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Friday, 25 May 2007

Islamic Finance Special Report

Financial Times, 25 May 2007
Do you know your ’sukuk’ from your ‘murabaha’? Find out more in the FT’s Islamic Finance Special Report:Backwater sector moves into global mainstream. Not long ago, Islamic finance was widely regarded as a specialised, if not obscure, backwater of global banking, write Roula Khalaf and Gillian Tett. Although the concept of tailoring financial services to devout Muslims has existed for more than three decades, this activity was largely limited to commercial banking - and focused on specific regions, such as Malaysia or the Middle East.

But in the last few years, Islamic finance - based on a strict interpretation of the Koran that bans the use of interest in transactions - has undergone huge expansion, partly driven by the oil-driven financial liquidity in the Gulf, and the fast growing number of Muslims seeking more religiously sanctioned products.

The phenomenal growth in what is still an opaque industry, however, has raised concerns over the need for more regulation and better supervision. The UK, now home to two Islamic banks, is vying to become a centre for Islamic finance. Sukuks, or asset-based Islamic bonds, are being marketed to international investors. Alexander Lis, managing director at Oliver Wyman, the consultancy, calculates that there are $300bn of assets managed according to Islamic principles, and more than 280 institutions - ranging from commercial to investment banks and investment funds - providing Islamic products.

Others put the scale of the industry even higher: the Financial Services Authority in the UK, for example, recently suggested it was as big as $500bn. Standard & Poor’s estimates that the sukuk market has reached $70bn, and will top the $160bn mark by the end of the decade.

Though Islamic banking still represents only 1 per cent of global banking assets, most observers expect this heady pace of growth to continue for many years. The development has been driven by economic and political factors. The so-called “war on terror” in the aftermath of the September 11 2001 attacks helped to consolidate a sense of Islamic identity across the Muslim world, prompting many more to seek ways of expressing their religious convictions. And the rise in the oil price has fuelled an unprecedented economic boom in the Middle East. The new demands for the recycling of capital flows have been met with innovation in the provision of Islamic financial products, offering ingredients, for the first time, for a larger scale industry.And while no major scandals involving the Islamic finance sector have come to light so far, the boom in the industry has occurred amid a much wider credit bubble in global financial markets. “Right now we have a credit bubble - you can sell almost anything to anybody, including in the Islamic finance world,” says one investment banker. “People should certainly be asking hard questions about financial practices in the Islamic finance sector.”

Analysts hope that regions where the industry is expanding rapidly, such as in the Gulf, will eventually adopt the Malaysian model of a single national Sharia board overseen by the government, rather than individual banks. Specific supervision and regulation for Islamic banks also has yet to take hold, with only Kuwait and Bahrain issuing separate regulatory regimes for the sector.

Innovation: Frenzied race to develop new ideas

When international bankers discuss Islamic finance, one word that repeatedly crops up is “innovation”, writes Gillian Tett. In the past five years, Islamic finance has not only swelled in size, but expanded in complexity, as bankers around the world have competed furiously to produce new, Sharia-compliant ideas – and proclaim how “innovative” they are being in marrying the Koran with modern finance.Middle Eastern issuers are now increasingly embracing the concept of using the capital markets, alongside bank loans. Islamic banks in the region – and elsewhere in the Muslim world – are also becoming more aware of the benefits of diversifying the risk on their own balance sheet.And the investor base of the Islamic finance world has become slightly more adventurous, too: instead of simply relying on quasi-deposit accounts, or items such as real estate, to park their funds, investors are turning to hedge funds and more complex capital markets products.

This has prompted Islamic finance to move increasingly into the capital markets arena, and embrace a host of new liquidity management tools as well as more structured products. It has also fostered the creation of new institutions, such as Islamic hedge funds, with a clutch of these springing up in London and the US recently.Moreover, as this trend has got under way, it has been greatly boosted by the arrival of Western investment banking groups into the field. For what Western bankers have discovered in the last couple of years is that many of the concepts which they have developed in other fields – such as tax planning or securitisation – can be applied to Sharia-compliant products too.

