Toby Birch, Managing Director, Oppenheim & Co Limited, Guernsey, makes  some good points about the sector in a recent essay. Read below.

Ready for Retail?

Toby Birch, Managing director, Oppenheim & Co. Limited, Guernsey; gives an insight into Islamic banking.

Anyone with even a passing interest in Islam will be struck by the common sense and simplicity of its message.  As a non-Muslim this is most striking when visiting any mosque and witnessing the relative informality of the clerical structure during prayers. If one delves deeper into its economic lessons then similar themes appear. It soon becomes apparent that there is profound wisdom and age-old understanding of human behaviour. Westerners struggle to comprehend why interest is a problem and shrug it off as a religious idiosyncrasy. However, there is nothing superstitious about refuting the use of usury. The UK will be spending more on interest than it does on defence in 2011 while the entire Euro currency block wavers under the weight of debt; exactly who is being irrational by urging its avoidance? Some smug commentators lump gold bugs and the ‘interest-free crowd’ into the same category, implying they are somehow unsophisticated. As one who is associated with both bullion and Islamic Finance, I would appear to be firmly wedged in that pigeonhole.

We are now all-too-familiar with the tale of the Emperor’s New Clothes, post-2008. The children’s fable reminds us of our reticence to ask simple questions for fear of sounding stupid. It sometimes takes the naïve or innocent to bare the obvious (pun fully intended). Similar demands must be made of the Islamic Finance industry, especially in its formative years. Recent reports claim that the asset base of such institutions is set to hit $1.5 trillion in 2012. It is difficult to determine how such forecasts are derived given the wide variety of data sources for each industry sub-set. The total may well be swelled by the accumulation of petro-dollars at Islamic banks alongside the issuance of sukuk (bonds) plus takaful (insurance) business. While the numbers are impressive and the growth rates likewise, one wonders whether such bank deposits are actually doing anything useful for the wider economy or simply stagnating and devaluing with the dilution of the US dollar. Perhaps the real numbers to look at are those of penetration rates.  There are 80 million Egyptians, most of whom are Muslim, and more in Indonesia, yet Islamic finance is an after thought. Few institutions have a regional strategy, let alone international presence, to enable distribution.

Given the history of Islam, one would expect its financial system to be a grass-roots phenomenon. After all, the religion was propagated by word of mouth, assisted by the example set by Muslim traders, known for their honesty and fair dealing. However, the modern industry has a hard, institutional feel to it. Western investment banks are drawn by the hefty corporate finance fees on big sukuk bond issues. There is minimal appetite for offering retail financial services. Small but sincere fund providers struggle to afford the extra costs of Islamic compliance. Large institutions argue that if one cannot afford a single scholar for your fund’s fatwa, let alone an entire Sharia Board, then hard luck, that’s the market rate. Their wealth management arms have also attempted to milk money from the wealthy in the Middle East, offering Islamic-looking funds catering for exotic and esoteric themes. The average fund size is apparently around $30m so it would appear their uptake has been unspectacular.  It is tough to track both the size and performance of such vehicles as the data is often the preserve of subscription-only services. The open qualities that spurred the spread of Islam appear to be lacking in its implementation. Another missing aspect is the simplicity, especially if one has ploughed through a Prospectus with a dizzying array of arrows on transactional diagrams. It is reminiscent of the illustrations for mortgage backed securities that supposedly proved their high credit ratings.

Institutions can rightly counter that the retail approach has struggled, citing the example of the Islamic Bank of Britain, requiring on-going funding from its shareholders. Like all modern businesses, scale is essential to compete with interest-based banking services. This is why Islamic retail banking requires more than just a large pool of Muslims to succeed; the customers need to have money to deposit as well. This allows banks to upsell services which are more profitable for both the institution and customers alike, and ultimately more useful for the wider economy. These are in the form of restricted and unrestricted accounts that allow greater flexibility for risk and reward. Ultimately this ‘equity’ approach is the most economically useful activity a bank can perform. It reduces systemic risk and counters the inflationary effect of credit creation. There is huge demand for borrowing by SME’s (small to medium sized enterprises) that cannot find finance. Even when secured, credit is offered at extortionate margins by the interest-based lenders. The tragedy for western economies is that SME’s generate the jobs but are being starved of financial fuel. For too-big-to-fail banks, the bail-out has been the greatest coup of the century. A generation of tax payers will have to fund their liabilities with none of the benefits. Like an implanted cuckoo, our banking system acts like a sibling but is really a parasite that gorges our food and throws us out of the nest once they’ve outgrown us. The government, like the host parents of the innocent bird, is tricked into feeding the invader until they are exhausted by its constant demands.

There are also enormous barriers from regulators, mainly in the form of the Basel Accords that encourage debt rather than equity-based assets by their very nature. The old Latin maxim of ‘who guards the guards’ springs to mind when considering such decrees. The proponents of usury permeate every institution, designing laws to protect bond holders and receivers of interest over those who take greater risk in the form of equity. There are also benign barriers to Islamic banking, even in tolerant countries like Canada whose regulators want banking availability for all religions, not just Muslims.  Perhaps the religious tag needs to be replaced with an ethical one to widen its appeal and palatability. After all, the avoidance of usury is not just common sense but is also a common theme for People of the Book (a term encompassing several other religions).

