Islamic Finance Resists Equity Shift, May Stunt Growth

Shariah finance has been labelled “copycat” for its reliance on debt funding

Reuters – KUALA LUMPUR, April 27 — When Kuwait Finance House Malaysia helped develop a US$1.3 billion (RM4.1 billion) real estate project in the country in 2005 as a partner in the deal, Islamic equity property ventures were a rarity.

Five years on, the bank is embarking on its fourth building project using a similar equity concept but few others in the industry want to follow the same path, reflecting Islamic finance’s slow and difficult shift away from debt instruments.

Debt funding’s dominance of Shariah finance has earned the US$1 trillion industry the tag of “copycat” and limited its growth as critics question its ability to offer a fairer way of sharing risks and rewards that truly distinguishes it from conventional banking.

“Profit-sharing or equity structures are the true way of doing Islamic financing,” said Siti Mariam Mohd Desa, Kuwait Finance Malaysia’s real estate advisory director.

“It is a different concept because if you were to give out straight loans, you may as well go to a conventional bank.”

As the global financial system emerges from the debt crisis and banks shy away from assuming added risks, practitioners want Islamic finance to rely more on partnership structures and less on straight financing which they say has created a brand of finance which is Shariah compliant in form, but not in spirit.

They say equity financing such as musharaka and mudaraba are closer to the Shariah’s aim of ensuring gains and losses are shared equitably and a shift back to it would help banks win new business beyond its traditional markets.

While Islamic finance has flourished in Muslim markets such as the Middle East and Malaysia, many non-Muslims are unconvinced, saying the industry differs from conventional banking only in name.

“We cannot add value in markets which are mimics of conventional markets. At the moment, it’s difficult to see the value-added,” said Safdar Alam, head of Islamic structuring at JP Morgan in Bahrain.

“It’s a real opportunity, with the increased awareness globally of Islamic finance, to demonstrate this value and the difference and benefits. This is a chance that we might miss if we don’t do this well quite quickly.”

But banks’ reluctance to bear the risk of projects funded, companies’ unwillingness to share profits and scarcity of banking capital make equity financing an unappealing proposition.

The recent property slump in the Gulf, where equity financing is more common, badly hit Islamic firms such as Bahrain’s Gulf Finance House and could compound banks’ fears of becoming project partners.

Kuwait Finance Malaysia, which uses the musharaka equity structure to develop real estate, had a non-performing financing level of 6.73 per cent in September, more than thrice the industry average.

Its parent Kuwait Finance House, the Gulf state’s top Islamic bank, posted a 24 per cent drop in net profit in 2009 to 118.74 million dinars.

Equity financing models were born out of a belief in Islam that the financier must share the risks if he wants the rewards and that profits should be earned through enterprise.

While equity funding is commonly associated with higher returns, bankers say it may not necessarily be more profitable than debt as the latter allows for higher leverage.

Traditionally, popular Islamic debt-based instruments such as istisna and murabaha have been likened to interest-based loans where banks take limited risks and are guaranteed a return.

But as Islamic finance grew beyond traditional roles such as agriculture financing to funding government budgets and billion dollar real estate projects, some banks began leaning more towards debt instruments to limit their risks.

As banks’ capital grows scarce, they will be wary of parting with large sums to back equity ventures, said Mohammad Faiz Azmi, PriceWaterhouseCoopers’s global Islamic finance leader.

“On the demand side, the issue are is there enough corporates who are essentially willing to give up the upside?” Faiz said, referring to profit-sharing structures.

“The reality is that the people that would want to have equity forms of financing are usually the ones that you want to avoid lending money to anyway.”

Some practitioners say the push for more Islamic equity financing is ill-conceived.

“From the shariah’s perspective, there is no such evidence to support (the view) that Islamic banks or whoever wants to do business should do profit-sharing more than debt-based,” said Shariah scholar Aznan Hasan, who advises Barclays Capital London and Malaysia’s stock exchange operator Bursa Malaysia.

“Whether it is debt or equity that suits you better, it depends on commercial and business decisions, not Shariah matters.” — Reuters

Did She Say That?

http://www.financeasia.com/article.aspx?CIaNID=118130
Dubai World creditors await court definition of Sukuk
At issue with Nakheel's sukuk is how a court will handle the restructuring, note observers familiar with Islamic finance. Much depends on the structure of the instrument. A court could declare the instrument the equivalent of a conventional bond with repayment terms comparable to international norms, or it could find the sukuk to be structured as either a mudharabah (profit-sharing) product or a musyarakah (a partnership involving profit- and loss-sharing) product, both of which would likely involve the creditors sharing some of the issuer's losses.

Creditors stand to benefit if a sukuk is declared essentially the same as a conventional bond, whereas the issuer stands to benefit if it is defined first and foremost as an instrument that is compliant with Shar'iah (Islamic law) -- and thus subject to the idea of profit-sharing.