Thus, behind the scenes, a bitter competitive struggle has broken out between the banks, as they each rush to transfer these innovative ideas to Islamic finance – often in conditions of great secrecy.The most visible sign of this innovation is seen in the world of “sukuk”: although these instruments, akin to bonds, were invented less than a decade ago, their issuance has risen sharply in the last couple of years and are now producing numerous permutations.

Less obviously, experimental ideas are now also emerging in product and infrastructure finance, aside from sukuk. Private equity is attracting intense interest too, as is the so-called diminishing musharaka structure, which produces an effect akin to the amortisation of a loan.

However, the field which is arguably attracting most brainpower of all is derivatives and structured finance. Until now, the use of such instruments has been extremely low in the Islamic world, meaning that most banks, investors and corporate issuers had little way of protecting themselves from items such as inflation risk.Moreover, a few devout Muslims argue that these innovations increasingly contravene the spirit of Islamic finance – even if they might match its letter. Concepts such as derivatives and hedge funds, for example, are considered particularly controversial, given the Koran’s ban on gharar (speculation). Nevertheless, these criticisms are certainly not hampering the development of new ideas at present; on the contrary most observers think that product proliferation will only intensify this year.

Products: No interest – but big deposits of ingenuity

As with other Islamic products, Sharia-compliant financial transactions, known as commodity murabaha, first emerged in the 1970s, when a group of wealthy Muslims began to look at ways to invest that did not flout strict religious laws laid out in the Koran, writes David Oakley. The Koran bans the payment of interest, or riba, as the creation of money from money itself is considered sinful.
“The essential difference between Islamic finance and conventional finance is not paying interest, whether it is commodity murabaha, Islamic bonds or in the retail space Islamic mortgages. Islamic finance tries to replicate the conventional market, but in a structure that uses profits rather than interest,” says Neil Miller, a partner at law firm Norton Rose, which specialises in Islamic finance.

Commodity murabaha replicate short-term money market deposits, usually taken out for fixed terms between one week and one year, and medium-term syndicated loans. A commodity murabaha is a contract between a bank and its client for the sale of goods at a price plus an agreed profit margin for the bank. As the bank is making profits rather than earning interest, this is considered Sharia-compliant. Profits are allowed under Islamic law. The instrument is called a commodity murabaha because the profits are made on the buying and selling of a commodity, usually metal, such as copper, aluminium or lead.

One bank will buy the metal at the spot price, or the current price. This bank will then sell the metal to another bank on a deferred payment basis, say for three months, at the spot price plus a mark-up or profit for doing so. The second bank will then immediately sell the metal to a broker or another institution for the spot price. The first bank has made a profit from the the mark-up, while the second bank has raised funds for its investments.

In the wholesale markets, Islamic finance can be broadly divided into commodity murabaha; equities; property investment; takaful, or Islamic-compliant insurance; foreign exchange, including Sharia-compliant currency swaps; Islamic bonds, or sukuk; and structured products. In the retail markets, individuals can use current and savings accounts, which are based on a profit-sharing principle, while personal loans, which are based on the trading of a commodity similar to commodity murabaha, and Islamic mortgages, which are in essence leasing arrangements, have also been created.

Equity investors are allowed to buy only shares from certain industries. For example, insurance stocks are excluded because insurance involves a degree of uncertainty, risk or speculation, known as gharar, which is prohibited. Investors are also banned from buying stocks that derive income from alcohol, pork, defence, gambling and entertainment. Stocks have to fit a certain financial profile, too. A debt-to-equity ratio of more than 33 per cent is unacceptable.

In the past year, the financial product that has been attracting the most publicity is the sukuk, a relatively new instrument that has only sprung up in the past five years. Today the size of the sukuk market is about $70bn, with growth helped by the rising oil price and the sharp fall in equities in the Gulf, encouraging investors to switch out of stocks. These instruments are designed in a similar way to conventional bonds, but pay coupon profits instead of interest.
Other instruments and asset classes starting to emerge are structured products, linked to commodity or equity prices, and hedge funds, although many bankers remain unconvinced that these funds are successfully trading. There is also debate over how far Islamic finance can replicate the conventional markets. For example, can derivatives such as credit default swaps, which offer protection against a company defaulting, be developed when any kind of speculation is banned under Islamic law?

