Before Islamic finance pops the Saudi champagne on surviving the sub-prime induced credit crisis, the industry, much like conventional Western finance, needs to take a step back and reflect about the pathway forward. By Rushdi Siddiqui, Global Head of Islamic Finance, Reuters.
The blueprint of the embryonic Islamic Finance phenomenon has been risk-averse, short-term, and liquidity oriented, hence a reliance on murabaha and Sharia compliance. You could say that at one level, its youth and risk-averseness prevented an Islamic "credit crisis".
There are 57 Muslim countries with a combined GDP of US$4.7trn and 24% (or 1.6bn) of the world's population. However, has Islamic finance provided investment benefits to the "man on the (African) street?" I've been involved in Islamic finance for more than 13 years, and believe not.
Recent industry "cheerleading", while capturing local paper headlines, has not addressed some of the important forecast "headwinds". If this niche market is to reach the US$1trn estimated size by 2010–11 and become a viable alternative for deploying savings into Sharia-compliant investments, it must raise and address questions relating to reducing the high information search costs in Islamic finance.
In this opinion piece, I want to raise and address some "headwind" issues in Islamic finance, starting off with the need for the industry to undertake a macro stress test, and then some "sub-surface" examination of Islamic screening and investing, the much over-looked Sharia risk, the case for financial indicators, and, finally, the cross-sell to the non-Islamic community.
Stress testing of Islamic banks
The US Treasury's stress test of 19 US banks was positioned as a confidence building, not solvency ensuring measure. An IMF official visiting the GCC region (in the spring) suggested stress tests for financial institutions in oil-exporting countries. Interestingly, at the recently concluded World Economic Forum (WEF) in Amman, Jordan, very little was mentioned on stress testing financial institutions in the region, with more discussion on acquisitions and geographic expansion as valuations were attractive. Where do Islamic financial institutions, which have presently avoided the bail-outs and bankruptcies in G7 countries, fit in the stress test phenomenon?
Islamic banks, within their capacity of "Amanah" (or trust), need to undertake a similar, but customised, stress test exercise consistent with the uniqueness of the home country. Does the board of directors of an Islamic bank have a fiduciary duty, as part of confidence building measures, to start the process of undertaking a stress test, or should it be imposed by regulators as part of governance and risk management? Any stress test should showcase, and not cheerlead, that a different banking model that has so far avoided the need for government financial support has something to offer the conventional banking system.
The sub-prime induced credit crisis has aptly flushed out the false premises and assertions of the disconnect between Islamic banking and finance and conventional finance. Islamic finance operates in the same macro "conventional" tax, regulatory and legal environment, and has the same present vulnerabilities of liquidity and confidence crisis, so one is right to highlight suggestions from the US Treasury that stress tests may have application for Islamic banks.
What is more, because of the Sharia prohibitions on riba (interest), gharar (uncertainty) and misyr (speculation), the Islamic bank eco-system has greater exposure to real estate and stock "loans", fewer risk and liquidity management tools, as well as an excessive reliance on commodity murabaha.
Finally, Islamic finance has been accused of being non-transparent and opaque, which may be attributed to the embryonic nature of the industry. While the Islamic finance industry rose globally on the back of oil prices, it still has an incomplete information offering for customers (with its continued emphasis on education), requires investment in more qualified personnel, and suffers from the usual complaint about lack of standards.
So, a key take-away lesson from the sub-prime induced credit crisis is its impact on Islamic banks, rather than forward looking scenario tests of declining oil prices, contraction of economy, increasing unemployment and higher cost of Islamic "credit", and reduction in government support.
Potential stress fractures in Islamic finance
Islamic financial institutions have indeed captured negative headlines since the days of peak of oil prices, easy, compliant credit, and government support. A few recent examples include:
* The Kuwait-based Islamic firm Investment Dar acquired the car manufacturer Aston Martin, and recently defaulted on its US$100m Islamic debt issue and is now undergoing restructuring
* Dubai's two Islamic mortgage-offering entities, Amlak and Tamweel, suspended operations and are in the advanced stage of merger discussions
* Government of Qatar purchases strategic interests in banks, including Islamic, in Qatar.
* Bahrain-based Gulf Finance House receives a negative outlook by S&P in early 2009 because of excessive leverage and a worsening operating environment for 2009
* Emirates Islamic Bank's first-quarter income (2009) fell by 56% compared with the same period last year due to losses from its investment securities and lower fee income.
