Financial Times Special Report on Islamic Finance

Today's Financial Times has an interesting Special Report on Islamic Finance here . Some of the more interesting tidbits worth taking not of are the following:
-the sukuk, or Islamic bond, market hasn't fared as well as the rest of the sector since the subprime crisis began last summer and the primary reason is driven by Sheikh Muhammad Taqi Usmani, one of the leading Islamic finance scholars who is head of the Accounting and Auditing Organization for Islamic Financial Institutions, ruled that most existing sukuk instruments were not in compliance with sharia due to the fact that most are structured to pay a guaranteed return. This violates the proscription on risk and sharing of profits and losses in Islamic law. The cooling effect it has had on the market has been tempered by the recognition that working through the issues and developing more rigorously compliant instruments in the future that are informed by this ruling will help fuel the market in the future.

-this brings up the issue of regulation that has been raging across the Islamic Finance blogosphere and publications in recent months that the lack of common regulatory frameworks may be impeding the market. The other factor that may hold the market back is the lack of qualified professionals who have the understanding of both finance and Islamic law. It now takes up to 15 years to train people in both and demand greatly exceeds supply and is driving up salaries.

-in the wake of Sheikh Muhammad Taqi Usmani's ruling there have been a few sukuk bonds issued but they've been structured through ijara (Islamic lease-to-own contract, for a glossary of Islamic financial terms look (here) ). This was in response to his ruling that mudaraba and musharaka "offered investors a repurchase undertaking where the issuer promises to pay back the face value of the bond when it matures or in the event of a default", thus violating the prohibition against guaranteed returns. Ijara contracts involve a sale and leaseback arrangement because an asset such as a building is used to raise money.

-the other interesting piece was on the UAE's Noor Islamic Bank (here) . This is one of the most ambitious ventures to date in Islamic banking and looks like they're working on some innovative approaches to banking in general by targeting lower income customers through the use of post offices to target the 50% of the population that doesn't have bank accounts and to expand to Africa and Asia. They also plan to include credit cards, microfinancing, salary payments and remittances/currency exchange. Do I hear mobile banking potential as well??

-hedging for rising prices in Islamic finance. Since derivatives are rather questionable in Islamic finance the issue of hedging against growing inflation rates is coming to the forefront. Real estate investment trusts are rapidly becoming one of the favored approaches particularly given the rise in real estate prices. One of the hurdles will be the lack of clear property laws.

What's clear is that the growing assertion of Islamic identities in the marketplace combined with the growing oil prices and growing global financial crisis are all coming together in interesting ways to drive innovation and the future of Islamic banking.

Islamic Banking & Sustainability in the Gulf

The UAE claims it has taken the lead in Gulf banking from Bahrain, in part on the back of growth of Islamic institutions like DIB (referred to as the first 'fully-fledged' Islamic bank, established in the 1970s), SIB (Sharjah) and Emirates Islamic Bank. Like the skyscrapers of the Gulf capitals, every year that passes brings a new superlative: Gulf Holding Company (GHC) recently listed on DIFX the most innovative Islamic banking product in the MENA region: $190 million worth of five year, floating rate sukuk al musharaka certificates (Ironically, GHC used this sukuk to finance a mixed use development in Bahrain).

While the mechanics Islamic banking strike Westerners as arcane (even if its profitability can no longer be denied), the scale and geographic breadth of demand makes it far more than a fad. Many of the instruments that form the core of the field –sukuk, takaful, etc.— based on the avoidance of riba and gharar (interest and excessive risk), and the sale of what one doesn’t have, are by design ‘bubble-fighting’. In an environment where so many are concerned with “over-exuberance” and the potential for indebtedness on a spectacular scale, widespread practice of Islamic banking and finance can serve as a reality check, instilling confidence, helping to grow a middle class, alleviating suffering and creating a moral export. Additionally, widespread use of, and access to Islamic finance addresses speaks to fears on the part of minority native populations that they are losing their Gulf-Arab-Muslim identity, this in a society where more than 85% of the population is from somewhere else.

Here we have an example of an area in which Dubai’s vast talent at turning everything it touches into a spectacle could either work to great benefit, or be self-defeating. At some point soon as various commentators have argued, Islamic banking as a profession will have to re-center itself, or face discrediting by its Muslim –and Western—adherents as either a perversion of the Shari’a or an impediment to the free market. If Gulf governments manage to work actively with Islamic banking professionals to apply its principles not just to the richest segments of societies but the poorest [see below post]; if more attention is paid to creating a robust set of standards governing the operation of Islamic banks and financial institutions, Islamic Banking will have delivered a major blow to its naysayers. It will also have helped create a more sustainable Gulf.

Renewed focus on poverty in Islamic Finance

In recent weeks we've seen a growing debate on the role that Islamic finance can play in the poverty alleviation domain, particularly through Islamic microfinance. In April a forum sponsored by the International Islamic Finance Forum that included Nobel Prize winner Muhammad Yunus, asserted that Islamic finance players needed to play a bigger role in the microfinance movement, an area where very little has been done so far (see link here) . Even the Islamic Development Bank, the Islamic analog to the World Bank, has established a $10 million poverty alleviation fund that focuses primarily on microfinance.