Supervision and regulation: Experts see need for a common approach

Created 17 years ago but now expanding its operations, AAOIFI – the Accounting and Auditing Organisation for Islamic Financial Institutions – works on two levels, writes Roula Khalaf. First, it has an accounting board that issues rulings on how transactions should be booked in banks’ financial statements. It has also started giving crash courses and issuing professional certifications for accountants working in the sector.Second, AAOIFI runs a Sharia board of 17 religious scholars whose role is to try to unify the various opinions issued by religious scholars on behalf of individual institutions. AAOIFI’s Sharia board rules on the Islamic credentials of financial products. Scholars on the board then abide by the AAIOFI rulings in their daily bank jobs.

The organisation, however, faces serious constraints. Set up by the industry itself, AAOIFI has no power of enforcement. With a permanent staff of only 15 – and an additional 40 outside consultants – the organisation’s resources are also limited. Only eight countries have adopted AAIOFI accounting standards as mandatory, though many other Islamic financial institutions tend to use them.Mohamed Nedal Alchaar, head of AAIOFI, argues that organisations such as AAIOFI – another is the Malaysia-based Islamic Financial Services Board – are becoming the checks and balances on the industry. But he acknowledges that a lot more needs to be done. “The industry has to be standardised – otherwise it will be local. For it to be a real viable alternative system it needs harmony. You cannot have a product be one thing in Bahrain and another in Malaysia,” he says.

Some analysts argue that the sector requires clear and specific regulations while others say this would shield Islamic institutions from competition and promote complacency. A recent report by KMPG notes that there is little consensus in the industry on how to create reporting and governance standards.Anwar Khalifa Alsada, deputy governor of the Bahrain central bank, says Islamic banks should be separately regulated. The industry, he says, needs more transparency, particularly for depositors. Unlike conventional banks, deposits in Islamic banks are not guaranteed. That is why, he says, Bahrain now requires Islamic banks to disclose more details about profit allocation between shareholders and depositors.

Mr Alsada and others, however, say regulators have an additional job – that of educating the public about the risks and benefits of Islamic banking. Indeed, analysts say some depositors appear unaware that (at least in some cases) their bank deposits are not guaranteed.

Investment banks: Wide array of new names join the party

Earlier this year WestLB underwrote a £225m package of Islamic finance to support a leveraged buyout of Aston Martin, the racing car group, by a group of Middle Eastern investors, writes Gillian Tett. The deal marks the first time that Islamic finance has been used for a private equity, leveraged buyout in the UK. But it also highlights another key trend: as Islamic finance expands in scale and complexity, the array of western financial institutions joining the party is widening by the day.

For while a few western banks, such as HSBC, BNP Paribas, Standard Chartered and Citigroup, have been running Islamic operations for almost a decade, they are now facing competition from a host of new names. These include Morgan Stanley, Barclays Capital and Deutsche Bank – as well as smaller players, such as WestLB, which last year alone arranged around a dozen Islamic deals, worth around $4bn.There are several reasons for the trend. One is the rich business opportunities that can now be found in the Middle East, as the result of the oil boom. HSBC calculates, for example, that Middle Eastern investors have now invested some $1,200bn in international assets alone in recent years, some of which is now being repatriated as the political climate has changed.

Other analysts suggest the region could enjoy some $20,000bn of oil income in the coming years – of which as much as a third could be used in the Islamic finance sphere, Darshan Bijur of the consultancy KPMG suggests.

And even before this extraordinary forecast comes into play, the business bonanza is also creating vast corporate financing and infrastructure needs. Not all of this is using Islamic finance. Indeed, until quite recently, markets such as Malaysia were more developed than the Middle East in their use of instruments such as sukuk. However, the Gulf region is embracing Islamic finance with a speed that has taken practitioners by surprise.

But western banks have also spotted other reasons to embrace the sector. One is the fact that Islamic products can often prove to be distinctly lucrative. For, like any nascent, fast-emerging area of finance, the sector is so fragmented and opaque that it can often produce high margins – particularly where products are not commoditised.

Moreover, contrary to what a casual onlooker might suspect, western investment banks do not appear to face any significant impediment as a result of their national affiliations – or lack of Islamic roots. That is partly because they tend to distribute their products through local Islamic banks, or act with a local partner.