* Dubai Islamic Bank's first-quarter profit (2009) dropped by 33% to Dh370m (US$101m) following provisions for bad loans.
Application of the IF stress test
The application of an Islamic finance stress test should be top-down from central banks, bottom-up from organisations such as the Union of Arab Bankers, and directed towards those entities dealing directly with the man on the street. The methodology must not be seen as initiated or heavily lobbied by Islamic banks, as it will result in a variety of tests that erode confidence and contribute to assertions of opaqueness of the industry.
It should also apply to Islamic commercial banks of all sizes based in the GCC and include Takafol operators. The confidence cuts across sectors, hence a "seal of approval" would confirm the "positive" spin of cheerleaders of Islamic finance and objectively showcase that the model works better or differently than its elder conventional counterpart in a crisis mode environment.
The stress test methodology must be transparent, comprehensive, and flush out the impaired Islamic assets. This naturally leads one to ask if a "bad Islamic bank" or even asset management company should be set up to buy these off-loaded assets as part of the cleansing process, assuming no Sharia prohibition issues such as discounting.
Potential top-line outcomes of an IF stress test include:
* The encouragement of consolidation among smaller capitalised banks. Perhaps it would make more sense for governments to acquire minority stakes in Islamic banks (such as QIA has done in Qatar), with the bank using the proceeds to acquire stakes in smaller Islamic banks. Consolidation could lead to the fostering of backdoor economic and financial integration within the GCC.
* Sale of non-core assets, reduction/elimination of dividends for a period of time, sell additional shares, etc.
* The role of the Islamic Development Bank (IDB) needs to be flushed out; will it co-act (with the home country central bank) as a lender of last resort for "stress test-failing" Islamic banks?
* The need for more and better risk and liquidity management tools.
* The need for better corporate governance, including independent boards of directors
* Islamic accounting rule harmonisation with IFRS (International Financial Reporting Standards).
* The fast-tracking of trust laws to offload asset-backed securitisations as sukuk securities.
* Islamic depositor protection to prevent "runs".
* Unaudited financial statements twice a year.
* Stress testing becomes a periodic undertaking rather than a one-off exercise.
In crises there are often opportunities to build confidence. The sub-prime crisis presents a compelling window of opportunity for Islamic finance to both showcase the merits of asset-based or backed financial intermediation as well as the deployment of savings into real investments without the leveraged derivatives' so-called financial weapons of mass destruction; wrappers.
The petro-liquidity spike, easy credit, and the government-encouraged sukuk environment may be over, but these events did not define Islamic finance, they just boosted its profile globally. Islamic finance can make friends and influence people, but it must undertake confidence-building within Islamic finance and cross-sell to non-Islamic users, by way of a customised stress test for stability and resiliency, as US Treasury Secretary Timothy Geithner would put it. This could be a good beginning for convergence.
Islamic investing
According to Lipper (Thomson Reuters' mutual fund division) data, there were a total of 526 Islamic funds as June 2009, with 269 or 51% equity funds and total assets under management (as of end-2008) at US$25bn. The rise of the Islamic private equity investor is attributed to the market acceptance of Sharia screens.
But has the industry been able to build on the success to other asset classes and positive (sustainability) screening? What about screening for the publicly listed companies in Muslim countries with stock exchanges? To-date, we don't have Islamic REIT indices or commodity indices, and yet the former (real estate) is an important asset class for Gulf investors, and the latter provides the foundation for murabaha contracts.
Despite the launch of an Islamic Sustainability Index in 2006, no funds, ETFs, or structured products have been launched off it yet. Sustainability has become a powerful phenomenon in non-Islamic investing, hence there is an ideal opportunity for building bridges through Islamic Sustainability investing.
If we look at Muslim countries with stock exchanges, they typically consist of about four or five economic sectors, unlike a developed country with 10 economic sectors. The largest economic sector in Muslim countries is the financial sector, accounting for anything between 35% to 75% of the market capitalisation. However, Islamic investors obviously cannot invest in conventional banks, insurance, leasing, etc, type of companies.