"The whole presentation of the structure is one where investors are meant to receive a share of the profits and not interest on debts - two very different obligations," said Khalid Howladar, a senior credit officer at Moody's. "It could be argued that, because an issuer is not generating profits, it should not have to pay sukuk investors."

Not everyone agrees: "This is a credit issue, not an Islamic issue," said Raja Teh Maimunah, global head of Islamic markets at Bursa Malaysia. "A sukuk is a bond and issuers need to pay back the money they borrowed."

The quandary faced by the holders of Nakheel’s Sukuk has been well documented and discussed in recent weeks. At this juncture, how they will move forward with the restructuring depends on how the courts define this instrument called Sukuk.

In the above article, the global head of Islamic markets at Bursa Malaysia claims that a Sukuk is a bond. I find it appalling that a person of such stature as Raja Teh with all her experience can come up with such a statement which IMHO seriously undermines the principles of Islamic finance.

In case she forgot, a Sukuk is defined as follows:

“Certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity” by Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI, Standard 17).

“A document or certificate that represents the value of an asset” by The Securities Commission (SC).

A bond is defined as a fixed interest financial asset. Bonds pay the bearer a fixed amount a specified end date. A discount bond pays the bearer only at the ending date, while a coupon bond pays the bearer a fixed amount over a specified interval (month, year, etc.) as well as paying a fixed amount at the end date.

Click here for a comparison between Sukuks and Bonds.

If Sukuk is a bond, why bother with the Shariah structures & approvals, legal documentations etc.? Why bother calling it a Sukuk?

Let’s put it this way, Sukuks and bonds are like fish and chicken, they are both sources of food and can be cooked the same way but they will NEVER look the same, taste the same, they will never be the same.

It is a credit issue, so going forward, let’s use Nakheel/Dubai World as an example and learn from it. The first and most important lesson to remember is to structure a Sukuk as a Sukuk and not as a bond. And that includes evaluating the credit from the Sukuk perspective and not the bond perspective.

For as long as the Islamic finance industry is lead by people with a conventional worldview on Islamic finance, it will never break away from being a conventional product with an Arabic name.

Saxony-Anhalt Sukuk Ijarah

In 2004, a €100 million Sukuk, structured as a Sukuk Ijarah, was issued in the federal state of Saxony-Anhalt in Germany with The Federal Republic of Germany guaranteeing the debts of Saxony-Anhalt. The underlying transactions are a number of buildings owned by the Ministry of Finance. The master lease was sold for 100 years to a special purpose vehicle, incorporated in the Netherlands for tax reasons. The SPV in turn rented the properties back to the Ministry of Finance for five years. The certificate holders receive a variable rent benchmarked to the EURIBOR over the leased period and the Sukuk is listed on the Luxembourg Stock Exchange. Incidentally, as of July 2007, the Saxony-Anhalt Sukuk remains the only sovereign Sukuk from a non-Islamic country to have tapped the market.

I am of the opinion that the Saxony-Anhalt is one of the best examples of how a Sukuk Ijarah should be structured, apart from one element – determination of the rental rates. Why can’t the issuer set the returns based on the actual, prevailing, market determined rental rates? Wouldn’t that have made it more authentic?

Wa'd

Wa’d is a unilateral promise and is considered as a voluntary contract. Al-Zarqa’ opines that it does not convey any binding effect on the promisor hence they are not obliged to fulfil the promise and will not be liable in a case where they fail to fulfil the promise made to the promisee.

The BNM Shariah Council in its 49th meeting held on 28th April 2005 / 19th Rabiul Awal 1426 resolved that an Islamic banking institution is allowed to enter into forward foreign currency transaction based on unileteral binding promise (binding only on the promisor) and the compensation for breaching of promise could be implemented. This permissibility is only applicable for currency hedging purposes. Such a transaction may be arranged between the Islamic banking institution and its customers, or between the Islamic banking institutions, or between the Islamic banking institutions and conventional banking institutions.

The fatwa of Islamic Bank of Jordan (Jordan Islamic Bank, al-Fatawa al-Syar’iyyah, 2001, v2, p.29) states that the bilateral promise made in currency exchange where it bonds both parties to the contract, is generally prohibited (umum al-nahyi) as it amounts to bai` al-kali’ bi al-kali’ (sale of debt with debt). However, if the promise is made unilaterally i.e. binding only on one party who made the promise, then the transaction is allowed.

Ibn Hazm (Ibn Hazm, al-Muhalla, Dar al-Turath, Cairo, V.9, p.583) has also allowed the promise made to sell and purchase of currency with an agreed price on the same day followed by actual conclusion of the contract afterward. The parties is also given the choice to proceed or not to proceed with the agreement made and thus do not conclude the actual contract. This is permissible according to Ibn Hazm as the promise is not binding on the parties.

