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Industry looks into a ‘mixed future’

Global recovery is not just about economic fundamentals – it is also about regaining confidence. MUSHTAK PARKER feels a number of pulses

While the past year has seen a rebound of sorts for the global Islamic finance industry, prospects for 2011 are at best mixed with the consolidation of the recovery especially of the Sukuk market and core business lines, including trade finance and cash management.

However, as Stella Cox, managing director of DDCAP Limited, who has worked in the Islamic finance industry for more than 25 years, emphasises, “Many reports suggest that Islamic banks have weathered the global crisis better than conventional banks. Selectively, this may be true, but some reports have been based upon over-simplified assumptions about Islamic fi nance without analytical evaluation or statistical data.

“It is inappropriate and dangerous to make conclusions about the sector as a whole on such basis and without consideration of the varying regulations, controls and conditions that prevail across the numerous jurisdictions in which Islamic banks operate.”

The global economic recovery in the aft ermath of the credit crunch and fi nancial crisis remains fragile and disparate aff ecting the developed economies the most because of the high exposure of their banks to the junk CDOs (collateralised debt obligations) that were backed by equally junk mortgages in the US market. The economic impact of the crisis has affected all economies and, therefore, both conventional and Islamic banks, albeit to varying degrees.

However, recovery is not only about economic fundamentals, prudent banking, early warning systems or stress testing. In the case of Ireland, the Bank of Ireland indeed did apply the stress testing to the major Irish banks, which, incidentally, passed the stress tests with flying colours, only to spectacularly fail shortly afterwards and precipitating a multinational bail out of the Irish banking system with the help of the International Monetary Fund, the European Central Bank and the UK Treasury, which even had the audacity to borrow money from the markets and lend it to the Irish at a higher margin, albeit over a period of 25 years.

From Left: Stella Cox - DDCAP Group, Madhu Kannan MD & CEO BSE, Avsar Sungurlu, assistant MD BMD Securities, Turkey

Recovery is also about confidence – political and market confidence. Some countries where Islamic finance prevails side-by-side conventional finance especially in the Middle East is undergoing a crisis of confidence precipitated by the recent ousting of Zainul-Abiddine Ben Ali as president of  Tunisia and the potential knock-on-effect it may have on a region screaming out for political, social, economic and financial reforms.

This coupled with the Sukuk defaults or restructuring by Kuwaiti, Saudi, Dubai issuers and repayment problems of the odd Bahraini Islamic financial institutions remains a defining caveat for the near future prospects of the Islamic finance industry.

After all, the protestors in the streets of  Tunis were amongst other things demonstrating about the senseless high unemployment, rampant corruption within the ruling family and their cronies, and the high cost of living with rising prices of basic commodities and foodstuffs. No bank can operate efficiently, honestly and profitably in an economy beset with such conditions. Perhaps it is no coincidence that BestRe, the oldest Islamic reinsurance company, which is an affiliate of the Bahrain-incorporated Salama Group, has relocated its headquarters from Tunis to Labuan in Malaysia.

Whether the banks, irrespective of whether they are conventional or Islamic, and regulators have learnt the lessons of the crisis only time will tell. The hope is that banking may never be the same especially if the provisions of  Basel III are adopted undiluted especially Tier I capital and the so-called contingent capital.

Retreat from cash

IDB President Dr Ahmad Muhammed Ali

In the Islamic finance space, there is likely to be a retreat from cash as investors start looking for better returns. But the sector is seriously constrained by the lack of asset diversification.

This is one reason why so many Islamic banks had such large exposures to one asset class – real estate. This is not to say that there are not many other asset classes. There are plenty – equities, Sukuk, commodity trade finance, project finance, SME financing and even micro-finance. But a combination of a supposed cultural affinity to “bricks-andmortar” and over-valuation of both land and real estate and the lack of proper regulatory and enforcement procedures, have all conspired to produce an irrational exuberance towards real estate investments creating an asset bubble that inevitably burst in the aftermath of the financial crisis as the credit crunch squeezed the cashflow of both developers, mortgage providers and customers.

Perhaps one positive consequence of the crisis is a resurgence of core business lines especially commodity trade finance. Not so long ago the criticism of the Islamic finance industry was that it was far too dominated by short-term commodity-based Murabaha. The balance sheets of most Islamic banks showed that most of their financing was indeed geared towards Murabaha and Al-Bai Bithaman Ajil (deferred payment sale) – up to 80 pert cent in some cases.

With the emergence of real estate and especially Sukuk, Murabaha trade finance started to decline, but not as dramatically as some claim. Commodity trade finance and Tawarruq (cash management and liquidity management using commodity Murabaha) have indeed increased over the last two years and the signs are this will continue in 2011 through to 2012.

