Islamic finance
Savings and souls
Sep 4th 2008| MANAMA
>From The Economist print edition
>http://www.economist.com/world/mideast-africa/displaystory.cfm?story_id=12052687
>
Muslims have a lot of money to invest. But it is a constant
struggle to reconcile faith and finance.
TO SEE Islamic finance in action, visit the
mutating coastline of the Gulf. Diggers claw sand out of the sea off Manama,
Bahrain’s capital, for a series of waterfront
developments that are part-funded by Islamic instruments. To the east, Nakheel,
a developer that issued the world’s largest Islamic bond (or sukuk) in 2006, is
using the
money to reorganise the shoreline of Dubaiinto a mosaic of man-made islands.
Finance is undertaking some Islamic
construction of its own. Islamic banks are opening their doors across the Gulf
and a new platform forsharia-compliant
hedge funds has attracted names such as BlackRock. Western law firms and banks,
always quick to sniff out new business, are beefing up their Islamic-finance
teams.
Governments are taking notice too. In July Indonesia, the most populous Muslim
country, said it
would issue the nation’s first sukuk.
The British government, which covets a position as the West’s leading centre
for Islamic finance, is also edging towards issuing a short-term sovereign
sukuk. Francehas begun its own charm offensive aimed at
Islamic investors.
Set against ailing Western markets such
vigour looks impressive. The oil-fuelled liquidity that has pumped up Middle
Eastern sovereign-wealth funds is also buoying demand for Islamic finance.
Compared with the ethics of some American subprime lending, Islamic finance
seems virtuous as well as vigorous. It frowns on speculation and applauds
risk-sharing, even if some wonder whether the industry is really doing anything
more than mimicking conventional finance and, more profoundly, if it is
strictly necessary under Islam (see article).
Sukuks in the souk
As the buzz around the industry grows, so do
expectations. The amount of Islamic assets under management stands at around
$700 billion, according to the Islamic Financial Services Board, an industry
body. Standard & Poor’s, a rating agency, thinks that the industry could
control $4 trillion of assets. Others go further, pointing out that Muslims
account for 20% of the world’s population, but Islamic finance for less than 1%
of its financial instruments—that gap, they say, represents a big opportunity.
With tongue partly in cheek, some say that Islamic finance should by rights
displace conventional finance altogether. Western finance cannot service
capital that wants to find a sharia-compliant
home; but Islamic finance can satisfy everyone.
Confidence is one thing, hyperbole another.
The industry remains minute on many measures: its total assets roughly match
those of Lloyds TSB, Britain’s fifth-largest bank (though some firms
that meet sharia-compliant
criteria may attract Islamic investors without realising it). The assets
managed by Islamic rules are growing at 10-15% annually—not to be sniffed at,
but underwhelming for an industry that attracts so much attention. Most of all,
the industry’s expansion is tempered by its need to address the tensions
between its two purposes: to serve God and to make as much money as it can.
That is a stiff test. A few devout Muslims,
many of them in Saudi Arabia, will pay what Paul Homsy of Crescent Asset
Management calls a “piety premium” to satisfy sharia. But research into the
investment
preferences of Muslims shows that most of them want products that benefit their
savings, as well as their souls—rather as ethical investors in the West want
funds that do no harm, but are also at least as profitable as other
investments.
A combination of ingenuity and persistence
has enabled Islamic finance to conquer some of the main obstacles. Take
transaction costs which tend to be higher in complex Islamic instruments than
in more straightforward conventional ones. Sharia-compliant
mortgages are typically structured so that the lender itself buys the property
and then leases it out to the borrower at a price that combines a rental charge
and a capital payment. At the end of the mortgage term, when the price of the
property has been fully repaid, the house is transferred to the borrower. That
additional complexity does not just add to the direct costs of the transaction,
but can also fall foul of legal hurdles. Since the property changes hands twice
in the transaction, an Islamic mortgage is theoretically liable to double stamp
duty. Britainironed out this kink in 2003 but it remains
one of the few countries to have done so.
However, just as in conventional finance, as
more transactions take place the economies of scale mean that the cost of each
one rapidly falls. Financiers can recycle documentation rather than drawing it
up from scratch. The contracts they now use for sharia-compliant mortgages in
Americadraw on templates originally drafted at
great cost for aircraft leases.
Islamic financiers can also streamline their
processes. When Barclays Capital and Shariah Capital, a consultancy, developed
the new hedge-fund platform, they had to screen the funds’ portfolios to make
sure that the shares they pick are sharia-compliant.
That sounds as if it should be an additional cost, but prime brokers already
screen hedge funds to make sure that risk concentrations do not build up. The
checks they make for their Islamic hedge funds can piggyback on the checks they
make for their conventional hedge funds.