Having said all that, it is clear that Wa'd is a non-binding unilateral promise meaning that in the event the promisor decides to rescind the promise, the promisee is in no position to demand compensation. In reality however, most banks demand compensation for breach of promise. How is it non-binding then?

Moving Away from Tawarruq?

Twenty-six Islamic banks signed off on a standardised Wakalah deposit agreement, which some bankers said could help the industry reduce its reliance on the controversial Commodity Murabahah structure, Reuters reports. “Besides cost and resource savings, the adoption of the standardised Wakalah placement agreement would promote transparency, consistency, operational efficiencies and robustness in Islamic deposit placement transactions,” said the Association of Islamic Banking Institutions Malaysia, which launched the template agreement. “In six months’ time, all the banks will be using the Wakalah,” said one Malaysian Islamic banker. “It has fewer issues than the Commodity Murabahah.”

Wakalah is an agency structure where a depositor or investor authorises an agent (the bank) to invest his funds in Shariah compliant assets or businesses.

Finding alternatives to replace controversial instruments is a step in the right direction and it augurs well for the industry.

Organised Tawarruq not a perfect structure

In its basic form, Tawarruq is an asset sale to a purchaser with deferred payment terms. The purchaser then sells the asset to a third party to get funds. Organised Tawarruq is similar although the transactions are executed through banks.

Reuters reports Shariah adviser Rusni Hassan saying that Organised Tawarruq as it is currently practised is not ideal from the Shariah's viewpoint.

According to the report (Nov 4, 2009), Rusni opines that organised Tawarruq should avoid specifying beforehand the parties' obligations under the contract although this protects their legal rights, backing a divisive Fiqh Academy ruling that had thrown the industry into turmoil. She objects to organised Tawarruq because the two contracts are in one when they should be independent of each other.

I agree with her views but I foresee it will further divide the industry especially when respected scholars like Nizam Yaqubi and Akram Laldin see no harm in organised Tawarruq.

Other scholars who disapprove of Tawarruq include Muhammad Nejatullah Siddiqi and Monzer Kahf.

Siddiqi views Tawarruq to be identical to interest based loans both from the functional and macroeconomic perspective. His justification for categorising Tawarruq as non-compliant is due to its harms (mafasid) being greater that its benefits (masalih). He lists;
1) creation of excessive debt;
2) exchange of money with more money in future, which is unfair in view of the risk and uncertainty involved;
3) debt proliferation, which is liken to gambling and speculation;
4) inflationary expansion;
5) inequity in the distribution of income and wealth;
6) greater instability in the economy; and
7) inefficient allocation of resources.
as the many harms of Tawarruq.

Kahf opines that Tawarruq is worse than the practice of interest-based loan legally and economically.

I have to disagree (with apologies) with Sheikhs Yaqubi and Akram on the permissibility of Tawarruq. Being of limited knowledge, I depend on the views and opinions of the scholars and in this case the arguments presented by Siddiqi make more sense to me.

Cost of Funds

When determining the interest rate to charge borrowers, one of the factors to consider is the cost of funds, i.e. the price the bank has to pay to the owners of the funds, who are either depositors or lenders for using the funds.

On the other hand, a partnership or trade based (Islamic) financial transaction should not have a cost of funds simply because the owners of the funds are not lending or selling the funds and therefore should not expect any consideration for the transaction. Funds are monetary capital and Shariah stipulates that money cannot be traded because it is not a commodity, it is merely a medium of exchange.

So, technically, under Shariah terms, capital has no cost. Surely this is a concept which traditional conventional bankers may find difficult to grasp.

Why is money devoid of any cost?
This is because the owners of money cannot expect to earn more money without undertaking some form of economic activity. Shariah stioulates that owners of money cannot trade the money for profit. Any exchange of money which is not equal in amount constitutes riba.

When determining the profits to be charged to customers (‘profits charged’, oxymoron?) for a Murabahah or Istisna transaction, banks cannot base it on the cost of funds simply because there is no cost to start of with. The cost of funds arises when Shariah based banks operate in an identical manner to a conventional banks, i.e. as an intermediary between lenders and borrowers.

Mudharabah and Musharakah are NOT Debt Contracts. Get it?

A Shariah expert claims that Asset-based Sukuk Mudarabah and Musharakah will fall out of favour as it is hard to accommodate a ruling on repurchase pledges, indicating the market would be permanently affected by the decree.

According to Moody’s, the issuance of Musharakah and Mudarabah based Sukuk fell 83 percent and 68 percent respectively last year.

