Sovereign wealth fund over mega bank?

At this year's NBAD's Global Financial Markets Islamic Forum in Abu Dhabi, I was requested to make a presentation on an Islamic sovereign wealth fund (SWF). That's an appropriate topic for an appropriate audience at the appropriate time.

The Islamic finance industry, as part of Islamic finance 2.0, needs to move away from product pushing to a more holistic approach, which includes big "ticket" offerings while becoming "conventionally efficient." An Islamic SWF would fill both roles for asset management.

The industry has been talking of an Islamic mega bank for a few years, from Al Baraka Banking Group chairman Shaikh Saleh Kamal to Malaysia's central bank Governor Zeti Athar Aziz, but will it have an OIC or G20 impact?

In the post crisis period, G20 regulators are examining ways and means to reduce the systemic risk associated with the mega banks. Islamic finance industry, without a lender of last resort and sporadic Islamic deposit insurance, needs to examine the suggestions before wholesale adoption of a proposed mega bank.

To understand a SWF, we need to de-mystify it before looking into the merits of an Islamic SWF. Additionally, we also need to look into the ideal western "model" of an SWF for asset class exposure and ask, "are there sufficient liquid Islamic asset classes for a diversified portfolio?"

One of the best definitions of a SWF is provided by Monitor Group/FEEM:

It is owned directly by a sovereign government
It is managed independently of other state financial institutions
It does not have predominant explicit pension obligations
It invests in a diverse set of financial asset classes in pursuit of commercial returns
It has made a significant proportion of its publicly-reported investments internationally

Here, three major points for an Islamic SWF include:

Ownership by OIC country. Should it be a country, bilateral or multi-lateral fund?
Funding of the fund via commodities, trade surplus, etc., and
What is the mandate of the fund? Is it for future generations, rainy day, Islamic lender of last resort, etc.?

Unintended exposure

Next, the "model" SWF for transparency has been Norway's oil fund, and examining third quarter 2010 asset class exposure provides some hope for an Islamic SWF. Table 1 shows the fund's largest equity holdings as of September 2010, with bias towards G7 countries and emphasis on telecommunications, energy and basic material sectors.

The same bias exists with global Islamic equity funds. Nine out of the 10 companies in Table 1 are Sharia compliant, excluding HSBC Holdings.

Thus, SWFs have unintended exposure to Shariah compliant companies as the global universe of compliant companies, according to S&P data, is nearly 3,000 companies with market capitalisation of $15 trillion (Dh55 trillion) at the end of 2010.

The challenge is on the fixed income exposure.

Sensitivities

Table 2 shows the fund's largest bond holdings as of September 2010. Concern for an Islamic SWF is accessing benchmark-sized sovereign or quasi sovereign sukuk. Outside Malaysia, sovereign sukuk and Islamic Development Bank (IDB), there are size and supply constraints in the $150 billion sukuk market.

Beyond equity and bond exposure, alternative asset classes are commonly utilised by SWFs, including hedge funds, private equity, commodities, REITs, real estate, FX, securities lending and so on. But how many of these asset classes may become Sharia compliant?

An SWF, as advised by western consultants, acquire strategic and financial stakes in companies across countries that may include board seats. Yet some G7 country politicians, both well-meaning and publicity-seeking, have inquired about SWF's intent, especially those from China and the GCC countries. The issue becomes more pronounced during election year cycles.

To date the record of SWF objectives has been both commercial and long term passive investors. Furthermore, distressed western companies, like Barclays, have tapped SWFs as "white knights" because of their deep pockets and quick turn-around time.

However, an Islamic SWF will have to jump through more hoops to prove their "commercial intent" over alleged back-door creeping of Sharia for portfolio investments in G20 countries. This is a failure of the Islamic finance industry to professionally lobby and properly establish a public relations and marketing industry body, much like AAOIFI or IFSB.

Finally, according to the Monitor/FEEM Research, there are 35 SWFs and 54 per cent are from Muslim countries. An Islamic SWF would not only spark Islamic asset management and Islamic equity capital market but would also have a global reach.

In the absence of more Muslim countries with the will, vision and gravitas to start discussions for an Islamic SWF, who will lead? UAE and/or Malaysia?

The writer is head of Islamic Finance at Thomson Reuters. Opinions expressed are in his personal capacity.

Indicators

Table 1