Economist - Islamic finance: Savings and souls
Riaz K Tayob
Sep 4th 2008 | MANAMA
From The Economist print edition
Muslims have a lot of money to invest. But it is a constant struggle to
reconcile faith and finance
Gillian Blease
TO SEE Islamic finance in action, visit the mutating coastline of the
Gulf. Diggers claw sand out of the sea off Manama, Bahrain's capital,
for a series of waterfront developments that are part-funded by Islamic
instruments. To the east, Nakheel, a developer that issued the world's
largest Islamic bond (or sukuk) in 2006, is using the money to
reorganise the shoreline of Dubai into a mosaic of man-made islands.
Finance is undertaking some Islamic construction of its own. Islamic
banks are opening their doors across the Gulf and a new platform for
sharia-compliant hedge funds has attracted names such as BlackRock.
Western law firms and banks, always quick to sniff out new business, are
beefing up their Islamic-finance teams.
Governments are taking notice too. In July Indonesia, the most populous
Muslim country, said it would issue the nation's first sukuk. The
British government, which covets a position as the West's leading centre
for Islamic finance, is also edging towards issuing a short-term
sovereign sukuk. France has begun its own charm offensive aimed at
Islamic investors.
Set against ailing Western markets such vigour looks impressive. The
oil-fuelled liquidity that has pumped up Middle Eastern sovereign-wealth
funds is also buoying demand for Islamic finance. Compared with the
ethics of some American subprime lending, Islamic finance seems virtuous
as well as vigorous. It frowns on speculation and applauds risk-sharing,
even if some wonder whether the industry is really doing anything more
than mimicking conventional finance and, more profoundly, if it is
strictly necessary under Islam (see article).
Sukuks in the souk
As the buzz around the industry grows, so do expectations. The amount of
Islamic assets under management stands at around $700 billion, according
to the Islamic Financial Services Board, an industry body. Standard &
Poor's, a rating agency, thinks that the industry could control $4
trillion of assets. Others go further, pointing out that Muslims account
for 20% of the world's population, but Islamic finance for less than 1%
of its financial instruments—that gap, they say, represents a big
opportunity. With tongue partly in cheek, some say that Islamic finance
should by rights displace conventional finance altogether. Western
finance cannot service capital that wants to find a sharia-compliant
home; but Islamic finance can satisfy everyone.
Confidence is one thing, hyperbole another. The industry remains minute
on many measures: its total assets roughly match those of Lloyds TSB,
Britain's fifth-largest bank (though some firms that meet
sharia-compliant criteria may attract Islamic investors without
realising it). The assets managed by Islamic rules are growing at 10-15%
annually—not to be sniffed at, but underwhelming for an industry that
attracts so much attention. Most of all, the industry's expansion is
tempered by its need to address the tensions between its two purposes:
to serve God and to make as much money as it can.
That is a stiff test. A few devout Muslims, many of them in Saudi
Arabia, will pay what Paul Homsy of Crescent Asset Management calls a
"piety premium" to satisfy sharia. But research into the investment
preferences of Muslims shows that most of them want products that
benefit their savings, as well as their souls—rather as ethical
investors in the West want funds that do no harm, but are also at least
as profitable as other investments.
A combination of ingenuity and persistence has enabled Islamic finance
to conquer some of the main obstacles. Take transaction costs which tend
to be higher in complex Islamic instruments than in more straightforward
conventional ones. Sharia-compliant mortgages are typically structured
so that the lender itself buys the property and then leases it out to
the borrower at a price that combines a rental charge and a capital
payment. At the end of the mortgage term, when the price of the property
has been fully repaid, the house is transferred to the borrower. That
additional complexity does not just add to the direct costs of the
transaction, but can also fall foul of legal hurdles. Since the property
changes hands twice in the transaction, an Islamic mortgage is
theoretically liable to double stamp duty. Britain ironed out this kink
in 2003 but it remains one of the few countries to have done so.