The signs are indeed positive. In January 2011, the President of the Jeddah-based Islamic Development Bank, Dr Ahmad Mohammed Ali, announced that the level of intra-trade between the IDB member countries has reached 17 per cent of their total trade and that this figure is projected to grow to 20 per cent by 2015. A new target, according to IDB sources, of 30 per cent intra-Islamic trade by 2020 will also be announced at the multilateral development Bank (MDB’s) annual meeting which is scheduled to be held in Yemen in May this year.

The IDB has extended trade fi nance to its member countries totalling US$42bn since it started operations in 1975. Since the establishment of a dedicated International Islamic Trade Finance Corporation (ITFC) by the IDB in Dubai, the importance of trade facilitation between member countries has been steadily increasing.

The value of Murabaha trade fi nance to key emerging Islamic markets spearheaded by ITFC through the delivery of classical structured models to support the development of commodity and agricultural supply chain transactions should not be under-estimated.

The IDB is also targeting specifi c regions to give them an extra boost in this respect. In January, for instance, Dr Ali convened a Donors Meeting at the IDB headquarters that specifi cally discussed a US$6bn Programme for Regional Cross Border Trade Facilitation and Infrastructure Project for the Mashreq countries, including Iraq, Jordan, Lebanon and Syria, over the next 15 years. Th e aim of the Programme, which also has input from the World Bank, is to enhance trade between the concerned countries and between them and the rest of the world.

Bid to cut constraints

The Programme aims also to reduce trade impediments and address major transport infrastructure constraints (both physical and non-physical barriers). The World Bank has estimated that, if fully implemented, by 2020 the Programme could increase the total non-oil international trade of the Mashreq countries by up to US$4bn annually, and bring intra-Mashreq trade up to 22 per cent of that total, compared to the current 17 per cent. “Many banks focused on core business strategies and the re-instatement of profi table and appropriately risk profiled activity in 2010,” explains DDCAP’s Stella Cox. “Amongst them, a good percentage of our clients report that they are keen to emphasise key, traditional areas of expertise and historically the application of classical, Murabahabased solutions to structured trade fi nance has been a cornerstone of the market.”


Irfan Afzal, of Gatehouse Bank

Indeed several Islamic bankers agree that given that there is only a very limited amount of mediumterm Shariahcompliant trade assets and hardly any, if at all, Shariah-compliant structured trade funds in the market, there is a huge pent-up demand for true Islamic structured trade funds.

“I think precisely because of this “perfect fit”; structured trade finance lends itself extremely well to the Shariah requirements for financing the sale and purchase of goods and/or commodities. Given the large pool of liquidity, the potential for Islamic finance going forward is tremendous,” says Irfan Afzal, executive vice president and head of structured trade finance and syndication at Gatehouse Bank.

He agrees that short-term commodity Murabaha has been the mainstay of a Shariah-compliant trade asset in the market and the product offering has not moved much beyond this LME warrant based commodity Murabaha over the past 10 years or so.

With the opportunities lying with financing real world trade flows, especially oil and gas, metals and soft commodities, there is certainly a volume of transactions being carried out by the leading players in Islamic finance in leveraging these trade flows. however, this is not being done on a “global product” basis, but rather on a bespoke, individual transaction basis; hence the fact that the volume of such transaction remains fairly low.

Afzal, however, maintains that there is a real need to “educate” the investor base so that they are able to differentiate between the diff erent asset classes and their associated returns – ie usually a fund implies an unsecured/market risk or an asset class such as real estate. A structured trade fund, by the nature of the underlying asset, is a “secured” asset class and the returns are in the three-to-four per cent per annum region, which for a secured trade transaction represents very good returns for the investor.

On the other hand, Tawarruq based on Commodity Murabaha for liquidity and cash management has courted some controversy over the last two years, but the guidelines and standards that have been issued by the Shariah committees of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the OIC Fiqh Academy respectively, as well as individual bank committees are precise and largely refer to Tawarruq Munazzam (Organised Tawarruq) and Reverse Tawaruuq, as opposed to classical Tawarruq, which is universally accepted by scholars.

“These standards (relating to Tawarruq),” says Stella Cox, “are issued in respect not only of products and structures, but also in respect of related trade execution. If asset-backed processes are to be followed strictly in accordance with Shariah stipulation there is usually a commercial impact.”

