Cloud over Islamic Banking
When
Dubai World decided to suspend payments on its $26 billion debt, among
the loans involved was a $4.05 billion repayment on a $3.52 billion
sukuk or Islamic bond issue. This presence of an instrument that has
gained some prominence in recent times has questioned the credibility
of the rapidly expanding field of Islamic commercial and investment
banking. The distinguishing feature of this sector of finance is the
generation of assets which are structured to be Islamic law or sharia-compliant.
The sharia bans usury or the charging of interest (riba) on money lent
to others. The issue then is to find alternative routes to ensuring
a margin between the cost of funds and the return they earn to cover
intermediation costs and make a profit.
One obvious way in which this can be done is for the provider of funds
to acquire an asset required by a potential borrower and then to ''lease''
the asset to her. Through periodic lease payments, the lessee compensates
the lessor for an amount equal to the capital outlayed and an interest-margin
equivalent. At the end of the required period the asset is transferred
to the lessee. Another possibility is the sale of an asset on a deferred
payment basis by the lender who then buys it back immediately for a
discount. That is, the client buys an asset from a financial institution
at a marked-up price that is to be paid at a later date, and then sells
the asset to the bank at a lower price to raise finance. The transfer
of ownership of an asset in both transactions ostensibly serves to establish
that the arrangement does not amount to lending money to earn interest.
Islamic bonds or sukuks are also structured along these lines. As opposed
to a normal bond which is a promise to repay a loan, the sukuk confers
partial ownership in an asset or business. This kind of transaction
normally involves a real asset that backs the provision of funds, and
is therefore considered safer, even if not completely safe. In fact,
when the crisis of 2008 broke and the world was experiencing a credit
crunch, the small Islamic finance segment was seen as having weathered
the storm because of its very different practices. That judgment, however,
has been questioned in the wake of the Dubai World payments suspension.
Methods
such as these to earn a return on money without formally charging ''interest''
amount to circumventing the sharia rather than adhering to it. This
is easier because of variations of interpretations of the law between
a more liberal Islamic country like Malaysia and a more orthodox one
like Saudi Arabia—a difference that is not neutralised by the existence
of industry bodies like the Islamic Financial Services Board that is
expected to evolve and set standards for these products. However, the
process of identifying certain products as sharia-compliant is rendered
credible by having a select group of scholars with the necessary knowledge
of Islamic law to vet the instruments created as part of the burgeoning
field of Islamic finance. Assets cleared by this elite group can then
be bought by investors wanting to make sharia-compliant investments.
Islamic finance has a long history, but burgeoned in the 1970s when
the oil shocks increased surpluses held by governments and corporations
in the West Asian region with religiously inclined states and investors.
Moreover, realizing that investors from this region would prefer to
invest in such religiously rated bonds, the world's financial firms
decided to enter this field. And in periods when credit in normal markets
was stretched, even otherwise staid borrowers chose to enter Islamic
financial markets to raise funds. In the process Islamic finance got
integrated with modern finance. According to The Banker's 2009 survey
of the top 500 Islamic financial institutions, ''The volume of sharia-compliant
assets of the Top 500 grew by an extremely healthy 28.6%, rising to
$822bn from $639bn in 2008. At a time when asset growth in the Top 1000
World Banks slumped to 6.8% from 21.6% the previous year, Islamic institutions
were able to maintain the 28% annual compound growth achieved in the
past three years.'' Underlying this growth was a certain distribution
of the world's surpluses and an assessment of the relative safety of
instruments generated by Islamic finance.
It is true that this sector is still a small segment of current finance
and is still substantially confined to dominantly Muslim countries.
Iran, Saudi Arabia and Malaysia are the three leading countries in terms
of sharia-compliant banking assets and Bahrain, Kuwait and Malaysia
are the leaders in terms of Islamic finance institutions. But the rapid
growth in this sector has seen the entry of unusual players both in
terms of financial engagement and in terms of borrowing. Most banks
and non-bank financial institutions have Islamic banking divisions.
These players from the world of conventional finance come armed with
the ability to generate unusual (and risky) derivative assets, which
they then apply to generating sharia-compliant instruments. In the event,
even though West Asia remains the centre of Islamic banking, investors
and borrowers from that region are increasingly turning to the City
of London to exploit its ability to develop opaque products. Even the
US is now host to a large number of institutions involved in activities
linked to Islamic finance.
Once the metropolitan centres of finance also establish themselves as
centres of Islamic finance, borrowers from the rest of the world who
would normally abjure these kinds of instruments and transactions choose
to both invest and borrow in these markets. The attraction is strong
for those seeking to tap the surplus funds of oil-rich Muslim nations.
