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Sukuk success

Islamic finance

Islamic finance is spreading globally and product structures are evolving rapidly. Can the industry keep its unique identity amid all this change? Simon Watkins, freelance journalist and former head of international sales at Credit Lyonnais, investigates.

The global Islamic finance industry has grown from about USD10bn worth of invested assets in 1975 to USD2.2trn today, according to the first ethical charitable trust, an adviser on Shari’ah compliance in the UK.

The tenets of Islamic finance generally forbid the payment of interest and investing in activities deemed speculative, uncertain or unjust (such as gambling, alcohol and the sale of certain foods). This has appeal beyond the Muslim world: indeed, about 80% of Shari’ah compliant investment products in Malaysia are held by non Muslim investors. Two questions then, arise: will the rise of Islamic finance continue, particularly given the lack of trust in Western banking, and what changes can be expected in the global Shari’ah investment mix?

Islamic finance hot spots

By the end of 2010 5.5% of the USD2.2trn invested in Islamic instruments was held in dedicated Islamic funds, with 31.1% in broader based assets (mainly in Shari’ah compliant bank accounts and money market vehicles). The rest was held in other Islamic instruments, particularly Shari’ah compliant bonds (sukuk), insurance packages (takaful) and equities products.

The main centres for Islamic finance have, according to Sohaib Umar, a partner in Ernst & Young’s Islamic financial services group in Bahrain, ‘stayed largely the same for the past three years: Malaysia continues to lead the way in sukuk and equities products, while Saudi Arabia does the same for bank deposits.’ Dedicated multiproduct Islamic funds are split largely among Malaysia, Saudi Arabia, Kuwait, Luxembourg, Bahrain, the Cayman Islands and Ireland.

Yet the focus of the Islamic finance industry – especially for bond and equity products – is set to change, says Sam Barden, chief executive of SBI Fund Management in Dubai. ‘Saudi Arabia, most notably, is likely to lose further market share to Bahrain, Dubai and non Muslim investment hubs, particularly Luxembourg,’ he says, explaining that Saudi Arabia’s lack of amenities for non Islamic financiers will hold it back.

Reaching new markets

In a bid to boost its growing dedicated Islamic bond and equity funds business, the Central Bank of Bahrain has introduced a new regulatory framework for collective investments. This allows for a wider range of activities, including hedge funds, derivatives and alternative investment vehicles.

Another Bahraini innovation, in March 2010, was the first globally standardised documentation for privately negotiated tahawut (hedging) products. This followed the publication of a ‘tahawut master agreement’ by Bahrain’s international Islamic financial market and the New York based International Swaps and Derivatives Association (ISDA). ‘This should bring the benefits of efficiency, certainty and liquidity to the Islamic finance markets, as did the development of the original ISDA master agreements in the 1980s,’ says Yousef Battiwala, an associate at London based commercial law firm Allen & Overy.

Dubai has also been making itself more attractive to foreign users of Shari’ah compliant instruments. In 2006 the Dubai Financial Services Authority (DFSA) signed up to stringent standards for information sharing and assistance between regulators set out by the International Organisation of Securities Commissions. The DFSA made 46 bilateral agreements with regulators of strategic importance to the Dubai International Financial Centre.

Financial centres outside the Middle East are also targeting Islamic finance investors, with Luxembourg is the best placed to win business, according to Barden. ‘No laws or amendments are needed for Shari’ah compliant funds to set up there, they are not charged any taxes, and the whole process can take as little as six weeks for both collective investment schemes and specialised investment funds,’ he says. ‘This timeframe contrasts with an average of two months in Bahrain and Dubai – and three months in Saudi Arabia.’

Shelter from the storm

Some champions of the Islamic finance model have argued that it has helped to shelter investors from the worst of the global financial storm. A study published by the International Monetary Fund in October 2010 confirmed that Islamic banks outperformed conventional institutions in the early stages of the crisis because of their smaller investment portfolios, lower leverage and adherence to Shari’ah principles. Their profits fell only slightly, while credit and asset growth remained strong.

However, as the crisis moved to the real economy in 2009, their profits were hit badly. ‘The end of 2009 brought a considerable shock to the Islamic finance complex, with the near default in December on Nakheel’s 2009 sukuk and prospects of other defaults on supposedly Shari’ah compliant investment products,’ says Roger Nightingale, chief global strategist for Pointon York, a London based investment and pension adviser. ‘Indeed, this near miss brought into sharp relief the fact that many of the financial instruments that had been branded as Shari’ah compliant were, in practical terms, no such thing.’

Playing by the rules

The diversity of rulings from Muslim scholars on what precisely is, or is not, a Shari’ah compliant investment could cause problems. For example, in Saudi Arabia, which follows the Wahhabi form of Islam, the interpretation of Shari’ah is strict. Meanwhile, the highly flexible reading of the laws in Malaysia, under the Shafi school of Sunni Islam, has helped to create the world’s largest Islamic bond market. The Gulf states generally chart a middle course between these two extremes.

Different interpretations can have a significant market impact, as happened in 2008 after a decision by the accounting and auditing organisation for Islamic financial institutions, the industry’s international standard setter. It stated that the repurchase undertakings in about 85% of apparently Shari’ah compliant bond and equity fund structures, based on mudaraba[1] and musharaba[2], violated the Islamic duty to share risk, says Nightingale. As a result, the issuance of these of products fell that year by 83% and 63% respectively.

The line between sukuk and traditional finance continues to blur, according to Khalid Howladar, senior credit officer for asset backed and sukuk finance at Moody’s in Dubai. In principle, sukuks should grant investors a share of an asset or business venture linked to the cash flows and risks of ownership. Western structures usually provide non asset backed, interest based funding for general corporate purposes. In reality, Howladar says, ‘most sukuk structures have more in common with conventional fixed income or debt instruments from a risk/return perspective.’

That said, if Islamic finance is structured in a way that involves the sharing of risk and reward equally, the financial effects will differ from those of a conventional loan. Additionally, where the key features of cash flows, risk and return of a supposedly Islamic fund are in essence the same as those of an interest bearing conventional bond, this should be made clear to sukuk scholars and investors at inception. This may slow the sukuk market’s growth and bolster the asset backed market. However, as Howladar says: ‘It is probably only by supporting the features that make Islamic finance different that any sustainable value will be added to the global financial system.’

1 Mudaraba: an investor provides capital to an entrepreneur for an investment activity, and the “profits” (notionally, cash flows generated from underlying assets) are shared at an agreed ratio, while the losses are borne by the investors alone.

2 Musharaba: all partners in the joint venture are entitled to a share in the profits at an agreed ratio (with excess income taken as an ‘incentive fee’). Losses are shared out in proportion to the amount invested.

This article first appeared in the March 2011 edition of Financial Management magazine.