But the seasoned Cox agrees that in the midst of the pressures faced by financial institutions in recent years, the desire to reduce or remove such cost implications seems oft en to have become a priority. As such endeavours to cut costs can result, intentionally or otherwise, in subtle revisions to approved structures and thereby adherence to the prescribed standards and stipulations for the arrangement.

If they are not identifi ed and immediately resolved, she continues, “situations such as this will ultimately tarnish the integrity of any structure.    There is no excuse for this as the Shariah authorities have made their concerns very clear. Their requirement is that Tawarruq should be utilised selectively in wholesale activity and with the utmost caution at consumer level where, again, there is particular concern about the introduction of leverage as well as the segregation of contractual responsibilities”.

Second wind for Tawarruq

Tawarruq as a product is certainly gaining a second wind as an increasing number of Financial Exchanges seek to off er Islamic liquidity management services that incorporate Tawarruq or a Commodity Murabaha. Already these have been launched by Bursa Malaysia through Bursa Suq Al Sila Commodity Platform based on Palm Oil contracts; and by the Bahrain Financial Exchange through the Bait Al Bursa Commodity Trading Platform. Similarly, the Jakarta Futures Exchange is also seeking to launch a similar platform. At the same time regulatory authorities such as the Central Bank of the UAE are choosing to base their new Shariah-compliant notes issuance programmes on the Murabaha contract.

One other major development in this space is the progress of the newly-established International Islamic Liquidity Management Corporation (IILM), whose inaugural CEO, Mahmoud AbuShamma started work on 1 February 2011 on a three-year tenure.

The IILM has an authorised capital of US$1bn of which US$80 million is paid in. Bank negara Malaysia, the central bank, together with the Saudi Arabian Monetary Agency (SAMA) are the two largest subscribers to the equity with US$10m each, followed by a US$5m subscription each by the central banks of Luxembourg, Mauritius, Kuwait, Qatar, Indonesia, Turkey, Sudan, UAE, nigeria and Iran and the Islamic Development Bank (IDB) and its private sector funding arm, the Islamic corporation for the Development of the Private Sector (ICD).

The IILM has one main objective to facilitate liquidity management across borders for Islamic fi nance. The only participants in the IILM are central banks, monetary authorities and multilateral agencies. “Liquidity management is part of the role of central banks,” reminded Governor Zeti recently. “We inject or withdraw liquidity from the system. Th ere are very strict criteria for the eligibility of assets. It is not the shareholders themselves that would allocate assets. Central banks can nominate entities to donate assets, which can be monetised. Th ey will issue Islamic commercial papers (ICP) against these assets through special purpose vehicles. Th ey will be the primary dealers and they will create the markets. As such, a network of primary dealers would have access to these instruments. But we don’t want scenarios like pension funds in California buying all the papers in the primary market. Th ey can buy some but the market has to be much wider.”

From a financial stability perspective, warned Governor Zeti, it is important that liquidity in the fi nancial system does not evaporate; or the system is dysfunctional because of inadequate liquidity. “The need is for highly-rated short-term instruments that can be traded in the international market. In Islamic fi nance we don’t have liquidity management instruments but institutions hold highly liquid assets. If the assets can be traded through the IILM then much fewer of these assets will be held by the institutions,” she added.

The high use of Murabaha has attracted some criticism over the years. But unless new ways of trade facilitation emerge it will continue to dominate especially with the share of Intra-Islamic trade continuing to spiral. To ensure ongoing Shariah compliance, DDCAP focuses on its continual adherence to the Murabaha contract stipulations as advised by clients’ Shariah advisers, which readily transfer to structured Murabaha trade fi nancing opportunities. Th e company also encourages regular inspection and audit of its business activities and processes by those advisers.

‘Gold standard’ call

One complement to Murabaha-based trade facilitation was recently suggested by Tun Mahathir Mohammed, the former Malaysian Prime Minister. Last year there were renewed calls for reverting to some form of gold standard in the international monetary system led by no less a person than Robert Zoellick, the President of the World Bank. he proposed the use of gold as a reference standard for a new international currency system.

Mahathir on the other hand sees the use of gold in the settlement of international trade, which involves large sums of money. “Payment in physical gold,” he explained recently, “would be inconvenient because of its bulk. The actual payment in gold could be minimised by a clearing house system where the trade between two countries would be by contra in which the deficit country will be indebted to the surplus country.

“Obviously the amount would be quite small relative to total trade and can be paid in gold. Even then, it should be by crediting and debiting in the books of the central banks operating the clearing house. Carried forward to the following month, or year, the payment can be through the defi cit country exporting to the trading partner the amount of goods or services worth the amount owed in the books.”

