Features : Sharing In Risk And Reward - Global Finance Magazine

SECTOR REPORT / ISLAMIC FINANCE

The range of Islamic finance techniques is growing rapidly, but some are concerned that the most innovative products may be flouting shariah principles.

While conventional financial markets are still reeling from the credit crunch, and the mega-mergers and large-scale financing deals that were once a headline feature have all but disappeared, one area where dealmaking is growing at breakneck speed is Islamic financing. Far from experiencing a pullback, Islamic financing is seeing increasingly innovative and larger-size deals being struck.

As evidence, Qudeer Latif, a partner at law firm Clifford Chance in Dubai, points to a landmark deal the firm advised on. Project Blue, which is majority owned by Qatari Diar Real Estate Investment Company, was able to arrange a $2.5 billion syndicated financing facility for its acquisition of London’s Chelsea Barracks. The deal was remarkable not only for its size—it was the largest Islamic financing ever on a UK property—but also for its ability to achieve a fully shariah-compliant financing structure that complied with complex UK tax regulations.

“A lot of work had to be done,” Latif explains. “We presented contracts to our shariah advisory board, and we were able to come up with a structure that was shariah compliant and legally enforceable from a tax perspective.”

Innovation in Islamic financing is only beginning. Looking ahead, Latif also talks about Islamic securitization in the conventional sense, with no recourse to corporate credit, and Islamic acquisition financing, which he says is growing based on high-profile transactions such as a consortium of Kuwaiti investors raising $1.4 billion to finance their acquisition, alongside other investors, of UK luxury-car manufacturer Aston Martin.

Islamic scholars and financial service providers are also exploring whether more complex instruments can be made shariah compliant. Latif says Islamic equivalents of interest rate and FX swaps are in the pipeline. There is also talk of Islamic equivalents of derivatives and hedging products. The Bahrain-based International Islamic Financial Market (IIFM), made up of central banks and monetary agencies from the Middle East and Asia, is working with the International Swaps and Derivatives Association (ISDA) on documentation for shariah-compliant derivatives products. “On the derivatives side we are not talking about speculative derivatives, but we are looking at them from a risk management perspective,” says Ijlal Alvi, CEO of IIFM.

Branching Out

Islamic banks are also shoring up their positions in Western markets. Recently, the UK’s Financial Services Authority approved two new Islamic investment banks, European Finance House (EFH) and Gatehouse Bank, which is the subsidiary of The Securities House KSCC, one of Kuwait’s leading investment companies. David Testa, CEO of Gatehouse Bank, says he expects there will be 10 Islamic banks in London by the end of next year, with most of them focused on investment banking. “I hope that Islamic banking will add some credibility to the investment banking sector,” he says.

Testa: Islamic banking will add credibility to the financial sector.

Even conventional banks and financial centers are waking up to the possibilities of Islamic financing. In January leading UK high street bank, Lloyds TSB, introduced an Islamic “nostro account,” which enables money being transferred across borders between accounts to be held in a shariah-compliant way. Lloyds is believed to be the first Western bank to provide such an account. “Islamic finance is certainly no longer niche; it is mainstream,” says Nik Norishky Thani, executive director of Islamic Finance at the Dubai International Financial Centre (DIFC). He points to the growing levels of global interest in Islamic financing coming from financial centers such as Hong Kong, Singapore, Switzerland and France.

Islamic assets under management reached $750 billion in 2006, and the Islamic financing sector is projected to reach $1 trillion by 2010, growing at a rate of between 15% and 20% annually. But as the industry targets an increasingly widespread and diverse investor base, including non-Muslim investors seeking portfolio diversification, Islamic financing is having to grapple with some growing pains.

“Having more players getting involved in Islamic financing is a good thing,” Thani continues, “but it does create challenges in terms of creating transparency about the real growth of the industry. There also needs to be better corporate governance and reporting.” In the sukuk (Islamic bond) market, for instance, Thani says most of the transactions are over the counter (OTC) and unreported. “This has to change. Regulators need to step in and start imposing transparency,” he says.

Testa of Gatehouse Bank believes the challenge for Islamic banks is to be seen to be doing the right thing. “There is an old-fashioned air about Islamic banking; it is straightforward asset-based or asset-backed financing,” he says. But as Islamic financing moves into more complex areas such as derivatives and hedge funds, questions are being asked as to whether the industry should strive for an Islamic equivalent of every conventional financial instrument.

