Guambat Stew: The dawning of Islamic finance

It is beginning to dawn on the financial press, ever so slowly, that there is a fundamental difference between Western finance and Islamic finance, as Guambat has railed on about of late.

The WSJ has a story today that, when read far enough down into it reveals:

Because Islamic law forbids the paying of interest, a sukuk isn't organized like a traditional bond. Instead, it is set up to collect a stream of income from a group of underlying assets.

At issue is whether the holders of the sukuk can take possession of the underlying assets, or whether they are simply entitled to the cash flows those assets produced.

Because there is no real precedent for this type of situation in the Dubai courts, and because the sukuk holders are effectively taking on the government, they will have to tread carefully as they try to protect their interests.

The NYT Dealbook has also reported similarly, but more expansively and first person, on the same notion during the last day, noting Dubai World was not just a one-off event but the leading edge of what was expected to be the development of new fields of global finance, and harvests of banking and legal fees, nearly as large as the oil fields of Arabia:

A Financial Mirage in the Desert

It was about two years ago, and I was in Dubai to cover an investment conference at a hotel along Jumeirah Beach. Hundreds of Western bankers dressed in Savile Row suits were packed into an enormous room to bone up on the intricacies of the next new thing in financial products: Shariah-compliant investments.

They wanted to sell them to wealthy, oil-rich Muslim investors who needed a way to increase their fortunes but whose options were limited. Any investment vehicle needed to conform to the spirit of the Koran, which forbids any investments that pay interest. No mortgages. No bonds. No clever derivatives. Just tangible assets in the so-called real economy.

It was a big honey pot — worth as much as $1 trillion that could yield billions in fees — and the bankers were determined to find a way in.

One discussion was led by a British banker from Barclays who had moved to the region to create an entire Shariah-compliance team. He shared tips about various ways to create “structured products” that would pass muster with Muslim investors. (To me, the investments looked like bonds, walked like bonds and talked like bonds — but he never called them that.) Some of the bonds that Dubai World is in jeopardy of defaulting on, by the way, are Shariah-compliant sukuk. Just don’t call them bonds.

With the benefit of hindsight — and you didn’t need much — there were plenty of other signs back then that Dubai was building a financial mirage in the desert.

And what became of all those Shariah-compliant financial instruments that were the hot topic of that panel I attended? It turns out that many of them that were sold prior to the crisis weren’t compliant at all.

The Shariah Committee of the Accounting and Auditing Organization for Islamic Institutions, which is based in Bahrain, ended up changing the rules to make them stricter because of widespread abuse. As Mr. Buiter described them on his blog, “these were window-dressing pseudo-Islamic financial instruments that were mathematically equivalent to conventional debt and mortgage contracts.”

Blessings, alas, can do only so much.

It's a great read. Please do.

Additional readings:

What can Nakheel sukuk holders expect in a default? This article is one post in a blogsite that has extensive coverage of the current Dubai crisis. In this post the blogger discusses in minute detail the structure and undertakings of the Nakheel sukuk that shookuk Dubai, concluding:

there are a tremendous number of uncertainties about the procedure for investors to enforce upon the various guarantees and collateral provided in the sukuk structures that would appear to give investors a claim on more than just the unsecured pledge of Nakheel and Dubai World, but in all cases, there is a lot of doubt about whether they will end up being legally enforceable.

These factors probably point towards some type of restructuring of the sukuk, rather than an outright default and legal challenge by investors.

Any restructuring would probably avoid a large mess, but would do nothing to clarify how the legal system would react in a similar situation in the future

From back in 2007:

Islamic Banking-Sukuk and Murabaha By Maurice Shohet 08/20/2007

Islamic banking is based on Islamic law and principles known as shari'a. It is equivalent to traditional banking in that payment for the investor, and for that matter collection for a borrower, is done through a share in profit rather than through interest. Islamic banking prohibits investment in companies, or lending to companies, that do business or trade in pork, alcohol, gambling, pornography, and entertainment.

Islamic banking has expanded considerably in recent years, and it is no longer restricted to banks owned or operated by Muslims. Increasingly, multinational banks have opened their own branches or windows dedicated to practicing Islamic banking. Some financial experts believe that as businesses diversify their investor base, Islamic banking will move to the mainstream as a viable financing option.

A recent "Standard & Poor's" report indicated that the current Islamic financial institutions can only provide services to 15% of the market needs (for financial services) of Muslims around the world. The report estimates the volume of financial assets compliant with Islamic law stands today at about $400 billion.

Islamic finance includes stocks, real estate investments, insurances, currency swaps compliant with shari'a, sukuk (Islamic bonds based on profit sharing rather than interest payment) and "Murabahat al-Sil'a" (a trading transaction where a bank sells a specific commodity at a price plus a specific profit agreed upon in advance).

The Islamic financial bonds (sukuk) are relatively new instruments and only came into existence during the past five years. They comply with Islam's ban on lending on interest and the trading of debt, and are backed by physical assets.

In the world of Islamic economies sukuk are equivalent to the financial bonds in the traditional world of the financial industry. They are tools used by financial institutions to raise cash.

The sukuk are proof of ownership title in a particular asset. They are distinguished by the need for the actual existence of the asset, as well as by their circulation potential in the Islamic financial markets.

Today's sukuk volume is estimated to be about $70 billion. The proceeds from Islamic financing are estimated to be $3 billion/day via London-the main center of the short and medium term financial transactions that are consistent with the provisions of shari'a. About 65% of the total value of the Islamic financial industry flow through the Gulf states and Malaysia

The term murabaha is derived from the Arabic word ribh which means profit. It is also known as mark-up or cost-plus financing.

This financial technique is the most popular and common mode of Islamic financing. It involves a contract between a bank and its client for the sale of goods at a price that includes a profit margin agreed upon in advance by both parties.

The process starts when a bank, at the request of a client, purchases for cash a certain object or commodity which the bank, in turn, sells to the client who requested the purchase at a profit. Since the client has no cash, otherwise he would not have resorted to the bank, the client buys the item on deferred payment. Repayment, usually in installments at certain intervals, is specified in the contract.

One important requirement of the murabaha sale process is that the sale contract through which the bank acquires the commodity and the sale contract through which it sells it to the client, are separate transactions.

Some critics have questioned the alleged religious foundation of murabaha because the profit margin attached to the total amount of the sale is tantamount to riba or interest in disguise. However, experience teaches that in theological disagreements on matters of finance, reality always gains the upper hand.