Furthermore, an equity culture either does not exist or is in its early stages of emerging in many Muslim countries. The debt/asset or debt/market capitalisation screen results in the elimination of many companies. So, Islamic equity investing in Muslim emerging countries presents challenges for investors looking to diversify portfolios, hence a reason for Sharia-compliant capital flight.
The Sharia scholars working with index providers or fund managers need to look at screening for Muslim countries, as existing Sharia screening does not promote Islamic equity investing in domestic markets. One way forward is to examine lessons from the conversion of conventional banks into Islamic banks and the "Islamic" majority ownership of target companies in Islamic private equity buyouts. In both instances, scholars give the converting bank and buyout a time-frame for full conversion.
Companies violating the debt screen could also, for example, be encouraged to equitise their balance sheets (sale of assets and proceeds used to retire debt) or issue sukuk and refinance conventional debt to meet the "conversion to compliance" process over a two to three-year period.
In effect, "non-compliant" companies are put on probation (and can be invested in with appropriate cleansing) for a period of time until they get certified as Sharia-compliant. This exercise becomes even more important if such companies see the marketing and PR benefits of being included in a high profile Islamic index, and potentially any related Islamic index funds and ETFs. For example, Plus, one of the largest toll operators in Malaysia, issued sukuk to refinance (conventional and BBA) debt to be able to join an Islamic index a few years ago.
Sharia compliance screening/investing, however, is only the beginning. The next stage is Sharia based investing, meaning the company’s primary business is consistent with Sharia precepts. We, at Thomson Reuters, have been able to identify more than 100 dedicated Islamic financial institutions, ie, Islamic banks, Takafol, and Islamic leasing companies from Muslim country exchanges and the UK (with the largest number from Kuwait). The next step is to create an Islamic Banking index and a Takafol index, as this opens many doors for Sharia based investing and creates a real (ECN) Islamic stock exchange.
Another way to think about this scenario concerns the food and food processing companies in the GCC that sell Halal end-products, yet their financial structure is such that they may fail the debt screen due to "excessive" conventional leverage. So put simply, a Muslim can consume their end-products as they are Halal, yet cannot invest in such (listed) company because its not Sharia-compliant due to leverage!
Finally, an interesting paradox exists in Islamic investing in the promotion of Islamic hedge funds, while Islamic microfinance, as a viable asset class, is rarely mentioned in media interviews and the ubiquitous Islamic finance conferences. We hear about the size and potential of Islamic finance for 1.6bn people, yet where is Islamic microfinance to enfranchise some of their needs? I believe it is an opportune time for the industry to look beyond its fiduciary duties to shareholders, and look at an important disenfranchised stakeholder through partial Zakat and purification disbursements from Islamic financial institutions for Islamic microfinance funds.
Sharia risk
Much like conventional finance, Islamic finance has exposure to various risks: market, operational, legal, "credit", liquidity, reputation, etc, plus Sharia risk. A simplified definition of Sharia risk is: a product or structure that was signed off by a Sharia board as consistent with Sharia precepts is no longer Sharia-compliant. Some high-profile examples of this include:
* Sh. Taqi Umani ruling on sukuk (guarantee of purchase undertaking)
* OIC Fiqh Academy announcement on Taawarooq (disguised interest)
* Sh, Yusuf DeLorenzo on Islamic swaps (linking returns to non-compliant benchmarks)
The IF industry is embryonic and really only became a global phenomenon in the last five to six years on the back of oil prices, hence its growing pains, associated with any emerging industry. The more important point is that Sharia scholars by and large provide the checks and balances and (can be said to) act as "consumer advocates" for retail offerings. So, Islamic finance must find the right balance between Sharia authenticity and the need innovation , growth and development.
The Islamic funds area flushes out an interesting Sharia risk issue. For example, Lipper covers 526 Islamic funds (August, 2009). See the table below for a fund breakdown by asset class.
Table
Islamic equity funds form the majority, of which 91% are actively managed, presenting a very interesting situation for Islamic benchmarking – see below chart.
Table
Islamic equity funds presently use Islamic (stock) indices (Beta), from index providers, for benchmark purposes, but is that appropriate when 91% of the funds are actively managed? Lipper has created an Islamic fund index that captures Islamic fund managers' attempt to capture Alpha. It is early days for the Lipper Islamic Fund Index, but such an index needs to be highlighted and promoted as it is a better measure of an Islamic fund manager's stock-picking abilities and justification for its fund management fees.
