Robin Wigglesworth in Abu Dhabi
December 9 2009 17:17
The Islamic finance industry may have recently breached the symbolically important $1,000bn mark in assets, but the past year been far from plain sailing, in spite of claims that the industry’s model is inherently more robust than conventional finance. Islamic financial institutions have proven equally susceptible to a global economic downturn and property correction as their larger conventional peers. More recently, potential exposure to Dubai has exacerbated concerns in the industry.
Dubai has been an active issuer of Islamic bonds, known as sukuk, and the exposure of Islamic banks to the emirate’s debt pile has caused the cost of financing to rise greatly during the past two weeks and triggered a rash of credit agency downgrades.
“Islamic banks have a very large exposure not only to Dubai but to structured finance in general,” says Nish Popat, regional head of fixed income at ING Investment Management.
The Islamic interbank rate is small and opaque, and rates are hard to gauge, but Mr Popat estimates the cost of overnight and short-term funding has shot up 100 basis points since Dubai announced it was restructuring $26bn of debts at its Dubai World conglomerate.
The cost of longer-term financing, procured through bonds and bank loans structured to comply with Islamic principles, has also soared – just as repayments loom for many Islamic financial institutions.
“A credit committee in New York and London views this region as one, and don’t necessarily differentiate,” says Nabeel Kazerooni, head of private equity at Gulf Finance House, a Bahrain Islamic investment bank. “Islamic banks are facing refinancings that they’ll now have a hard time with.”
Mr Kazerooni estimates that the cost of longer-term financing has gone up by “at least” 300 basis points.
Dubai’s sukuk is not the only concern for the industry. Islamic banks avoided exposure to subprime investments and conventional complex debt instruments thanks to a prohibition against interest, but a relatively high exposure to real estate is starting to prove painful, bankers say.
“When crises happen they impact all financial institutions – Islamic or conventional to the extent of their exposure to those underlying markets,” says Iqbal Khan, chief executive of Fajr Capital, an Islamic investment company.
The industry is also facing an internal debate over its direction, and controversy over the “Islamic-ness” of many of its products and services.
Last year a senior Islamic finance scholar shocked the industry when he said many Islamic bonds did not comply fully with Muslim principles. The Islamic debt market recovery has subsequently lagged behind conventional bonds, and uncertainty around sharia interpretation continues.
“The industry needs clarity,” says Neil Miller, head of the Islamic finance practice at lawyers Norton Rose. “We don’t want to come up with a structure, get it approved by the scholars, only to find out that 12 to 18 months down the line the structure isn’t compliant any more. This induces a level of reputational risk that is hard to deflect.”
The sukuk market is not the only area affected by a renewed focus on ensuring compliance with sharia law.
Last April, the International Islamic Fiqh Academy, an influential group of scholars and clerics, ruled that a popular instrument known as tawarruq was also being misused.
Tawarruq allows customers to buy a commodity from an Islamic bank with a deferred payment date, and then immediately sell it back to the bank at a lower price – in effect borrowing money in a way that in theory is sharia compliant.
The instrument’s flexibility has meant its use has exploded, both as a means of borrowing money but also as a liquidity management tool for banks.
However, scholars have always said it should be used only as a last resort, and involve a third party. Its widespread use – and resemblance to a conventional loan – led the Fiqh Academy to rule that “organised use” was no longer allowed, dealing a potentially serious blow to the industry, experts say.
Some industry insiders say Islamic finance will always face a certain amount of disagreement, as it attempts to reconcile modern finance with religious law that incorporates many schools of thought.
Yet high-level disagreements on sharia interpretation and a financial crisis have not quelled grassroots demand for Islamic financial services, experts say.
Bankers are particularly enthusiastic about the potential in populous, largely untapped markets such as Egypt, Pakistan, India and Indonesia.
“The industry doesn’t have as strong fundamentals as it likes to think. At the end of the day people will go with the best returns, service and transparency, and if we don’t improve Islamic financial services, people might start staying with or returning to conventional finance.”
The settlement of Dubai's $4bn sukuk settlement now represents a looming litmus test for Islamic finance, and one that will have to be resolved before the industry regains its former vim, bankers say.
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