However, just as in conventional finance, as more transactions take
place the economies of scale mean that the cost of each one rapidly
falls. Financiers can recycle documentation rather than drawing it up
from scratch. The contracts they now use for sharia-compliant mortgages
in America draw on templates originally drafted at great cost for
aircraft leases.
Islamic financiers can also streamline their processes. When Barclays
Capital and Shariah Capital, a consultancy, developed the new hedge-fund
platform, they had to screen the funds' portfolios to make sure that the
shares they pick are sharia-compliant. That sounds as if it should be an
additional cost, but prime brokers already screen hedge funds to make
sure that risk concentrations do not build up. The checks they make for
their Islamic hedge funds can piggyback on the checks they make for
their conventional hedge funds.
Mohammed Amin of PricewaterhouseCoopers, a consulting firm, says the
extra transaction costs for a commonly used Islamic financing
instrument, called commodity murabaha, total about $50 for every $1m of
business. That is small enough to be recouped through efficiencies in
other areas, or to be absorbed in lenders' profit margins. In addition,
bankers privately admit that less competition helps keep margins higher
than in conventional finance. "Conceptually, Islamic finance should cost
more, as it involves more transactions," says Mr Amin. "The actual cost
is tiny and can be lost in the wash."
The other area of substantive development has been in redefining
sharia-compliance. New products require scholars to cast sharia in
fresh, and occasionally uncomfortable, directions. Some investors
express surprise at the very idea of Islamic hedge funds, for example,
because of prohibitions in sharia on selling something that an investor
does not actually own.
"You encounter a wall of scepticism whenever you do something new," says
Eric Meyer of Shariah Capital. "It is no different in Islamic finance."
He says that it took eight long years to bring his idea of an Islamic
hedge-fund platform to fruition, applying a technique called arboon to
ensure that investors, in effect, take an equity position in shares
before they sell them short. Industry insiders describe an iterative
process, in which scholars, lawyers and bankers work together to
understand new instruments and adapt them to the requirements of sharia.
Differences in interpretation of sharia between countries can still
hinder the economies of scale. Moreover, the scholars can sometimes push
back. Earlier this year, the chairman of the Accounting and Auditing
Organisation for Islamic Financial Institutions (AAOIFI), an industry
body, excited controversy by criticising a common form of sukuk issuance
that guarantees the price at which the issuer will buy back the asset
underpinning the transaction, thereby enabling investors' capital to be
repaid. Such behaviour contravened an AAOIFI standard demanding that
assets be bought back at market prices, in line with the sharia
principle of risk-sharing. The sukuk market has enjoyed years of rapid
growth (see chart), but early signs are that the AAOIFI judgment has
dented demand.
Although Islamic finance has done well to reduce its costs and broaden
its product range, it has yet to clear plenty of other hurdles. Scholars
are the industry's central figures, but recognised ones are in short
supply. A small cadre of 15-20 scholars repeatedly crops up on the
boards of Islamic banks that do international business. That partly
reflects the role, which demands a knowledge of Islamic law and Western
finance, as well as fluency in Arabic and English. It also reflects the
comfort that this handful of recognised names brings to investors and
customers.
There are plenty of initiatives to nurture more scholars but for the
moment, the stars are pressed for time. That can be a problem when banks
are chasing their verdict on bespoke transactions. It takes a scholar
about a day to wade through the documentation connected with a sukuk
issue, for example. But scholars are not always immediately available.
"You've got to have the scholar's number programmed into your mobile
phone and be able to get hold of them," says a banker in the Gulf. "That
is real competitive advantage."
Assets are another bottleneck. The ban on speculation means that Islamic
transactions must be based on tangible assets, such as commodities,
buildings or land. Observers say that exotic derivatives in intangibles
such as weather or terrorism risk could not have an Islamic equivalent.