Mohammed Amin of PricewaterhouseCoopers, a
consulting firm, says the extra transaction costs for a commonly used Islamic
financing instrument, called commodity murabaha,
total about $50 for every $1m of business. That is small enough to be recouped
through efficiencies in other areas, or to be absorbed in lenders’ profit
margins. In addition, bankers privately admit that less competition helps keep
margins higher than in conventional finance. “Conceptually, Islamic finance
should cost more, as it involves more transactions,” says Mr Amin. “The actual
cost is tiny and can be lost in the wash.”
The other area of substantive development
has been in redefining sharia-compliance.
New products require scholars to cast sharia in fresh, and occasionally
uncomfortable, directions. Some investors express
surprise at the very idea of Islamic hedge funds, for example, because of
prohibitions in sharia on selling something that an investor does not actually
own.
“You encounter a wall of scepticism whenever
you do something new,” says Eric Meyer of Shariah Capital. “It is no different
in Islamic finance.” He says that it took eight long years to bring his idea of
an Islamic hedge-fund platform to fruition, applying a technique called arboon
to ensure that investors,
in effect, take an equity position in shares before they sell them short.
Industry insiders describe an iterative process, in which scholars, lawyers and
bankers work together to understand new instruments and adapt them to the
requirements of sharia.
Differences
in interpretation ofsharia between countries can still hinder the economies of
scale. Moreover, the
scholars can sometimes push back. Earlier this year, the chairman of the
Accounting and Auditing Organisation for Islamic Financial Institutions
(AAOIFI), an industry body, excited controversy by criticising a common form of
sukuk issuance that
guarantees the price at which the issuer will buy back the asset underpinning
the transaction, thereby enabling investors’ capital to be repaid. Such
behaviour contravened an AAOIFI standard demanding that assets be bought back
at market prices, in line with the sharia principle of risk-sharing. The sukuk
market has enjoyed years of rapid growth (see chart), but early signs are that
the AAOIFI judgment has dented demand.
Although Islamic finance has done well to
reduce its costs and broaden its product range, it has yet to clear plenty of
other hurdles. Scholars are the industry’s central figures, but recognised ones
are in short supply. A small cadre of 15-20 scholars repeatedly crops up on the
boards of Islamic banks that do international business. That partly reflects
the role, which demands a knowledge of Islamic law and Western finance, as well
as fluency in Arabic and English. It also reflects the comfort that this
handful of recognised names brings to investors and customers.
There are plenty of initiatives to nurture
more scholars but for the moment, the stars are pressed for time. That can be a
problem when banks are chasing their verdict on bespoke transactions. It takes
a scholar about a day to wade through the documentation connected with a sukuk
issue, for example. But
scholars are not always immediately available. “You’ve got to have the
scholar’s number programmed into your mobile phone and be able to get hold of
them,” says a banker in the Gulf. “That is real competitive advantage.”
Assets are another bottleneck. The ban on
speculation means that Islamic transactions must be based on tangible assets,
such as commodities, buildings or land. Observers say that exotic derivatives
in intangibles such as weather or terrorism risk could not have an Islamic
equivalent. But in the Middle East, at least,
the supply of assets is limited. “Lots of companies in the Gulf are young and
don’t have assets such as buildings to use in transactions,” says Geert Bossuyt
of Deutsche Bank. This limits the scope for securitisation, a modern financing
technique that is backed by assets and is thus seen by sharia scholars as
authentically
Islamic. There are not enough properties to bundle into securities.
Governments have more assets to play with.
The Indonesians have approved the use of up to $2 billion of property owned by
the finance ministry in their planned sukuk issuance later this year. But
oil-rich governments in the Gulf have
little need to issue debt when they are flush with cash. That is a problem.
Sovereign debt would establish benchmarks off which other issues can be priced.
It would also add to the depth of the market, which would help solve another
difficulty: liquidity.
It may seem odd to worry about liquidity
when lots of Muslim countries are flush with cash, but many in Islamic finance
put liquidity at the top of their watchlist. The chief concern is the mismatch
between the duration of banks’ liabilities and their assets. The banks struggle
to raise long-term debt. In a youthful industry, their credit histories are
often limited; they also lack the sort of inventory of assets that corporate
sukuk issuers have.
Desert liquidity
As a result, Islamic banks depend on
short-term deposit funding, which, as Western banks know all too well, can
disappear very rapidly. “Lots of assets are generally of longer term than most
deposits,” says Khairul Nizam of AAOIFI. “Banks have to manage this funding gap
carefully.” If there were a liquidity freeze like the one that struck Western
banks a year ago, insiders say that the damage among Islamic banks would be
greater.
There are initiatives to develop a sharia-compliant repo market but
for the time being the banks have only limited scope for getting hold of money
fast. Loans and investments roll over slowly. The lack of sharia-compliant
assets and a
tendency for Islamic investors to buy and hold their investments have stunted
the secondary market. The shortest-term money-management instruments available
today are inflexible. Cash reserves are high, but inefficient. Western banks
with Islamic finance units, or “windows”, are just as troubled by tight
liquidity as purely Islamic institutions are: their sharia-compliant status
requires them to hold
assets and raise funds separately from their parent banks.