However, the pattern also reflects a distinctive point about the way that Islamic finance operates: namely, that the religious “brand” of any product typically rests not in the reputation of the institution that has produced it – but with the religious scholars who have approved it. Thus, western banks have entered this field by engaging the service of esteemed religious scholars who can rule on the Islamic merits of products.

Some, such as HSBC, have done this by creating a dedicated Sharia advisory board, attached to a specific Islamic banking unit. Others, such as Deutsche Bank, have created so-called Islamic “windows” (or dedicated pools of capital that are used only for Sharia-compliant finance) – but have used Islamic finance consultancies for religious advice.

Still others, such as Barclays Capital, have turned to Islamic scholars on an ad hoc basis, as product opportunities arise. Either way, by engaging renowned Islamic scholars, the banks have been able to create the necessary Islamic “branding” – whatever their origins.

However, the pattern also reflects a distinctive point about the way that Islamic finance operates: namely, that the religious “brand” of any product typically rests not in the reputation of the institution that has produced it – but with the religious scholars who have approved it. Thus, western banks have entered this field by engaging the service of esteemed religious scholars who can rule on the Islamic merits of products.

Some, such as HSBC, have done this by creating a dedicated Sharia advisory board, attached to a specific Islamic banking unit. Others, such as Deutsche Bank, have created so-called Islamic “windows” (or dedicated pools of capital that are used only for Sharia-compliant finance) – but have used Islamic finance consultancies for religious advice.

Still others, such as Barclays Capital, have turned to Islamic scholars on an ad hoc basis, as product opportunities arise. Either way, by engaging renowned Islamic scholars, the banks have been able to create the necessary Islamic “branding” – whatever their origins.

It remains an open question just how sustainable this approach will be in the long term. After all, the expansion of the Islamic financial industry this decade has occurred in a very benign credit climate. However, if markets were to crash, investors and issuers might become more discriminating about the source of Islamic products – particularly if the Sharia-compliant qualification of a product sold by a western bank ever came into dispute.
London: Capital takes a leading role

Next month London will record an-other first in the fast-growing Islamic financial services market when it holds a sukuk summit, writes David Oakley. London is the leading western market place for Islamic finance, even challenging the three main Muslim centres – Bahrain, Dubai and Malaysia – for business in some products as it takes advantage of its position as the world’s main financial hub alongside New York.

The sukuk summit, organised by the British government and the first to be held in a western country, will see central bankers, investment bankers and policymakers converge on London’s Whitehall from Europe, the Middle East, Malaysia and Japan to discuss the future of this relatively new form of finance. So far, London has unequivocally positioned itself in the vanguard. More money flows through the British capital via the most-widely used Islamic financial instrument, commodity murabaha, than in any other centre.

Last month the UK became the first western country to announce plans to issue a sukuk. It has established the first secondary market in these Islamic bonds, albeit with small volumes, and seen the first attempts at creating shariah-compliant hedge funds.Last month the UK became the first western country to announce plans to issue a sukuk. It has established the first secondary market in these Islamic bonds, albeit with small volumes, and seen the first attempts at creating shariah-compliant hedge funds.

It has also used the technical expertise at its disposal at the investment banks based in the City to develop structured instruments, such as commodity and equity linked products that follow the prices of these assets. In the retail market, it is the only country in Europe that offers Islamic banking products.

The organising of the sukuk summit is the latest in a long line of government initiatives, supported by the UK regulator the Financial Services Authority, aimed at developing the Islamic financial market.In March, the government announced draft legislation that will give companies issuing Sharia-compliant bonds the same tax relief as those issuing conventional bonds, by allowing them to offset the coupon payments on the securities against the company’s profits for corporation tax purposes.

The government has also lifted double stamp duty on Islamic residential mortgages and commercial property loans. In the past, these loans were subject to two charges as an Islamic loan involves a bank buying a property, then selling it on to an individual or business for a higher price or fee. This avoided paying interest, but was in British law considered two transactions requiring stamp duty to be paid twice.

In the west, London is in a league of its own. In the US, Islamic bonds are not permitted to exist under most state laws, while many Americans still remain hostile to Islamic finance after the September 11 attacks. In France, despite having a Muslim population of 6m – three times the size of the UK’s – the authorities and regulators have been slow to realise the potential of this sector.

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