But in the Middle East, at least, the supply of assets is limited. "Lots
of companies in the Gulf are young and don't have assets such as
buildings to use in transactions," says Geert Bossuyt of Deutsche Bank.
This limits the scope for securitisation, a modern financing technique
that is backed by assets and is thus seen by sharia scholars as
authentically Islamic. There are not enough properties to bundle into
securities.
Governments have more assets to play with. The Indonesians have approved
the use of up to $2 billion of property owned by the finance ministry in
their planned sukuk issuance later this year. But oil-rich governments
in the Gulf have little need to issue debt when they are flush with
cash. That is a problem. Sovereign debt would establish benchmarks off
which other issues can be priced. It would also add to the depth of the
market, which would help solve another difficulty: liquidity.
It may seem odd to worry about liquidity when lots of Muslim countries
are flush with cash, but many in Islamic finance put liquidity at the
top of their watchlist. The chief concern is the mismatch between the
duration of banks' liabilities and their assets. The banks struggle to
raise long-term debt. In a youthful industry, their credit histories are
often limited; they also lack the sort of inventory of assets that
corporate sukuk issuers have.
Desert liquidity
As a result, Islamic banks depend on short-term deposit funding, which,
as Western banks know all too well, can disappear very rapidly. "Lots of
assets are generally of longer term than most deposits," says Khairul
Nizam of AAOIFI. "Banks have to manage this funding gap carefully." If
there were a liquidity freeze like the one that struck Western banks a
year ago, insiders say that the damage among Islamic banks would be greater.
Gillian Blease
Gillian Blease
There are initiatives to develop a sharia-compliant repo market but for
the time being the banks have only limited scope for getting hold of
money fast. Loans and investments roll over slowly. The lack of
sharia-compliant assets and a tendency for Islamic investors to buy and
hold their investments have stunted the secondary market. The
shortest-term money-management instruments available today are
inflexible. Cash reserves are high, but inefficient. Western banks with
Islamic finance units, or "windows", are just as troubled by tight
liquidity as purely Islamic institutions are: their sharia-compliant
status requires them to hold assets and raise funds separately from
their parent banks.
There are other sources of danger, too. Because Islamic banks face
constraints on the availability and type of instruments they can invest
in, their balance-sheets may concentrate risk more than those of
conventional banks do. The industry's ability to steer its way through
stormy waters is largely untested, although Malaysian banks do have
memories of the Asian financial crisis in the 1990s to draw on.
None of these tensions need derail the growth of Islamic finance just
yet. There is plenty of demand, whether from oil-rich investors, the
faithful Muslim minorities in Western countries or the emerging middle
classes in Muslim ones. There is lots of supply, in the form of
infrastructure projects that need to be financed, Western borrowers
looking for capital and ambitious rulers eager to set up their own
Islamic-finance hubs. The industry is innovative; new products keep
expanding the range of sharia-compliant instruments. And as in
conventional finance, the economics of the Islamic kind improve as it
gains scale.
But further growth itself contains a threat. The AAOIFI ruling on sukuk
earlier this year neatly captured the contradictory pressures on the
industry. On the one hand, bankers are worried that the narrow
enforcement of sharia standards is liable to stifle growth; on the other
some observers fear that Islamic finance is becoming so keen to drum up
business that its products, with all their ingenuity, are designed to
evade strict sharia standards. This presents a dilemma. If the industry
introduces too many new products, cynics will argue that sharia is being
twisted for economic ends—the scholars are being paid for their
services, after all. But if it fails to innovate, the industry may look
too medieval to play a full part in modern finance.
Balancing these imperatives will become even harder as competition grows
fiercer. Anouar Hassoune of Moody's, a credit-rating agency, believes
that unscrupulous newcomers could harm the reputation of the entire
industry, "like the space shuttle undone by something the size of a 50
cent coin". Islamic finance serves two masters: faith and economics. The
success of the industry depends on satisfying both, even if the price of
that is a bit more inefficiency and a bit less growth.
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