Islamic finance must learn to resolve inner tensions

By Roula Khalaf (Available at :http://www.ft.com/cms/s/0/e0b55e5a-1d8b-11de-9eb3-00144feabdc0.html)

A small idea is developing into a big hope in the Middle East. It is that the answer to the global financial crisis lies in Islamic finance. Proponents of the $800bn industry argue that the prohibition on dealing in interest has saved Islamic institutions, preventing them from investing in all the dubious structures that have brought down high-flying international institutions. One cheerleader for Islamic finance is Humayon Dar, chief executive officer of BMB Islamic, a subsidiary of The BMB Group, the global alternative asset management company. He says he was starting to worry about his job at the end of last year because of the changing economic climate. “But I’m pleasantly surprised. The inquiries we’ve been receiving are numerous,” he says.

On the surface, the story of Islamic banking as a haven in a world torn by financial mayhem is an attractive tale. But is it more than what one analyst describes as “good marketing”? To be clear, many of the Gulf’s Islamic banks have not been immune to the financial crisis – the liquidity squeeze in the region has put pressure on these banks just as much as their conventional counterparts. The volume of sukuk, or Islamic bonds, has dramatically declined, though predictions abound that it will take off again later this year. But it is true that Islamic banks have been relatively protected because they had no exposure to securitised debt-based assets.

This fortunate condition, however, may be due to the immaturity of the industry. The financial wizards who flocked to Islamic banks in recent years had not yet engineered the synthetic structures that would pass muster with sharia (Islamic law) scholars, whose job is to sign off on the probity of products. As Emmanuel Volland, analyst with Standard & Poor’s, the rating agency, says: “Islamic banks were not caught by toxic assets as sharia law prohibits interest. At the same time, you can create and invest in very risky assets and be sharia compliant.”

In fact, Islamic banking is all about taking risk. Depositors keep their money in profit-sharing accounts and so, in theory at least, they participate in both the profits and the losses of the banks. In practice, however, banks have consistently given depositors returns that are on a par with the interest rates that conventional banks deliver. Now, as their profits decline, banks are dipping into “profit equalisation reserves” to keep depositors satisfied. But they will face a dilemma if the economic downturn continues. Devout Muslims have increasingly migrated to Islamic banks in recent years, but will the trend survive if some of them start losing their money?

Islamic banking has always struggled to balance the pressure to safeguard deposits against the need to abide by religious principles. Now the balancing act is more difficult to manage. Last year a leading sharia scholar questioned a popular type of sukuk that promised to pay back the face value of the bond at maturity or in case of default. The scholar argued – and others had to agree – that this guarantee ran counter to the spirit of Islamic finance, which stipulates that risk must be shared.

For those who closely watch the industry, there are more pressing concerns. As a recent S&P report noted, because of a lack of liquid sharia-compliant asset classes, some Islamic banks invested in equities, exposing themselves to the correction of recent months. The leading risk today, however, comes from the exposure to the real estate market. The rating agency estimates that this amounts to 20 per cent of total loans.

When the short-term risks and the longer-term uncertainties are put together, the outlook for the Islamic finance industry looks less rosy than its supporters claim. It may have been lucky so far, and perhaps it will learn lessons from the troubles of conventional banks. But Islamic bankers will also have to think harder about how the industry can develop, and how it can resolve the tensions within.

Best Regards
ZULKIFLI HASAN
DUBAI, UAE

Note: InsyaAllah, my response to the above article will be published in the Financial Times. Just wait and see.

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  • AL BANDA CAFE, DUBAI CREEK

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