One would expect to see leadership in the Middle East where retail banking has more potential for significant success. However, Malaysia appears to be taking pole position with greater uptake for Islamic products and services. Just like any other service, the benefits of Islamic finance needs to be sold to customers. It cannot depend on duty or devoutness alone, especially when customers pay a higher price for the privilege. After all, why should individuals invest according to Sharia values when Muslim countries’ Sovereign Wealth Funds fail to do so? Using these principals for investment and business transactions is not just the right thing to do but is beneficial for the economy and investors alike. It avoids the destabilising effect of derivatives and leverage while enhancing genuine yield generation and sustainability of the equity approach.

While recognising the need for capital markets one should not overlook the fact that institutional money is ultimately sourced from mass market deposits, pensions, insurance and investments. This stable source of capital could provide some of the liquidity and long-term funds Islamic banks are desperate for. Will a retail revolution arise in 2011? Probably not, if 2010 is anything to go by. We will likely endure another year of sponsor-driven conferences with their euphemisms, tales of growth paradigms and fancy funds. Like their western counterparts, some Islamic financiers want a speedy return to business as usual, finding formulae to mimic an interest-based – and ultimately self-destructive - system. Islam is the oldest yet the latest thing whose tenets stand firm as generations come and go.  The lack of consumer empowerment has allowed the industry to follow fashion, dictating trends from the top; it would be wonderful for Islamic finance to flourish organically from the bottom-up.  

In a recent Zawya article, two lawyers--Hessam Kalantar and Owen Delaney--summarize the legal, organizational, strategic and financial issues involved in putting together debt restructuring plans for insolvent, nearly insolvent or generally distressed groups. While the article understandably leaves much to be desired concerning the actual substantive Shar`i issues related to such restructurings, the authors note that

Any successful restructuring of Shari'a compliant instruments will require consultation with, and approval from, the relevant Shari'a boards. The company's  Shari'a board will need to approve numerous facets of the restructuring plan, most notably the compliance of the various refinancing mechanisms with the precepts of Shari'a, particularly the amendments to Shari'a compliant financing arrangements and the implementation of the refinancing.  While some creditors may choose to rely on such approval, others may require that the relevant refinancing arrangements be approved by their own Shari'a board.  Upon a determination by the respective boards that the arrangements are Shari'a compliant, fatwas (or Islamic compliance certificates) in relation to the arrangements will need to be obtained. Balancing the interests of multiple Shari'a boards may be almost as time consuming as balancing the competing interests of creditors, and this should be taken into account with scheduling and timing expectations so far as consummation of the restructuring is concerned.  

From a recent Housing Wire article ("BofA finds securitization investors limit options for mortgage servicing"):

Bank of America Home Loans President Barbara Desoer said in written testimony before the Senate Banking Committee that because the majority of its mortgages are held by investors, the bank is "constrained" in its role as a mortgage servicer for three-fourths of their mortgage portfolio.

The committee will hear testimony Tuesday from BofA (BAC: 11.763 -2.79%) and JPMorgan Chase (JPM: 39.24 -2.10%) on recent foreclosure and documentation problems at the two banks and others. Each suspended foreclosures because employees signed affidavits without properly reviewing documentation, a problem, according to the Congressional Oversight Panel, that could threaten the entire financial system.

Read the rest...

Is the recent mortgage documentation scandal merely a case of 'procedural problems,' to be quickly moved past, or is it indicative of massive fraud that has profound implications for the entire conventional mortgage industry. Yves Smith's New York Times Op-Ed  addresses some of the issues at stake. She notes 

"Evidence is mounting that these [procedural] requirements were widely ignored. Judges are noticing: more are finding that banks cannot prove that they have the standing to foreclose on the properties that were bundled into securities. If this were a mere procedural problem, the banks could foreclose once they marshaled their evidence. But banks who are challenged in many cases do not resume these foreclosures, indicating that their lapses go well beyond minor paperwork (my emphasis)."

Robust and dynamic ethico-legal systems are characterized by a balance between considerations of form and substance. This is a point that should be remembered the next time that Islamic financial ethicists' traditionally-informed concern for the form--as well as the 'substance'--of contracts is derided by external and internal critics.

October 4, 2010

A new IMF study compares the performance of Islamic banks and conventional banks during the recent financial crisis, and finds that Islamic banks, on average, showed stronger resilience during the global financial crisis.

But the study also finds that Islamic banks faced larger losses than their conventional peers when the crisis hit the real economy.

In “The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study,” economists Jemma Dridi of the IMF’s Middle East and Central Asia Department and Maher Hasan of the IMF’s Monetary and Capital Market Department look at the effects of the crisis on bank profitability, credit, and asset growth in countries where both types of banks have a significant market share. The new working paper adds an empirical dimension to the debate on the relationship between Islamic banking and financial stability, a topic that has generated renewed interest since the global crisis.