But the opportunities are not restricted to West Asia, since well-to-do
Muslims with investible surpluses are geographically widely distributed.
General Electric was the first western conglomerate to exploit this
opportunity by issuing Islamic bonds. It has been followed by Tesco
of the UK and Toyota of Japan among others. Governments too—such as
those of Thailand and South Korea—have expressed interest in mobilising
money using such instruments.
It was this asymmetry wherein conventional finance cannot service the
demand for sharia-compliant investments, but conventional borrowers
can issue sharia-compliant bonds and conventional investors can choose
to park their money in such instruments that led to the belief that
Islamic finance had a great future. Moreover, in terms of stock, Islamic
finance accounts for less than 1 per cent of all extant financial instruments.
Finally, the rapidly growing emerging markets are the regions where
a majority of the world's Muslim population lives. Their demand for
assets to invest in is likely to increase if emerging market growth
returns to pre-crisis levels. The potential for growth therefore seems
immense. And recent rates of increase in the volume of such instruments
validate these expectations.
However, here were adequate grounds to be sceptical. One factor that
constrains the growth of this sector is higher cost resulting from the
multiple transactions that typically have to be executed to make an
arrangement sharia-compliant. Instruments constituted on that basis
involve higher transaction costs and higher interest rates, making them
uncompetitive. Moreover, if transactions have to be linked to assets
to keep them within the bounds of Islamic law, the proliferation characteristic
of derivative financial instruments that feed on themselves is not possible.
In addition to this, there is the problem that sharia-compliant investors
are expected to avoid patronising institutions that have borrowed too
much, as is the case with most highly leveraged modern financial firms.
However, the sheer need for an adequate volume of assets to meet the
investment needs of those wishing to be sharia-compliant may have encouraged
dilution of character to permit expansion of the volume of these assets.
Such dilution may be facilitated by the shift of Islamic banking at
the margin away from more orthodox Muslim countries to more liberal
ones. According to a Standard & Poor's estimate quoted by the Financial
Times, about 45 per cent of all Islamic bond issues between January
and July of 2009 took place in Kuala Lumpur, way above Saudi Arabia's
22 per cent. They helped raise $9.3bn and put Malaysia on top of the
global league table for issuance.
The ''capture'' of Islamic banking by the now-discredited world of modern
finance with its abstruse products, speculative practices and unwarranted
bonuses has meant that Islamic finance merely mimics conventional finance.
Products existing in not-so-ordinary financial markets are dressed up
to be sharia-compliant. The industry has in the process courted controversy.
One example quoted by the Financial Times (December 7, 2009) was a statement
by Sheikh Taqi Usmani, a respected member of the group of scholars accepted
as certifiers of sharia-compliant instruments that ''many Islamic bonds
went too far in mimicking conventional, interest-paying bonds, which
are banned by Islam.'' So influential was this remark that it triggered
a downturn in the Islamic debt market, possibly because of fears about
redemption of investments that get identified as non-Islamic.
But it is not just the degree of adherence to Islamic tenets that is
a problem with these assets. An additional problem is that with the
industry mimicking conventional finance it has imported all of the problems
typical of modern finance. This tendency has been aggravated by the
requirement that Islamic banking transaction must be based on assets.
Players with oil to sell are unlikely to borrow on the basis of that
commodity. But accumulated capital assets are limited in many countries
where Islamic banking is popular. Thus often the assets that commonly
underlie Islamic financial instruments are real estate and equity, which
can display volatile movements in value. This increases the probability
of default because of speculative decisions. Dubai World would by no
means be the first instance of default, if that occurs. Others like
US-based East Cameron Partners, the Kuwaiti company Investment Dar,
and the Saudi Arabian Saad Group have defaulted in the past, on debts
which include those raised through issues of sukuks. In fact, three
among the largest issues of Islamic bonds in countries belonging to
the Gulf Cooperation Council are in various stages of default.
This implies that the presumption that these Islamic bonds are safer
because they have to be backed by assets is not really true. One problem
is that even when assets are involved, they may have been just accommodated
to meet sharia requirements, in ways that leave investors little recourse
to the assets. Another can be that the assets involved may prove worthless
when sought to be liquidated. This is what seems to be happening in
the case of Dubai World, and its developer arm Nakheel, where the assets
concerned are reclaimed shorelines or strips of desert which were to
be transformed into some version of Paradise on Earth to satisfy the
whims of the wealthy. When the crisis shrank the surpluses of the wealthy,
there were no takers for the part constructed real estate assets, rendering
them almost worthless. The resulting losses forced Dubai World to declare
that it was not in a position to redeem its promises to pay. That not
only hurt investors. It also questioned the credibility of the recent
and rapidly growing versions of what has been presented as Islamic finance.