There are other sources of danger, too.
Because Islamic banks face constraints on the availability and type of
instruments they can invest in, their balance-sheets may concentrate risk more
than those of conventional banks do. The industry’s ability to steer its way
through stormy waters is largely untested, although Malaysian banks do have
memories of the Asian financial crisis in the 1990s to draw on.
None of these tensions need derail the
growth of Islamic finance just yet. There is plenty of demand, whether from
oil-rich investors, the faithful Muslim minorities in Western countries or the
emerging middle classes in Muslim ones. There is lots of supply, in the form of
infrastructure projects that need to be financed, Western borrowers looking for
capital and ambitious rulers eager to set up their own Islamic-finance hubs.
The industry is innovative; new products keep expanding the range of
sharia-compliant instruments.
And as in conventional finance, the economics of the Islamic kind improve as it
gains scale.
But further growth itself contains a threat.
The AAOIFI ruling on sukuk earlier this year neatly captured the contradictory
pressures on the industry.
On the one hand, bankers are worried that the narrow enforcement ofsharia
standards is liable to
stifle growth; on the other some observers fear that Islamic finance is
becoming so keen to drum up business that its products, with all their
ingenuity, are designed to evade strict sharia standards. This presents a
dilemma. If the industry introduces too many new
products, cynics will argue that sharia is being twisted for economic ends—the
scholars are being paid for their
services, after all. But if it fails to innovate, the industry may look too
medieval to play a full part in modern finance.
Balancing these imperatives will become even
harder as competition grows fiercer. Anouar Hassoune of Moody’s, a
credit-rating agency, believes that unscrupulous newcomers could harm the
reputation of the entire industry, “like the space shuttle undone by something
the size of a 50 cent coin”. Islamic finance serves two masters: faith and
economics. The success of the industry depends on satisfying both, even if the
price of that is a bit more inefficiency and a bit less growth.
A short introduction
Faith-based finance
Sep 4th 2008.
>From The Economist print edition
>http://www.economist.com/world/mideast-africa/displaystory.cfm?story_id=12052679
>
The whys and wherefores of Islamic finance
THE
modern history of Islamic finance is often dated to the 1970s, with the launch
of Islamic banks in Saudi Arabiaand the United Arab Emirates. But its roots
stretch back 14 centuries.
Islamic finance rests on the application of Islamic law, or sharia, whose
primary sources are the Koran and the sayings of the Prophet Muhammad. Sharia
emphasises justice and partnership. In the world of finance that translates
into a ban on speculation (or gharar) and on the charging of interest (riba).
The idea of a lender levying a straight interest charge, regardless of how the
underlying assets fare in an uncertain world, offends against these
principles—though some Muslims dispute this, arguing that the literature in
sharia covering business practices is small and that terms such as “usury” and
“speculation” are open to interpretation.
Companies
that operate in immoral industries, such as gambling or pornography, are also
out of bounds, as are companies that have too much borrowing (typically defined
as having debt totalling more than 33% of the firm’s stockmarket value). Such
criteria mean that sharia-compliant investors steer clear of highly leveraged
conventional banks, a wise choice in recent months.
Despite these prohibitions, Islamic
financiers are confident that they can create their own versions of the
important bits of conventional finance. The judgment of what is and is not
allowed under sharia is made by boards of scholars, many of whom act as a kind
of spiritual rating
agency, working closely with lawyers and bankers to create instruments and
structure transactions that meet the needs of the market without offending the
requirements of their faith.
Non-Muslims may find the distinctions
between conventional finance and Islamic finance a trifle contrived. An options
contract to buy a security at a set price at a date three months hence is
frowned upon as speculation. A contract to buy the same security at the same
price, with 5% of the payment taken upfront and the balance taken in three
months upon delivery, is sharia-compliant.
Then again, winning over non-Muslims is not really the point.
There is no ultimate authority for sharia compliance. Some worry
that this may hold the industry back. Malaysiahas tackled this by creating a
national sharia board. Some industry
bodies, notably the Accounting and Auditing Organisation for Islamic Financial
Institutions (AAOIFI) in Bahrain, are working towards common standards. That
a few scholars dominate the boards of the big international institutions also
helps create consistency. But differences between national
jurisdictions—between pious Saudi Arabiaand more liberal Malaysia, say, are
likely to remain.
Both of these countries feature in the top
three markets for Islamic finance, measured by the quantity of sharia-compliant
assets (see
table). Top is Iran, although international sanctions keep its
industry isolated. The Gulf states, awash with liquidity and with a roster of
huge infrastructure projects to finance, are the most dynamic markets.
Britainis the most developed Western centre,
although France, with a much larger Muslim population, wants
to close the gap.
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