Bankers and lawyers have been seeking ways to structure Sukuks that comply with a 2008 ruling by AAOIFI which forbids “borrowers” in Sukuk Mudarabah and Musharakah from promising upfront to pay back their face value at maturity. This follows a rule that parties must share risks under these structures but the industry had been concerned it would make Islamic bonds less palatable to investors. But the market is trying to find ways to accommodate the prohibition. However, Shariah adviser Dr Mohd Daud Bakar said it would be tough to do so, "It's very difficult because it goes against the very essence of Mudarabah and Musharakah because you cannot guarantee the capital (or profits) in equity-based contracts." (Reuters)

Which is exactly my point. Mudarabah and Musharakah are equity-based contracts and therefore should not be treated as debt-based contracts. Why the industry continues to structure debt papers based on an equity structure baffles me.

A Sukuk is not a bond and a Sukuk is defined by the underlying contract that governs it.

After so many years of being exposed to Shariah based finance, I’m stumped that the so called Islamic bond fund managers (and the rest of the market really) still view Mudarabah and Musharakah Sukuks as debt instruments. Well, I’m telling them again – it’s NOT. Sukuk Mudarabah and Musharakah investors are not borrowers, they are partners who are supposed to understand and willing to assume risks associated with such investments.

The market should take the lead by re-identifying their investment needs and demand the appropriate structure. If they want to invest in fixed income instruments, look for Ijarah, Murabahah or Istisna based structures.

If they want to invest in Mudarabah and Musharakah Sukuks, they better make sure they are looking at them from the equity perspective.

The reason why we are facing this problem is because we (the market/industry) continue to apply Shariah based finance on the conventional platform. If a Mudarabah and/or Musharakah based Sukuk has identical features with a conventional bond, why bother having an Islamic finance industry? Since the underlying structure is identical, we might as well merge the two since there is no difference apart from the name and legal documentation.

The growth of the Sukuk market can only be achieved if the industry accepts Sukuk as a unique instrument instead of equating it to and treating it like a conventional bond.

Islamic Derivative Contracts Soon?

Reuters reports that the first template for over-the-counter Islamic derivative contract will be launched this year or by early 2010. The contract is expected to pave the way for quicker and cheaper Islamic risk management and more frequent cross-currency transactions.

According to Ijlal Ahmed Alvi, chief executive officer of the International Islamic Financial Market (IIFM), "It's a completely new instrument. We have done the consultative work. Now what we are waiting for is the Sharia meeting... some time in December". The IIFM, an industry body backed by the central banks of several Muslim countries, has been working with the International Swaps and Derivatives Association (ISDA) on the contract. Once in place, the new Islamic derivatives contract is expected to initially attract at least 150 players.

Scholars are however split on the legitimacy of derivatives; some see them as permissible instruments to hedge risks but others dismiss them as speculative transactions, which Islam forbids.

My contention is that derivative instruments is not the only solution to hedge of risks. There is no need for Shariah based finance to mimic each and every conventional instrument. Isn’t there any indigenous Shariah based risk management tool?

3Ps – Products, Placement, Promotion

Experts (in Islamic banking & finance) are saying that in order to effectively challenge and compete with conventional finance, Islamic finance needs more products and a wider distribution channel. It would be difficult to attract liquidity into the industry without adequate products and distribution network. This growing industry also needs to develop more unique financial solutions and not resort to merely replicating conventional finance’s product line.

The wealthy GCC sovereign funds are believed to resort to investing in conventional products due to the lack of Shariah approved investment options.

Shariah based finance and investment is mainly based on partnerships and joint-ventures making it suitable for private equity ventures, venture capital as well as asset management. These sectors will allow the Islamic finance industry to create products according to Shariah values, especially on the prohibition of riba via pre-determined return rates.

According to a report published by Ernst & Young this year, as of 1Q 2009, there are only 14 Shariah compliant funds larger than USD500 million out of the 750 Islamic mutual funds under management. Total assets under management is less than USD50 million.

John Sandwick, an Islamic asset management consultant claims that the supply of Islamic funds is not enough to satisfy the demand. The market needs more products. The advent of the pension fund in the Middle East as well as the growing takaful industry will definitely increase the need for more products.

Experts also pointed out most Islamic funds tend to focus on equities and real estate and not much asset diversification especially into fixed income investments.

Sukuk is a ready made instrument to facilitate the Islamic asset management industry. Ijarah, Murabahah and Istisna based Sukuk will provide asset managers with more fixed income investment options.

Silke Bernard, a lawyer specialising in funds said, Islamic funds lacked access to the large distribution platforms used by asset managers and that Islamic funds often lacked the required minimum size of typically USD100 million and a track record of several years required by large asset managers.

It is often pointed out that there is a sizeable amount of Islamic (GCC) wealth looking for Shariah compliant investments. There have also been claims that Shariah compliant investment is already attracting a global fan base from Europe to Australia and Japan and this augurs well for the industry’s long term growth.