Too big to ignore

Islamic finance is one of the fastest growing segments of the global financial industry. In some countries, it has become systemically important and, in many others, it is too big to be ignored. It is estimated that the size of the Islamic banking industry at the global level was close to $820 billion at end-2008. The largest Islamic banks are located in the countries of the Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates).

While Islamic banks play roles similar to conventional banks, fundamental differences exist between the two models. The main difference between Islamic and conventional banks is that the former operate in accordance with the rules of Shariah, the legal code of Islam. The central concept in Islamic banking and finance is justice, which is achieved mainly through the sharing of risk. Stakeholders are supposed to share profits and losses, and charging interest is prohibited.

There are also differences in terms of financial intermediation, the paper notes. While conventional intermediation is largely debt based, and allows for risk transfer, Islamic intermediation, by contrast, is asset based, and centers on risk sharing. One key difference between conventional banks and Islamic banks is that the latter’s model does not allow investing in or financing the kind of instruments that have adversely affected their conventional competitors and triggered the global financial crisis. These include toxic assets, derivatives, and conventional financial institution securities.

Crisis impact

To control for varying conditions across financial systems, the paper looks at the actual performance of Islamic banks and conventional banks in countries where both have significant market shares (see Chart 1). It uses bank-level data covering 2007−10 for about 120 Islamic banks and conventional banks in eight countries—Bahrain, Jordan, Kuwait, Malaysia, Qatar, Saudi Arabia, Turkey, and the United Arab Emirates. These countries host most of the world’s Islamic banks (more than 80 percent of the industry, excluding Iran) but also have large conventional banking sectors. The key variables used to assess the impact are the changes in profitability, bank lending, bank assets, and external bank ratings (more..)

The CIBAFI has reposted the Wesleyan Argus article on Sh. Taha Abdul-Basser's Dec 2009 lecture at Weslyan University. In light of the current events, it seemed appropriate to post their repost.

In his lecture on Feb 16, 2009, Taha Abdul-Basser, chaplain of the Harvard Islamic Society and doctoral candidate in religion at Harvard, proposed a solution to the current economic crisis that is not often considered: follow Islamic law, known as Shariah.

The lecture, entitled “Islamic Finance: Islamic Solution to Global Financial Crisis,” was part of a series of events scheduled for “Islam in Conversation Week,” organized by the Muslim Students’ Association (MSA) and the chaplain’s office. The theme is “Living Shariah in the Contemporary World.”

“We want to show that Islam is not limited to spirituality or one’s relationship with God—even though that is an extremely important concept—but also, how our relationship with humanity is,” said Sister Marwa Aly, the Univerity’s Muslim Chaplain. “Islam is a way of life, so it has a stance on the environment, on economics, on politics, on social justice and even on entertainment.”

Shariah is a frequently used term, but is often employed without a full understanding of its meaning. Students in the MSA hope that the talks given throughout the week will encourage dialogue and help people more fully understand Shariah.

"Hopefully, organizing a lot of talks about Shariah will help people better understand what it means,” said MSA member Jourdan Hussein ’11.

Islamic finance is based on Shariah, which includes writings from the Qur’an and from Muhammad, and the scholarly teachings that inform Islamic law. Its underlying precept is the illegality of any usury—transactions that demand interest from a person receiving a loan.

It also states that all financial transactions must be done with caution, and prohibits directing the flow of money itself when no tangible assets are involved. Thus, under an Islamic system, the complicated packaging of mortgages partly responsible for the current financial crisis would never have occurred “The speaker was really informative and had a great background with which he supported many of his ideas of how Islamic financial policies and ideas could be beneficial to the falling economy today,” said Raghu Appasani ’12. “I am glad I [attended] because I did not even know that there was a whole separate Islamic financial sector that was so successful.”

Islamic banks use mechanisms that do not charge interest, which include “lease to own” agreements and diminishing equity balances, in which two partners would take out a mortgage with one eventually buying out the other. These financial systems exist in the Muslim world, such as Saudi Arabia and Malaysia, but also increasingly in the West, most notably in Great Britain.

Although Abdul-Basser conceded that the Islamic system is comparably smaller, these Islamic institutions have better withstood the financial crisis because they never undertook the risky mortgages and then resold them.

Abdul-Basser said that many financial systems in the world need structural changes, instead of continuing the practices that led to the crisis.

The reforms Abdul-Basser mentioned in his lecture had all been suggested by secular economists—Islamic reforms need not be necessarily religious. He cited Joseph Stiglitz, a Nobel Prize-winning economist at Columbia University, and Nouriel Roubini, a professor at New York University who predicted many aspects of the financial crisis.

His suggestions, based on Stiglitz’ work, included creating incentives for executives that reward thinking beyond short-term gains to form financial product safety and financial system stability commissions to oversee financial companies and prevent excessively risky loans, along with other regulations to limit excessive borrowing. Abdul-Basser also suggested briefly nationalizing banks in order to reform their practices, before returning to privatization.

“I thought that if what the lecturer discussed could be somewhat secularized, it seems as though it could absolutely work.” said Phil Ross ’12, who attended the lecture. “The lecturer really got his opinion across that restructuring our system to encompass certain facets of Shariah-compliant banks would go a long way towards stopping the bleeding that was caused by excessive lending.”