The interesting observation from the above chart is a lack of demand for passive investing funds, with index trackers and Exchange Traded Funds (ETFs) totalling about 9% of all funds. A number of theories have been put forth on why investors look to actively managed funds to invest in, including a belief that a manager has to "do something" (pick stocks) to obtain performance; fund sponsor's interest to opt for the higher fees associated with actively managed funds.
Numerous studies in the West have shown that passive investing outperforms active management in the medium and long term, hence, it may be just a matter of time before an Islamic finance entity labels itself the "Islamic Vanguard", the US based fund company known for passive investing funds.
One of the benefits of passive Islamic investing is the reduction of Sharia risk. At this stage of development, Islamic index funds and ETFs follow an Islamic index, from one of the established index providers, either by replicating or optimising. The index provider's value add for any fund/ETF sponsor is not only creating the screened Sharia-compliant universe, but also maintaining its continued compliance and monitoring corporate actions.
Thus, it is in the best interest of the index provider to be vigilant on continued compliance during the review periods and in between, as it affects their brand reputation. For example, when a company is removed from the underlying Islamic index, it is removed immediately from the licensed Islamic index fund/ETF.
(With actively managed Islamic funds, the Sharia board typically allow the fund manager 30–60 days to remove a non-compliant company from the underlying Islamic index.)
Financial indicators in Islamic finance
Does the industry need to establish Islamic economic and financial indicators to measure the pulse at any given time, allow for time series analysis and a comparison with more "conventional" indicators? It sounds important enough for the industry to have already established such indicators, but it is not easy, as the following questions need addressing:
* Jurisdiction – Where is the Islamic market that we need to measure? Is it a region (GCC, but not much Islamic finance in Oman)? Is it a country (Saudi Arabia, Malaysia, Pakistan, Sudan, and what about Iran)? What about non-Muslim countries with an established Muslim population that have planted the flag of Islamic finance hub (Singapore, Hong Kong, UK and now France)?
* Do we include Islamic equity indices? If so, most of the Sharia-compliant companies in Islamic indices by market capitalisation weighting are from OECD countries. Yes, there are Islamic indices for Muslim countries, but the biggest sector (conventional finance) is removed, so an adequate overview of screened companies from economic sectors such as basic industries, telecoms (few companies, at best), consumer goods/services, etc, miss out on the financial sector. Yes, there are listed Islamic banks and Takafol (insurance) companies, but they have small free-floats and/or are generally illiquid.
* What about fund flows into Islamic funds, especially if the money is from Muslim countries? According to Lipper data, only 500-plus Islamic funds have assets under management of about US$25bn (2008), yet the private wealth in, say, GCC is around US$1.8trn.
* Examine the general growth of sukuk and Islamic syndicated loans (used mainly for project finance) over a time horizon, and specifically look into size, issuer (sovereign, corporate, etc), type (straight, convertible, exchangeable), currency (hard currency or local country currency), mode of contract (ijara, musharaka, etc), publicly listed versus private placement, etc. Sukuk may give a pulse of compliant capital raising in Malaysia, Bahrain, Saudi Arabia, and UAE for primary market issuance, but there is minimal secondary market trading.
Islamic economic indicators may not make sense today but conventional indicators in Muslim countries would probably suffice. However, financial indicators such as Islamic fund flows, Islamic indices of Muslim countries, a potential Islamic banking and Takafol Index, sukuk and syndicated loan issuance and trading data may be a good place to start in capturing the "pulse" of Islamic finance.
Cross-sell to non-Islamic users
For Islamic finance to become a global phenomenon and a viable alternative to the conventional asset class, it must reach across the secular aisle and emphasise substance over form. If we are to capture the essence of the conventional financial industry, it is basically about two issues: performance and the cost of capital. If the risk-adjusted returns form Islamic funds are better than their conventional counterpart, then funds will flow as investors typically chase yesterday's performance. And if the cost of capital is cheaper with sukuk, we should see non-Islamic (Western) issuers with more developed issuance programmes, and not just one-off issues.
Conclusion
Islamic finance has moved beyond an uncertain experiment during its embryonic life. Teething problems remain but with the right tools, collaboration between regions and greater transparency, convergence towards Western conventional markets and a greater share of investors' portfolios is well within reach.
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