A time to reflect

What would you say have been the key features of the impact on Islamic finance, in aggregate, from the world financial crisis?

It has been well documented that the crisis in global finance has been greater in developed economies and across major international banks than in emerging markets. As Islamic finance originated in, and has been key to the growth of, a number of emerging markets, it has in some ways been less severely impacted than conventional markets. However, there are some common themes in how the economic crisis has impacted.

The first issue is liquidity. A combination of focus on asset-backed finance and absence of liquidity management instruments makes Islamic finance particularly vulnerable to illiquidity. Many banks tend to invest in illiquid assets, such as real estate, which are traditionally a long-term investment. Some of the more conventional liquid instruments, such as trade finance, do not appear as much in Islamic finance, although that is changing as Islamic banks start to enter these markets. Islamic financial institutions comply with the risk-averse principles of Islamic Law (Sharia), which does not permit speculation or gambling. Consequently, Islamic banks do not have access to some of the liquidity tools of conventional banks, such as derivatives.

The second issue is risk concentration, not only in relation to property but to the Middle East as a region, particularly given that property is the main asset in GCC Islamic finance. In addition, GCC economies have suffered from fluctuations in oil export revenues and the strength of the dollar as many of these countries are pegged to the US dollar.

Finally, Islamic finance is a nascent industry and, as such, national governments are still developing the appropriate legal infrastructure to support the market. For instance, in Islamic finance, hybrid instruments which are neither debt nor equity require specific legislation. In my view, some of the things which have occurred are necessary adjustments for what is a young industry. Islamic finance has had a honeymoon period, a wonderful journey, but now the system is facing a challenge and there is a need to standardise both the industry and documentation. That is just part of a natural evolution, a growing pain.

The comparison of sukuk against conventional bond finance may be considered a key barometer of the development of the industry. Would you elaborate in this particular field in both primary and secondary market terms?

The essence of sukuk is that it is neither debt nor equity, but a mechanism of participation in an investment. But participants who are unfamiliar with Islamic finance tend to categorise sukuk according to their experience of conventional finance. So, an issuer may regard sukuk as equity, with the investor completely at risk, whereas an investor may look upon it as debt. The documentation will give it the ‘asset-backed' treatment, but the senior bankers who market it will apply ‘name-led' perception, like fixed-income products. After all, the majority of sukuk are sold to financial institutions. I agree that sukuk is a kind of bellwether, representing the face of Islamic finance. In this respect, there is a need to be clearer as to asset quality, a need for complete transparency. This is because of the way risk is managed; the exposure for the investor is direct and is not qualified by derivatives.

There has been a severe dip in the primary market, which Moody's, for instance, has tracked very well. The market has been interrupted by recent activity in the capital markets, wherein Middle East liquidity has been sharply affected. While Malaysia has issued a phenomenal amount of sukuk, we expect issues from the Middle East to increase significantly over the coming years.

On the secondary side, there has been very little trading over the past 12 months, although this is picking up. The majority of sukuk are bought to hold. The market is in fact craving regular quality issuers, such as the Islamic Development Bank's MTN programme.

Would you comment on whatever regional variation there has been in that assessment, i.e., Far East, Middle East, Western experiences? Has there been any discernible shift between the centres from this episode, or in fact across the past decade?

The impact on Gulf issuers has been quite significant, as the market has been marked by the Dubai experience. There is also caution about the legal issues surrounding property, the concept of beneficial ownership, and of recourse to the asset in the event of default, i.e., how available is the asset at the heart of the transaction, considering that sukuk is meant to mean unitary, shared ownership.

Malaysia, which has a strong domestic capital market, has been relatively undisturbed. The country has extended its leadership in sukuk issuance relative to other markets, and has come closest to developing a standardised product. But the liquidity available in Malaysia is not being seen in other markets. In the UK and Europe the main issue has been taxation, and these mature markets are still seeking to resolve this issue. The UK is leading Europe in creating a welcoming market for Islamic finance. Due to the distractions of the bigger crisis, however, it is taking longer than initially thought for most governments to change the relevant legislation.

As for the rest of the world, notably the US, evidence has shown an appetite for dollar issuance. Two examples may be mentioned. In the first, an oil rig-based (ijara) transaction in the Gulf of Mexico has showed that if sukuk documentation is not done well, transactions can run up against litigation, and there are instances where Islamic businesses have to go through conventional court systems. In the second instance, GE Capital's sukuk issuance [Aa2/Stable-rated] proved that a well-structured, asset-backed programme that is attractively priced will succeed, diversify issues' funding and participants' investments and, ultimately, lead to more issuances.

How about the Gulf specifically? What is your view of its emergence from this traumatic episode, including Dubai's story? Do you detect a rebalancing of portfolios and type of Islamic finance exposure in the Gulf, re-examining the focus on real-estate-related business and due recognition of risk?

There are three points to make regarding the impact of Dubai:

Firstly, sukuk is a relatively new capital market instrument that requires a new investor mindset for investment. Presently it is bought on a buy-to-hold basis, primarily by financial institutions. As investors learn more about sukuk and understand its asset-backed structure and cashflow, one can expect more market activity and trading volume in sukuk, which should encourage liquidity and increased issuance and depth. We continue to experience strong interest and support from the Gulf, specifically from financial institutions and, increasingly, from a trade finance perspective.

