP about microfinance product development that I think has lessons for the Islamic finance industry as a whole.

The article discusses the way that microfinance institutions use daily journals from a sample of their customers or potential customers to determine how people actually use their money and how they engage with financial institutions to develop what financial needs are not being met currently by financial institutions (i.e. what are they using cash for that a financial intermediary could help them get a better outcome). While I don't believe that Islamic financial institutions are flying blind in regards to their clients needs, it does appear that in some cases they are developing products that they can make money selling and then taking them to market and hoping that the supply will create a demand. In other cases, they see a need (e.g. a financial product not being offered by Islamic banks and developing their own Shari'ah-compliant version and bringing it to market).

The problem with these approach is that they take as their premise either that the products that they develop to be profitable (for the bank) have a natural market or that conventional banks are offering products that always suit the needs of consumers. My idea of "going back to the basics" for Islamic finance is based on the premise that financial institutions creating products to suit their own needs (in terms of generating high profits) or by replicating conventional products (which creates added complexity) do not do the best job in fulfilling the financial needs of the consumers who look to Islamic banks for Shari'ah-compliant alternatives to conventional banks (mostly Muslims, but non-Muslims should be the market as well if Islamic banks have a change of growing across the world).

One aspect of the article that I think makes it useful for Islamic banks is that it is developed from the perspective of microfinance institutions that have a small market share in terms of the customer's business that they want to see grow. Islamic banks start by trying to attract customers who either do not use banks or are with conventional banks. Similarly, microfinance institutions are trying to get the business of people who rely on cash for most of their transactions because they don't have access to banks.

The analogy is not perfect, but an Islamic bank that is developing new products would be well served asking Muslims who don't use banks (or who have non-interest-bearing deposit accounts only) what aspects of their financial life are most inconvenienced by their lack of access to banks. With that need in mind, they can develop financial products that fulfill that need, whether or not it ends up being a product identical to a conventional offering. Instead, it seems that banks are assuming that people need a credit card (for example) and are structuring a complex series of murabaha transactions to create a payment/credit system that extends credit to the customer without formally being structured as a loan from the bank to the customer that is repaid with interest.

If Islamic banks want to cater specifically to the portion of the Muslim population that wants a credit card, but don't want to pay interest, then creating Islamicized versions of credit cards etc. will work fine, but why would a non-Muslim get an Islamic credit card that has all the metal trading behind that adds cost when a regular credit card will charge far less? Even if the underlying goal is to include Muslims into the financial system, there will be plenty of Islamic banks offering complex structured versions of credit cards. Working from a bottoms-up perspective (starting with the institution rather than trying to effect top-down change on the Islamic finance industry), an Islamic bank can choose not to offer every conventional product as an Islamic finance product without having to be concerned with overall access to finance among devout Muslims who don't work with conventional banks.

See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html