It is a bit puzzling why Islamic bankers haven't jumped into this market quite awhile ago given the ethics of Islamic business and finance and the fact that one of the five pillars of Islam is the payment of alms, or zakat. Of particular interest could be Islamic insurance or takaful. Islam forbids riba and gharar (risk). Western insurance entails investment of capital in a way that violates the prohibition against riba, or making money from money. Furthermore, the prohibition against gharar is largely against speculation and gambling and one of the most important juristic rulings against conventional insurance is based on the assertion that insurance is the sale of risk or uncertainty and this violates Islamic teachings on ethics in contracts. To get around this prohibition the institution of takaful was created which is a form of solidarity insurance or joint guarantee. Now, anyone familiar with the microcredit practices of Grameen Bank will immediately recognize the "solidarity" aspect that forms the basis of the mutual guarantee that drives high repayment rates at Grameen. Back in the early 1990s I spent a year studying Grameen Bank and its replication and from the narratives of members I often mused that savings and insurance might be just as important, if not more powerful, than micro-loans for the poorest of the poor. The way the solidarity circles worked in practice was itself an informal type of insurance. In the latter half of the 1990s we saw growing interest in microinsurance in Africa where high HIV rates jeopardized the sustainability of many microfinancial institutions and even Grameen created a health insurance scheme, Grameen Kalyan, after they discovered that over half of the defaults on loans were linked to health crises that depleted household assets.

So where might all of this lead in terms of innovation in the Islamic banking sector? There will be tremendous opportunities for those who recognize that 'innovation' often means creating the appropriate products and delivery mechanisms to reach the so-called "base of the pyramid" (no comment on the terminology here!). The ethics of Islam, if we can put substance over form as Mahmoud Al-Gamal has been insisting for years, could create the platform for numerous products and services in Islamic banking or for those wanting to engage with predominantly Muslim populations. Microtakaful, shari'a compliant microloans and social businesses could come together in a number of ways to impact the triple bottom line for those savy enough to engage with Islamic law, social entrepreneurship and Islamic business practices. Just take a look at the current market for mortgages in the West and the growing ethical/financial crisis to see the opportunities for how Islamic banking could make inroads, even in the West, soon!

Global Halal Investing and Sukuks - Inherently Safer?

Quite an interesting article on global sukuk dynamics from the Emirates' Business 24/7 today. It suggests that global investors - Muslims and non-Muslims - are increasingly turning to sukuk bonds as hedges against excess risk in global markets, particularly the US. Are properly structured, well-managed sukuks inherently a better option than western-style government or company debt instruments? Are they somehow safer? My gut reaction is a big, "It depends". At bottom, it depends most on the financial fundamentals of the entity issuing the contract. If the fundamentals aren't there ( or are not transparent and accountable), it doesn't much matter what legal enforcement code is. The Gulf financial markets are of course on an up-swing right now, and up-swings tend to obfuscate all manner evils and irrationality.

The test of a lot of these assumptions about the safety of Islamic banking instruments will come in the next down cycle in the Gulf (although competing financial centers in Malaysia, London and elsewhere may make this picture less clear). For now, Gulf and global investors seem happy to continue to move from US markets into global halal investments. While the latter shows tremendous upside (especially in the short run), abandoning bargain opportunities in the US markets is likely a mistake.

Islamic Banking in Africa Taking Off - Not Just For the Rich

This week's Economist article is actually a bit late to the party: Islamic banks having been working at various levels across Africa for a number years. Nonetheless, it's striking just how fast the sector is growing.

Another point the Economist article made (quoting Anouar Hassoune of Moody's) also struck me as a little odd: that Shariah-compliant instruments and products are a "luxury product". What he means (I think) is that Islamic banking tends to better in markets that have an established financial market infrastructure and appropriate enforcement mechanisms than in markets that have weaker markets and rule of law.

On one hand, you could say that would be true of any banking system, Shariah or not. On the other hand, this gets to a deeper idea worth pursuing: How well can Islamic banking and related products compete with existing banks in underserved markets - especially in countries or regions that are predominantly Muslim?

It's instructive to watch what's happening in Pakistan right now. Investors have been employing sukuks (similar to bonds) to underwrite a wide assortment of economic development projects, recently naming Dubai Islamic Bank and Standard Chartered Bank Pakistan to manage its first local currency sukuk. This follows a series of sukuk deals over the last three years that have helped attract significant foreign investment into the country.

Searching for promising opportunities, Islamic banks are stepping up investments in key beachhead markets in Africa - especially in regions that have long been dominated by Western Banks. If they are smart, they will also recognize that they could also capture substantial market share in consumer services and products, working niche markets that current banks serve poorly, or not at all. Islamic banks can serve a wide population - not just those at the top of the food chain. Flush with cash and able to move quickly, with attractive early markets, these banks are in an enviable position. Whether they fully realize the opportunity in front of them and whether their competitors can protect their market share are open questions.