Secondly, confidence needs to be restored in the financial status of the government-related entities (GREs), particularly in Dubai. When GREs issue sukuk, investors expect government support behind the issue, and any deviation affects the credibility of sukuk in the market.

Thirdly, the (unnecessary) complexity of some sukuk transactions, while not the same as risk per se, is offputting to investors, and encourages undue comparison with complex and riskier conventional banking deals. BLME has been working on the structure of sukuk and liaising with the UK tax authorities to create a tax and regulatory environment that is conducive to a sukuk issuance.

How would you compare the profiles of Islamic finance versus its conventional counterpart in terms respectively of the banking and investment domains?

Let's just say that in terms of opportunity there is one big difference between the conventional and Islamic spheres, namely the ability of retail Islamic banking to be taken to people's hearts in the Muslim nations, e.g., in Turkey.

Otherwise, the model for Islamic finance has historically been regarded as ‘clunky'; it didn't have an equivalent range of products as conventional finance and, when it mimics them, they can be cumbersome to use (for example, there is no such thing as an overdraft). It is one reason why BLME came along on the wholesale side, to be a catalyst for developing institutional products. Some Islamic contracts such as partnership (Musharaka) and investment models (e.g. Wakala) lend themselves very well to mutual fund and private equity business, whereas the use of others such as sales (Murabaha) and leasing (Ijara) can be widened and better adopted to offer a wide range of financing tools.

The lack of homogeneity in Islamic financial regulation is taken to be a continuing restraint on the sector's growth. How problematic is this absence of common standards, epitomised by an apparent distinction between the Gulf and Asian (Bahrain versus Malaysia) approaches? How important is it that some form of accepted harmonisation is adopted?

Ideally, there would be common standards. But in fact I don't believe it would resolve these issues. It would also be wrong to introduce one set of regulations just to satisfy bankers; Islamic finance relies on the faith and trust of its investors and has to respond to the needs of its customer base. One has to respect that there is a common set of principles, i.e., Sharia, but that differentiation is allowed. This issue is likely to recede as the growth of Sharia-based banks displaces Sharia ‘windows', which will enable a stronger platform on which to develop compliant products. The incentive is for collaboration between different centres rather than competition in this respect, which is a trend that we are beginning to witness.

What do you make of the various efforts of different centres, around the world to generate Islamic business, and the likely result or pecking order?

Malaysia is well ahead commercially because, under their interpretation and approach, they have developed something quite robust. The GCC will bounce back because, apart from its foreign exchange and budget surpluses, it has significant appetite for Islamic finance, is politically stable, and continues to show significant demand for investment.

The Organisation for Economic Co-operation and Development (OECD) centres will help to internationalise Islamic finance and consolidate provision. Indeed, the biggest change will come from successful issuers in these established financial markets, such as GE.

Just through their existence, the fringe Asian centres will be fundamental to overall development, rounding off the global presence of Islamic finance.

Where do you perceive London in this array, considering its deliberate efforts to build on its traditional strengths? What about the political background of the damage that the past couple of years has done to the City, and the European dimension?

It is widely recognised that London and the UK are driving growth in Islamic finance. Each year's Finance Act brings a positive legislative adjustment. Only the US can rival development in finance under English law in its openness or in making Islamic finance accessible. The UK has a considerable headstart however, and in 2009 it became possible for a UK issuer to use a property-backed asset for an ijara structure. We also have the weight of the international banks in this market to push Islamic finance forward.

As for the international crisis and its aftermath, Islamic finance has considerable opportunity, because it has a back-to-basics approach. Fundamentally, it is an asset-backed, risk-averse and transparent financial system of the type being promoted by governments and regulators.

In the UK especially, the Muslim population, of which there are approximately three million, is of particular relevance, as politicians are keen to integrate the Muslim community into the wider society, including the economic and financial spheres. The wider availability of Islamic finance will help to facilitate this process.

Please explain how you see BLME fitting into this construct and market locally? What is its strategic approach, and how is it evolving?

BLME is the largest Islamic bank in Europe, with £250 million (Dh1,359 million) in paid-up capital, with the majority of shareholders being Kuwaiti institutions and individuals. All of BLME's offerings are Sharia-compliant; however the principles of Sharia law (no speculation, transparency and partnership) are appealing to all sectors and businesses, not only to those seeking Islamic financing. These are companies which had a ready choice of options, but were attracted to Islamic finance through relationships, initially, but which then serve as precedents for others to follow.

Examples include SMEs such as Thamesteel (trade finance), Eddie Stobart and Ocado (lease finance) and property financier Chelsfield.

Naturally, as a new bank, we initially build up exposures focused on a small client base, offering Treasury and Corporate Banking (property, lease and trade finance) services. To diversify our exposures we have concentrated on building our product offering and deposit base. Early last year BLME also successfully launched Private Banking and Asset Management divisions. We have also recently introduced a Premier Deposit Account with attractive (profit) rates, both to strengthen the funding base and generate brand awareness.

- The viewpoints expressed herein are those of Dr Janekeh and do not necessarily represent those of BLME.