Indeed, he pointed out that the clearing house system has worked for the settlement of cheques. Th rough the above mechanism, the need to move physical gold does not arise, except in very special circumstances. The system would eff ectively be a kind of barter trading in which the value of the goods or services would be quoted in an international unit of gold or by weight of gold.

During his time in office, Mahathir pioneered the Bilateral Payments Arrangement (BPA), a unique bilateral payments and trade settlement arrangement between Malaysia and developing countries which at the time by-passed the need for costly correspondent banking in London, new York and Frankfurt, perhaps to the chagrin of the World Bank and IMF.

Gold is making inroads in other commodityrelated products such as exchange-traded-commodities (ETCs) and its adjunct exchange-traded-funds (ETFs). Kuveyt Turk Participation Bank (KTPB), one of the largest Turkish Islamic banks, late in 2010 launched the KTPB GoldPlus ETF, which was structured with physical gold in its portfolio, based on the London spot gold price in USD/ounce converted to Turkish Liras/gr. Th e ETF tracks the Dow Jones Islamic Market Turkey Index, but in January 2011 the Istanbul Stock Exchange launched its own Participation Index comprising the top 30 Turkish stocks that are also in conformity with Islamic investment principles.

Avsar Sungurlu, assistant managing director of BMD Securities, which manages the GoldPlus ETF, believes that the product is exportable to the GCC countries and elsewhere. “Both Turkey and the countries in the region have a strong demand for gold culturally and also the rally of gold in the past few years has attracted a lot of attention to gold as an investment vehicle. People usually preferred to buy and keep the gold physically in the past, but we observe that as the banking system reaches a wider client base, gold investors increasingly start to keep their gold in banks and invest in gold accounts,” he explained.

Another person who thinks that more Islamic ETFs and ETCs will come to the market over the next few years as investors get more acquainted with such products is Madhu Kannan, managing director and CEO of the Bombay Stock Exchange (BSE), which recently launched the BSE TASIS Shariah 50 Index.

“We have been pleased by what has been a very warm response to this product by market participants,” he confi rmed. “Our main priority will be to launch domestic and international ETFs/ETCs/ Mutual Funds off of this index within the next 12 months. We also are in the process of working with fi rms to off er structured products to clients based off of this index,” he confi rmed.

One other product, which is increasingly an asset securitisation and investment vehicle for trade receivables, is Sukuk, which has seen a dramatic proliferation since 2005. In the wake of the financial crisis, the Sukuk market suff ered a confi dence shortfall because of a small number of defaults, payment restructuring and simply potential new issuers delayed going to the market because of very costly pricing.

The Sukuk market, predicts Jamil Jaroudi, CEO of Elaf Bank in Bahrain, is bound to make a comeback. “I am confident that we may see the volume of Sukuk reaching US$30bn in 2011 – the same size as before the crisis, although the market will continue to be dominated by sovereign and quasisovereign issuances.

“Perhaps in 2012, corporate issuances will start equalling origination activity in the sovereign market. GCC markets suff ered the most through defaults. Th e defaults awakened everybody – the regulators, Shariah boards and the investment bankers – all to do a better job. Whenever there was a Sukuk default, the media immediately started to speculate about the future of the Sukuk. But in the conventional bond industry there have been tens of defaults and the media never asked about the future of the bond industry,” he added.

Others such as DDCAP’s Stella Cox agree that in core markets including Malaysia and the GCC, the expectation is of increased levels of issuance by corporates, although ongoing issuance by sovereigns is still important on a regular or recurrent basis to establish renewed confi dence in the market and also to create that all important yield curve that will attract the attention of new classes of investor.

The latest data from Bursa Malaysia, the national stock exchange, suggests that the global Sukuk market rebounded in 2010 with total issuance outstanding reaching US$30bn, an increase of 20 per cent on 2009 and double the volume of 2008, when the market hit an all-time low.

Raja Teh Maimunah, global head of Islamic Markets at Bursa Malaysia, explained that “the general consensus amongst industry players is that global Sukuk issuances for 2011 will surpass the record high of US$34.2bn in 2007. We are seeing issuers more willing to list their issues and be subjected to reporting and disclosure requirements in order to attract investors as the credit crisis has caused investors to be more aware of the importance of transparency and are thus demanding greater governance. We see this as a positive development as the industry steps to the next level in embracing higher governance standards.”

Th e good news is that in emerging new markets, Sukuk origination is gaining momentum. Yemen recently announced that it is planning to issue its debut sovereign Sukuk in 2011. Also, the governments of Tatarstan in Russia and Kazakhstan have both teamed up with the Amanah Raya Group of Malaysia to conduct feasibility studies to facilitate the issuance of Sukuk.

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