Testa is adamant that Islamic financing cannot “be all things to all men.” “There are a lot of areas we can never do, such as financing Guinness, for example,” he explains. He says that some parts of the industry may be trying to replicate conventional financial products but that Gatehouse is “selective” in opportunities it pursues and focuses on what being shariah-compliant means, which is backed up by a strong advisory platform comprising leading Islamic scholars. “The way in which the [Islamic financing] industry is developing, it is focused on the best-quality assets,” he asserts.

Siddiqui: Islamic investing could be considered an “alpha” strategy.

For Islamic financing to be successful, it needs to have similar breadth and access to financing solutions currently available in the conventional markets, says Thani of the DIFC. “That does not mean merely copying them,” he explains. “We need to provide a bona-fide alternative to conventional financing. That means financing in a manner that meets the core of Islamic financing’s objective—investing and finance in a responsible and ethical manner.” Fundamental principles such as no usury, the prohibition of uncertainty (gharar) or speculation, and prohibiting investment in illegitimate or haram activities (gambling, alcohol) form the core of Islamic investment. It is these principles, says Thani, that helped Islamic banks avoid exposure to the subprime crisis that has plagued Western banks. “Islamic banks were not exposed to it because the fundamental Islamic principles did not apply to subprime assets,” he says.

Rushdi Siddiqui, global director of the Dow Jones Islamic Market Indexes, says Islamic investment is a style of investing that uses financial screens that can be classed as an “alpha” investment strategy. The screens he is referring to are financial-ratio screens that Dow Jones uses to decide which stocks should be included in any one of its more than 70 Islamic stock indexes.

“If a company has too much debt, non-operating interest income or high accounts receivable, it will not be in the index,” says Siddiqui. A large amount of accounts receivable means sales are not translating into earnings, which has an impact on the stock price, he explains. Similarly, if a company has too much cash generating interest income, it means that income is not being plowed back into the business, which also affects stock price.

Using debt screens, Siddiqui says they were also able to identify “highly leveraged” companies like WorldCom and Enron, which were removed from Islamic stock indexes.

Treading a Fine Line

At times it seems that Islamic financing is not that far removed from conventional financial markets. The Islamic equivalent of bonds or fixed income is the sukuk, which is asset-backed, and the return is yielded by leasing the asset. Some sukuk are even linked to the London Interbank Offered Rate (Libor), which is based on the interest rate at which banks lend unsecured funds to one another.

Earlier this year Sheikh Muhammad Taqi Usmani, chairman of the board of scholars of the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), stated that 85% of Islamic bonds were structured too much like conventional bonds. He was referring to those sukuks that contain repurchase agreements, which state that the borrower will pay back the face value at maturity. According to Usmani, the repurchase agreement goes against the risk and reward sharing principle of shariah. Alluding to his remarks, Siddiqui said any industry that is “embryonic” is bound to experience growing pains, but that the challenge was not to stifle the growth of the industry.

Thani believes questions surrounding the validity of some sukuks under shariah law should not be debated on the fringes of seminars but by a central platform, similar to the World Bank, for example, where any scholar and practitioner could bring up issues they had in a more constructive way. “The industry does not have an adequate platform to address and solve these issues,” he says.

While there are differing thoughts on jurisprudence under shariah law, Thani says everyone in the industry works toward a consensus or “centrist view,” which means that extremely liberal or very narrow views are generally not accepted by scholars or practitioners. “With standardization, what we are really trying to achieve is a consensus,” he explains, “but we don’t want to codify Islamic principles, as that could curtail the development of Islamic finance.”

Siddiqui is encouraged by the increasing “exchange of ideas” between more liberal scholars in the East and those in the Gulf. “There is a growing understanding,” he says. “That does not mean that the more liberal scholars have got it wrong all along. It is going to take time for harmonization.”

Sharing in risk and reward is a fundamental principle of Islamic investment. But to what extent can the Islamic financing industry remain true to these fundamental principles as investor demand for new and more innovative products increases? Latif of Clifford Chance believes that the shariah scholars will say, “Enough is enough, this is no longer shariah compliant,” if eventually innovation in the Islamic financing space goes too far. “But,” he adds, “we are some way off that stage yet.”

Anita Hawser